Rise of Cross-Asset Correlations

Save this PDF as:
 WORD  PNG  TXT  JPG

Size: px
Start display at page:

Download "Rise of Cross-Asset Correlations"

Transcription

1 Global Equty Dervatves & Delta One Strategy Rse of Cross-Asset Correlatons Asset Class Roadmap for Equty Investors Summary Cross-Asset Correlatons: Over the past ten years, cross-asset correlatons roughly doubled. Globalzaton of captal markets, and new rsk-management and alphaextracton technques have drven the secular ncrease of cross-asset correlatons. The recent cyclcal ncrease s a result of elevated macro volatlty. We beleve that understandng the fundamentals and techncals of cross-asset correlaton wll be an ncreasngly mportant task for nvestors. Currences: The ncreasng share of EM equtes, US and Japan debt, and the declnng share of US equtes n Global market captalzaton s an mportant drver of correlaton between currences and equtes. Rsk-on/off tradng, currency carry trades, and cross-asset arbtrage are further strengthenng ths correlaton. Interest Rates: Investors who decrease rsk exposure usually sell equtes to buy Treasury bonds. These rsk flows cause a postve rate/equty correlaton. Postve rate/equty correlaton and a breakdown of the so-called Fed Model occurred n 1997 when three successve crses caused global de-rskng and a flght to Treasures. Rsk of a correlaton reversal s posed by severe stagflaton or treasury/ equty contagon. Commodtes: Hstorcally, dversfcaton benefts resulted n sgnfcant nvestment nterest for commodtes. The tradtonally negatve correlaton to equtes reversed sharply n 008, as a result of deleverng and demand destructon. About 4 of current commodty/equty correlaton s a spllover from FX/equty correlaton. Despte dversfcaton benefts, commodtes are not mmune to tal events such as the one recently exhbted by slver. Credt: Wth current correlaton of ~8, credt, equtes, and equty volatlty are the most correlated assets. Correlaton of credt and equtes s logcal as both are prced based on the value and volatlty of company assets. In practce, correlaton s drven by captal structure arbtrage and hedgng of credt wth equty nstruments. Equtes: Due to the globalzaton of captal markets, cross-regonal equty correlaton rose steadly over the past 0 years. Recent hgh levels have dmnshed the benefts of cross-regonal dversfcaton. Macro volatlty s a more sgnfcant drver of sector and stock correlaton. Specfc rsk-management and alphaextracton trends mpactng correlaton were dscussed n our report: Why we have correlaton bubble. Alternatve Assets: Low correlaton between strateges and ablty to generate alpha make hedge funds an attractve asset class. Over the past ten years, hedge fund assets ncreased notably relatve to the sze of global equty markets. Dscplned rskmanagement technques and alpha extracton employed by hedge funds lkely contrbuted to the secular ncrease of correlatons. Hybrd Dervatve Trades: In ths secton we hghlght several trade deas that take advantage of current levels of cross-asset correlatons. Equty hedges contngent on nterest rates, currences, or commodtes can sgnfcantly reduce the cost of equty hedgng and be talored for specfc scenaros such as US stagflaton or a debt crss. Global Equty Dervatves & Delta One Strategy Marko Kolanovc AC (Global Head) J.P. Morgan Securtes LLC Davde Slvestrn (EMEA) (44-0) J.P. Morgan Securtes Ltd. Tony SK Lee (Asa Pacfc) (85) J.P. Morgan Securtes (Asa Pacfc) Lmted Mchro Nato (Japan) (81-3) JPMorgan Securtes Japan Co., Ltd. Equty Dervatves Strategy US Marko Kolanovc Adam Rudd Amyn Bharwan Kapl Dhngra Mn Moon EMEA Davde Slvestrn Bram Kaplan Peng Cheng Asa Ex-Japan Tony Lee Clara Law Sue Lee Japan Mchro Nato Hayato Ono See page 6 for analyst certfcaton and mportant dsclosures, ncludng non-us analyst dsclosures. J.P. Morgan does and seeks to do busness wth companes covered n ts research reports. As a result, nvestors should be aware that the frm may have a conflct of nterest that could affect the objectvty of ths report. Investors should consder ths report as only a sngle factor n makng ther nvestment decson. In the Unted States, ths nformaton s avalable only to persons who have receved the proper opton rsk dsclosure documents. Please contact your J.P. Morgan representatve or vst

2 Table of Contents Drvers of Cross-Asset Correlatons...3 Rse of Cross-Asset Correlatons...3 Correlaton Rsk/Reward...4 Volatlty, Rsk Management, and Alpha as Drvers of Correlaton...4 Currences...7 Rsk On/Off and Global Currency Flows...7 Interest Rates...10 End of Fed Model and Use of US Treasures as Global Rsk-Free Asset...10 Commodtes...1 Slver Bullet for Asset Allocaton...1 Credt...15 Captal Structure Arbtraged...15 Equtes...17 Why We Have a Correlaton Bubble...17 Alternatve Assets...19 Hedge Funds and Correlaton...19 Hybrd Dervatve Trades...1 Implementng Cross-Asset Vews...1 Appendx: Smple Correlaton Model...4

3 Drvers of Cross-Asset Correlatons Rse of Cross-Asset Correlatons Correlaton measures the degree to whch prces of assets move together. Over the past decade, nvestors wtnessed a sgnfcant ncrease of correlaton between equtes as well as an ncrease of correlaton between other rsky assets such as credt, foregn exchange, nterest rates, and commodtes. 1 Hgh levels of correlaton usually pont to a common source of rsk for asset prces. In tmes of hgh macro uncertanty, the prces of equtes, rsky bonds, ol, gold, and emergng market currences are largely drven by changes n the macroeconomc outlook. In addton to a recent ncrease due to macro volatlty, cross-asset correlaton has been on a secular rse due to changes n market structure. Integraton of global economes, ncreased effcency and globalzaton of fnancal markets, and new rsk-management and alpha-extracton technques have all contrbuted to a rse n cross-asset correlaton levels. In ths report we dscuss trends n cross-asset correlatons and ther mpact on nvestors. Fgure 1 shows the average correlaton between 45 developed world and emergng market country equty benchmarks contaned n the MSCI All Country World Index. Over the past 0 years, the average correlaton between these country benchmarks roughly doubled. Ths secular ncrease of cross-regonal equty correlaton s a result of the ntegraton of global economes and captal markets. Lberalzaton of flows of goods between economes (free trade, outsourcng of labor), the rse of Emergng Markets (e.g., BRICS), and globalzaton of the fnancal ndustry (e.g., global banks and hedge funds) all contrbuted to the ncrease of cross-regonal correlatons. Whle the globalzaton of captal markets reduced dversfcaton and cross-market arbtrage opportuntes, the benefts of globalzaton are mmense the rapd growth of emergng economes has led to mproved economc well-beng for bllons. Smlar to cross-regonal equty correlaton, the correlaton between equtes, credt, foregn exchange, nterest rates, and commodtes all ncreased over the past two decades. Fgure shows the average levels of cross-asset correlatons for the tme perod, and compares them to the average correlaton levels over the past fve years. On average, correlatons between dfferent asset classes more than doubled. Each of these cross-asset correlatons wll be dscussed n the rest of the report. Fgure 1: Globalzaton Rse of Correlaton Between Equty Market Benchmarks for 45 Emergng and Developed Economes Average Correlaton Between 45 Equty Country Benchmarks Feb, 86 Mar, 89 Apr, 9 May, 95 Jun, 98 Jul, 01 Aug, 04 Sep, 07 Oct, 10 Fgure : Cross-Asset Correlaton Levels Increased for Equtes, Credt, Foregn Exchange, Interest Rates, and Commodtes Asset Class Correlaton Between * Past 5Y Change Equty DM Country Indces 31% 47% 17% Equty EM Country Indces 3% 45% 3% Equty DM and EM Indces 38% 74% 36% Equty Economc Sectors 57% 69% 1% Equty Indvdual Stocks 5% 41% 16% Credt Hgh Yeld and Equtes 46% 64% 19% Credt Hgh Yeld and VIX 37% 6 4% Foregn Exch. DM Currences and Equtes -1% 8% 9% Foregn Exch. EM Currences and Equtes 6% 4% 36% Interest Rates 10Y Rate and Equtes -38% 9% 67% Commodty All Commodtes 5% 5% 1% Commodty Commodtes and Equtes -5% 1% 17% Average 19% 45% 6% * For Credt All Currences vs. USD 1 For a detaled study of equty correlatons and ther drvers, please see our report: Why we have a correlaton bubble. 3

4 Correlaton Rsk/Reward A common lst of asset classes ncludes: equtes, credt, nterest rates, foregn exchange, commodtes, and alternatve assets. Asset class s generally defned as a group of securtes that exhbt smlar characterstcs, behave smlarly n the marketplace, and are subject to the same regulatons. In other words, the correlaton between assets plays an mportant role n the defnng of an asset class tself. In the early 1990s, correlaton between Emergng Market (EM) stocks and Developed Markets (DM) stocks was ~3 and the two sets of equtes were consdered separate asset classes. Over the past three years, EM/DM correlaton was ~8 and the two asset classes morphed nto one. Smlarly, the recent correlaton of Hgh Yeld credt spreads to equtes of ~75% s hgher than the current average correlaton between S&P 500 stocks of ~45%. Below we consder the mpact of cross-asset correlaton on the rsk and reward of mult-asset portfolos. The volatlty of a mult-asset portfolo ncreases wth the level of cross-asset correlaton and the volatlty of the assets n the portfolo. 3 Hence, the hgher the cross-asset correlaton, the hgher the portfolo volatlty. If the portfolo volatlty s reduced by lower cross-asset correlaton, nvestors can free up rsk captal that can be employed to generate addtonal returns. Consder a portfolo of the followng rsky assets: emergng and developed market stocks, hgh yeld bonds, commodtes, and currences. As shown n Fgure, these assets are hghly correlated. Over the past 15 years, the correlaton between these assets ncreased from ~ to ~45%, ncreasng by 5 correlaton ponts. Assumng an average annualzed asset volatlty equal to that of equtes (14.3% US equty volatlty snce 1871), ths ncrease of cross-asset correlaton would cause portfolo rsk to ncrease by more than a thrd (35% ncrease n rsk). Assumng that ted rsk captal could have been employed to generate the average return of equtes (8.9% annualzed total return for US equtes snce 1871), the mplct cost of ths cross-correlaton ncrease s estmated at 31 bass ponts per annum. 4 Fgure also shows a dramatc ncrease n equty/rates correlaton. An ncrease of equty/rate correlaton reduces the rsk of a portfolo of equtes and Treasury bonds. Consder a portfolo wth equal weghts nvested n equtes and US Treasury bonds. The ncrease of more than 60 ponts n rates/equty correlaton over the past 15 years reduced the rsk of an equty/treasury portfolo by a quarter. Assumng that the freed rsk captal could have been employed to generate the average return of equtes and treasures (6.8% annualzed total return snce 1871), the mplct beneft of the crosscorrelaton ncrease s an estmated at 180 bass ponts per annum. 5 In addton to the descrbed mpact on a mult-asset portfolo, cross-asset correlaton can have a sgnfcant mpact on equty-only portfolos. For nstance, the most recent FX and Ol prce movements have mpacted the performance of equtes. Equty nvestors can also trade cross-asset correlaton drectly through dervatve products such as rate/equty, FX/equty, or commodty/equty hybrd optons (descrbed n the last secton of ths report). We beleve that understandng the fundamentals and techncals of cross-asset correlaton wll be an ncreasngly mportant task for all portfolo managers. Volatlty, Rsk Management, and Alpha as Drvers of Correlaton In tmes of elevated macro uncertanly, nvestors and rsk managers look at equtes, rsky bonds, commodtes, and currences as sources of portfolo rsk. As portfolo rsk s adjusted up or down n a rsk-on/off tradng style, the prces of all rsky assets tend to move n sync. In ths rgd nvestment approach, any asset s vewed as havng an exposure or beta to the macro rsk and some asset-specfc alpha. Gven the level of macro rsk and the magntude of alpha avalable n the asset class, a rsk-on/off tradng approach determnes the market level of cross-asset correlatons. Investopeda webste. 3 For a more exact expresson, see the Appendx. 4 For a portfolo of Equtes, Hgh Yeld Bonds, Commodtes, and Currences, the portfolo s rsk ncreased 1.4% for each cross-asset correlaton pont ncrease. The equvalent performance opportunty cost was 1bps for each pont ncrease n cross-asset correlatons. 5 For a portfolo of Equtes and US Treasures, the portfolo s rsk decreases 0.5% for each pont ncrease n rates/equty correlaton. The equvalent performance beneft s 3bps per pont ncrease n equty/rate correlaton. 4

5 Ths relatonshp between cross-asset correlaton, macro volatlty, and avalablty of alpha n markets s summarzed n Fgure 3 (for a more formal explanaton, see the Appendx). Essentally, a hgh level of macro volatlty causes hgh crossasset correlaton. In addton, a lack of alpha also causes an ncrease of correlatons. Interestngly, n a hgh-alpha envronment spkes n macro volatlty have a muted mpact, whle n a low-alpha envronment macro volatlty can cause a dramatc spke n cross-asset correlaton. Fgure 4 shows theoretcal levels of cross-asset correlaton (vertcal axs) as a functon of alpha and macro volatlty. In order to have a large spke n cross-asset correlaton, not only s macro volatlty needed, but the level of alpha n the markets needs to be depleted. Fgure 3: Relatonshp Between Cross-Asset Correlaton, Macro Volatlty, and the Magntude of Alpha Opportuntes n the Market Fgure 4: Graphcal Representaton of the Relatonshp Between Cross-Asset Correlaton, Macro Volatlty, and Magntude of Alpha More VOLATILITY More Correlaton Less VOLATILITY Less Correlaton Less ALPHA More ALPHA More Correlaton Less Correlaton CORRELATION Less ALPHA Volatlty has greater mpact on Correlaton 65% 5 35% VOLATILITY 5% 5% 35% ALPHA % In the rest of ths report, we explan the fundamentals of cross-asset correlaton between currences, rates, commodtes, credt, equtes, and alternatve assets. We also lnk the ncrease of cross-asset correlaton to the current hgh macro volatlty and to developments n rsk-management and alpha-extracton technques. US Treasures and Rsk Management Dscplned rsk management and portfolo dversfcaton can contrbute to an ncrease of cross-asset correlatons. For nstance, when nvestors ncrease ther equty rsk exposure by purchasng US, Developed World, and Emergng Markets equtes n proporton to market captalzaton, ths leads to a net sellng of USD and buyng of foregn currences. In addton, when the addtonal rsk captal s obtaned by reducton of holdngs of government bonds (n proporton to current government bond market captalzaton), t causes sellng of US Treasures. Ths type of rsk-on/off flows s causng the current negatve correlaton between USD and global equtes, and the postve correlaton between equtes and treasury yelds (see the Currences and Interest Rates sectons). Over the past few years, many nvestors started ncreasng commodty allocaton due to ther low hstorcal correlaton to other rsky assets and resstance to nflaton. Rsk-on flows nto commodtes, along wth USD/Equty correlaton (note that commodtes are prced n USD), recently gave rse to a strong postve correlaton between equtes and commodtes. Rsk hedgng wth lqud dervatve products can also have an mpact on correlatons. However, dervatves are not the cause of correlaton but just facltate the prevously descrbed rsk-management technques. For nstance, hedgng of equty exposure s typcally mplemented va ndex futures on lqud, captalzaton-weghted ndces such as the S&P 500. Tradng of these nstruments can mechancally ncrease correlaton between large-cap stocks. Smlarly, hedgng credt portfolos wth VIX or S&P 500 products can result n ncreased credt-equty correlaton. 5

6 Alpha Extracton A decrease of asset-specfc alpha ncreases the level of cross-asset correlatons. An example of alpha capture that causes correlaton ncrease s statstcal arbtrage. In a smple par strategy, an arbtrageur s tradng two correlated assets buyng the underperformng asset and sellng the outperformng one. The trade ncreases the correlaton between the par and captures (dmnshes) the alpha. Ths type of arbtrage can be mplemented between pars of stocks, sectors, and regonal markets, between ndces and ther consttuents, and more generally between dfferent assets such as currences, rates, and equtes. Smlar to statstcal arbtrage, alpha s extracted by varous relatve-value tradng strateges. Captal structure arbtrage s a relatve-value approach of tradng equty versus credt. It can be employed on an ndvdual securty as well as an ndex level (e.g., tradng CDX aganst S&P 500). Captal structure arbtrage can cause an ncrease of credt/equty correlatons. Currency carry trades nvolve sellng low-yeldng currences (e.g., USD and JPY) and buyng hgh-yeldng currences, or more generally rsky assets denomnated n these currences. Ths generalzed currency carry trade can cause an ncrease of FX/equty correlaton, and even an ncrease n commodty/equty correlaton. An ncrease n the amount of assets nvested n alpha-extracton strateges may have a secular mpact on cross-asset correlatons. Hedge funds assets, currently at ~$T, experenced sgnfcant growth over the past ten years. Whle not all hedge funds can consstently generate alpha, the ncrease of hedge fund assets lkely had a net effect of alpha reducton and thus ncrease of correlaton. The descrbed market changes that contrbuted to a secular ncrease of cross-asset correlatons also brought some benefts. For example, cross-regonal captal flows provde captal to emergng economes, electronc tradng can mprove lqudty for all market partcpants, and credt/equty arbtrage equally dstrbutes rsk and reward between bondholders and shareholders. Cross-asset correlatons wll lkely decrease alongsde macro volatlty. However, the descrbed market developments should persst and reset correlaton levels to a new, hgher, norm. 6

7 Currences Rsk On/Off and Global Currency Flows It s well known that an ncreased rsk appette of nvestors results n an nflow of captal nto Emergng Market stocks. In order to purchase these stocks, funds need to be converted nto local EM currences. Gven the lqudty of EM stocks and currences, these nflows typcally cause both assets (EM stocks and currences) to apprecate at the same tme, gvng rse to postve correlaton between equtes and EM currences. Increased nterest for EM equtes and the rsk-on/off tradng style caused a remarkable ncrease of EM Currency/Equty correlaton over the past seven years (Fgure 5). In fact, the current average correlaton between the S&P 500 and EM Currences s hgher than the average correlaton between largecap US stocks even at the peak of the fnancal crss n 008. Smlar rsk flows drve the correlaton between equtes and currences of major developed economes such as USD, EUR, and JPY. Of partcular nterest for equty nvestors s the strong negatve correlaton between equtes and USD. Developments n global equty markets over the past ten years can help us understand ths relatonshp. Fgure 6 shows the market captalzaton of US, Developed World ex US, and Emergng Equty Markets snce The fgure shows the relatve rse of EM, and declne of US market captalzaton. Ten years ago, US equty markets represented ~6 of global equty market captalzaton, wth emergng markets only 6%. In the decade from 001 to 011 the US equty market halved to ~35% of global market captalzaton, Developed Markets ex US ncreased to 41%, and Emergng Markets expanded to 4% of global equty captalzaton. 6 The relevance of captalzaton changes to currency/equty correlaton s that, whle ten years ago the rsk-on trade nto global equtes (n proporton to global market captalzaton) nvolved net buyng of USD, snce 004 (and n partcular over the past three years) the global rsk-on trade nvolves net sellng of USD n order to purchase EM and Developed World ex US equtes. Fgure 5: Correlaton of EM Currences (vs. USD) and S&P Correlaton of EM Currences wth S&P 500 Jul, 93 May, 96 Mar, 99 Jan, 0 Nov, 04 Sep, 07 Jul, 10-1 Fgure 6: Global Equty Market Captalzaton Snce 1998 Market Captalzaton ($Bn) US DMxUS EM Year US DM ex US EM % % % ,800 5, % 1% ,900 6, % 1% 000 1,300 7, % % ,800 7,500 1,00 57% 37% 6% 00 10,500 6,100 1, % 6% 003 8,100 6,100 1,000 53% 4 7% ,300 8,600 1, % 8% ,300 10,500,00 47% 44% 9% ,300 11,900 3,300 43% 45% 1% 007 1,800 14,700 4, % 15% 008 1,900 16,900 7,800 34% 45% 1% 009 7,900 9,500 3,600 38% 45% 17% 010 9,900 1,300 6,500 34% 43% 3% ,400 13,400 8,000 35% 41% 4% 6 The perod ncludes 9/11/011, wars n Iraq and Afghanstan, emergence of BRICs, and strengthenng of European Monetary Unon. 7

8 Equally mportant s to look at the captalzaton of global government debt markets shown n Fgure 7. Currently, US and Japanese government bonds represent 6% of the market. US Treasures and Japan government bonds are the largest, most lqud, and broadly held rskless assets. US Treasures alone represent almost 3 of all government bonds, and almost 6 of all AAA-rated bonds. In other words, US Government debt s most broadly used as a lqud store of rsk-free assets. A rsk-on trade nvolves shftng allocaton from rskless nto rsky assets, and wll therefore nvolve net sellng of US (or Japan) debt and sellng the USD (or JPY) to buy rsky assets such as equtes two-thrds of whch are denomnated n non-us currences. 7 The rsk-on/off mpact to asset allocaton between government bonds and more rsky assets wll also cause correlaton between nterest rates and equtes dscussed n the next secton. Fgure 8 shows the correlaton of DM currences (excludng JPY) and equtes over the past 0 years. We note that correlaton started sgnfcantly ncreasng n 004, whch s roughly the tme US equty market captalzaton dropped below half of the global market captalzaton. As the US captalzaton dropped to roughly a thrd, correlaton between DM currences (excludng JPY) and equtes further ncreased. The same chart shows correlaton of JPY/USD and equtes. Gven the role of Japan s government bond market (the largest lqud rsk-free asset pool), correlaton of JPY/USD to equtes s negatve, n clear contrast to the rest of DM currences. Fgure 7: Global Government Debt Market Captalzaton Country Debt ($Bn) % of Total S&P Rat. % of GDP Japan 10,779 34% AA-u 6 USA 9,077 8% AAAu 59 Italy,99 7% A+u 118 France 1,869 6% AAAu 84 Germany 1,761 5% AAAu 79 UK 1,76 5% AAAu 77 Span 939 3% AA 63 Canada 633 % AAA 34 Greece 479 1% BB- 144 Belgum 451 1% AA+u 99 Netherlands 449 1% AAAu 65 Austra 76 1% AAA 70 Portugal 06 1% BBB- 83 Australa 03 1% AAAu Next 10 1,05 3% Source: J.P. Morgan Equty Dervatves Strategy, Bloomberg. Fgure 8: Correlaton of DM Currences (vs. USD) wth S&P 500 (Sold); Correlaton of JPY (vs. USD) wth S&P 500 (Dashed) Feb, 91 May, 94 Aug, 97 Nov, 00 Feb, 04 May, 07 Aug, DM Currences (ex JPY) wth SPX JPY wth SPX We have shown how secular changes n global equty and bond market captalzaton as well as rsk-management technques (namely asset allocaton between rsky and rskless assets) mpact the correlaton between currences and equtes. Next we address the role of alpha-extracton technques such as currency carry trades and cross-asset statstcal arbtrage. Currency carry trades nvolve borrowng n low-yeldng currences, and sellng the currency to nvest n hgher-yeldng currences or other hgher-yeldng assets such as equtes. Hstorcally, low-yeldng currences were the JPY, and more recently the USD. Hgher-yeldng currences were typcally rsker EM currences or commodty-drven developed world currences. In both cases the currency carry trade s a rsk-on trade that nvolves sellng USD or JPY whle buyng currences (or assets) postvely correlated wth equty or commodty rsk. Through ths mechansm, the currency carry trade strengthens the USD/equty correlaton, as well as correlaton between equtes, currences, and commodtes. Cross-asset statstcal arbtrage nvolves smultaneous tradng of currences, equtes, and commodtes. A computer model establshes and forecasts covarance between these assets, then algorthmcally trades based on dscrepances between the expected relatve moves of assets and observed moves. Ths type of statstcal tradng can provde lqudty and sap the market mpact from trades n each asset class. However, the result s an ncrease of cross-asset correlaton. We can fnd 7 Or alternatvely buyng rsker corporate or non-us government debt from countres such as Italy, Span, and Greece. 8

9 potental evdence of hgh-frequency statstcal cross-asset tradng actvty n the behavor of currency/equty correlaton calculated over dfferent tme horzons. Asset allocaton flows typcally occur over long-term tme horzons. For nstance, a portfolo manager may decde to revew the allocaton to rsky assets vs. rskless bonds on a weekly bass, but wll not adjust rsk exposure mnute-by-mnute. Fgure 9 below shows EUR/USD correlaton to equtes calculated based on 5-, 15-, 30-, 60-, and 180-mnute returns over the past sx months. We note that EUR/USD to equty correlaton s hghest for the shortest tme nterval (5 mnutes) and decreases for longer tme perods. Ths suggests that some form of cross-asset tradng, most lkely of a statstcal nature, does take place at hgh frequency. Hgh correlaton between currences and equtes has a varety of mplcatons for equty nvestors. The negatve correlaton between USD and equtes ncreases the volatlty of foregn assets (e.g., ADRs) to US nvestors. Smlarly, for foregn nvestors ths makes US equtes less volatle as equty and USD rsks partally offset each other. Another nterestng applcaton of currency/equty correlaton s the possblty of cross-asset hedgng. If FX optons are cheaper than equty ndex optons, nvestors could hedge equty exposure wth FX optons. In ths approach the nvestor reles on the stablty of correlaton between currences and equty, and seeks FX optons that are cheaper than S&P 500 optons. Fgure 10 below shows the sx-month downsde skew for the S&P 500 and the average skew for FX optons of DM currences aganst USD. 8 Skew s expressed as a rato of out-of-the-money (OTM) put mpled volatlty to at-the-money (ATM) mpled volatlty. We note that S&P 500 skew s tradng persstently hgher than FX skew. The reason for ths s the supply/demand mbalance for equty ndex put optons (more buyers than sellers of downsde protecton). Meanwhle, FX skew was farly low pror to 004, but gven the steady ncrease of currency/equty correlaton (Fgure 8), FX skew has been rsng as well. Despte ths ncrease, FX skew for certan currency pars may stll be cheaper than S&P 500 skew, makng FX puts an attractve alternatve hedge for equtes. 9 Fgure 9: EUR/USD Correlaton to S&P 500, Calculated from 5-, 15-, 30-, 60-, and 180-Mnute Returns Fgure 10: S&P 500 and DM Currences vs. USD Downsde Skew 5 48% 1.3 S&P 500 Skew Correlaton % 33% 9% DM FX (ex JPY) Skew % Interval (Mnutes) 1.0 Apr, 01 Sep, 0 Feb, 04 Jul, 05 Dec, 06 May, 08 Oct, 09 Mar, 11 8 Skew measures the dfference between the prce of OTM downsde puts to at-the-money puts. Hgh levels of skew mply a hgh probablty of a large downsde move, whch ncreases the prce of downsde put optons. 9 For specfc examples of currency/equty hedgng, see J.P. Morgan publcatons: Tal-Rsk Hedgng wth FX Optons and VIX, Equtes, and Dollar Carry Trade. 9

10 Interest Rates End of Fed Model and Use of US Treasures as Global Rsk-Free Asset In the prevous secton, we explaned the role of US and Japan government debt as a lqud, rskless storage of assets. When nvestors ncrease rsk exposure, they typcally sell some government debt, and nvest the proceeds n DM and EM equtes, rsky debt, or commodtes. Reducng rsk exposure nvolves sellng rsky assets and buyng treasures (flght to qualty). Ths rsk-on/off asset allocaton approach has caused a postve correlaton between equtes and nterest rates over the past ten years. Postve correlaton between rates and equtes adds sgnfcant dversfcaton benefts to a portfolo of rsky assets and treasury bonds as rsky assets declne n value, treasury bonds apprecate and vce versa (e.g., see Correlaton Rsk/Reward secton). Another reason for use of Treasures as a rsk-free asset and a postve equty/rate correlaton s an actve monetary polcy. If the economy s overheatng and rsky assets rally, the central bank may ncrease rates to cool down the economy. Conversely, f rsky assets are sellng off, the Fed may cut rates to support growth and avod recesson (Greenspan/Bernanke Put). Gven the postve nomnal yeld of treasury bonds and negatve correlaton to equtes, treasures are consdered to be a superor rskless asset to cash deposts. The wdespread usage of US Treasures as rskless storage has caused an ncrease of equty/rate correlatons and decrease of treasury yelds over the past 15 years, as shown n Fgure 11. Hstorcally, the correlaton between equtes and rates was not always postve. Moreover, there are theoretcal reasons why ths correlaton should n fact be negatve. The so-called Fed Model states that treasury yelds should be roughly equal to equty earnngs yeld (E/P or smply the nverse of the P/E rato). 10 The so-called Fed Model therefore mples drect negatve correlaton between treasury yelds and equtes the hgher the stock prce, the lower the equty yeld and hence the lower the treasury yeld. The ratonale behnd the Fed Model s that nvestors compare the yeld generated by holdng treasures to equty earnngs yeld, and nvest ther cash deposts nto the one that looks more attractve (untl treasury yeld and earnngs yeld become equal). Market data over the past ten years have proved ths reasonng to be flawed. Fgure 1 shows a 30-year hstory of rate/equty correlaton. We note that pror to 1997, rate/equty correlaton was ndeed negatve, as predcted by the so-called Fed Model. Ths changed vrtually n one day, when the Asan crss caused rsk contagon across global markets on 10/7/ Ed Yarden, Fed s stock market model fnds overvaluaton, Topc Study #38, US Equty Research, Deutsche Morgan Grenfell,

11 Fgure 11: Correlaton of 10Y Treasury Yeld and S&P 500 Fgure 1: Regme Change of Equty/Rate Correlaton Occurred n 1997/ Correlaton of 10Y Treasury Yeld and Equtes % 5 5% 10/7/97 - The frst 'Global Rsk-off' Event Asan Crss Splls over - Worst 1-day drop of NDX on record, prompts early market close. Treasures yelds drop to mult-year lows. Wthn next 1 months, Fed cuts rates 3 tmes as a response to Asa, Russa and LTCM Crses 5 Apr, 9 May, 95 Jun, 98 Jul, 01 Aug, 04 Sep, 07 Oct, Y Treasury Yeld -8-5% -5-75% Feb, 76 Dec, 80 Oct, 85 Aug, 90 Jun, 95 Apr, 00 Feb, 05 Dec, 09 Fed Model Regme Global Rsk On/Off Regme Investors across the globe sold rsky assets and pled nto Treasury bonds, drvng yelds lower. The frst global Rsk-off event resulted n the worst one-day returns for the Nasdaq and Dow Jones, and caused Treasury yelds to drop to two-year lows. Over the next 1 months and as a response to the crss, the Fed postponed one rate ncrease, and subsequently cut rates three tmes thereby renforcng the postve correlaton between equtes and yelds. Smlar equty selloffs and Treasury ralles occurred twce more n the next year durng the LTCM and Russa debt crses. Rsk-off events have become truly global affectng all asset classes (EM and DM Equtes n the Asa crss, Emergng Market Debt n the Russa crss, Equty Volatlty, Interest Rate Swap Spreads, and M&A Spreads n the LTCM crss). These events establshed treasury bonds as the rskless asset of choce and reversed the levels of equty/rates correlaton for years to come. Despte our vew that equty/rate correlatons wll stay postve, there are certan scenaros that could cause a weakenng or reversal of ths relatonshp. Whle the return of an outdated Fed Model nvestment approach does not pose a rsk for correlaton, the occurrence of Stagflaton or even full-fledged US bond/equty contagon could reverse the equty/rate correlaton. In the case of Stagflaton, treasury yelds are expected to ncrease as a result of ncreased nflaton expectatons. A low or negatve growth outlook and ncreased nflaton expectatons could cause an equty selloff. In ths way, the occurrence of Stagflaton could cause equty/rate correlatons to drop or even turn negatve. The most dramatc reversal of equty/rate correlatons could happen n the event of full-fledged US bond/equty contagon. Ths could occur as a result of a US fscal crss, promptng foregn nvestors to abandon US Treasures as the rsk-free asset of choce. A sharp ncrease n rates would be followed by a broad selloff of all dollar assets. Ths type of tal event could result n equty/rate correlaton droppng towards -10. In addton, ths event would lkely trgger a dramatc reversal of equty/currency and equty/commodty correlatons, lkely weakenng cross-regonal equty correlatons (e.g., US equtes underperformng). Investors wary of a potental US fscal crss and the tal-rsk scenaro descrbed above could use an equty/rate correlaton vew n order to nexpensvely hedge ther equty exposure. An example trade would be to buy an out-of-the-money put opton on the S&P 500 ndex, wth a payoff that s contngent on treasury yelds rsng above a certan level. Gven the current postve correlaton between rates and equtes, the cost of ths type of hybrd would be sgnfcantly cheaper (as compared to the smple S&P 500 put opton). For more detals on ths trade, see the last secton of ths report (Hybrd Dervatve Trades). 11

12 Commodtes Slver Bullet for Asset Allocaton Pror to the fnancal crss n 008, commodtes were essentally uncorrelated to equtes and bonds, and were relatvely weakly correlated among themselves. These attractve features were hghlghted n numerous studes n the md-000s. For nstance, a 006 Ibbotson Assocates study concluded that ncludng commodtes would have mproved performance by 133bps, and suggested that an optmal asset allocaton should nclude a sgnfcant proporton of commodtes. 11 In addton to dversfcaton benefts, commodtes are consdered to be a store of value and a hedge for nflaton. These fndngs were largely based on hstorcal analyses and dd not take nto account the potental prce and correlaton mpact of wdespread commodty allocatons. These attractve hstorcal propertes of commodtes caught nvestors attenton and sgnfcant funds started flowng nto the asset class. The demand for commodtes from Chna and other emergng economes, the bengn monetary polces of central banks, and ncreased geopoltcal tensons caused large prce ncreases, further fuelng nterest n the asset class. For nstance, assets nvested n Commodty ETFs roughly doubled every year snce ther launch n 005 and currently stand at ~$150bn. In addton to ndvdual commodtes, broad commodty ndces such as GS, DJ UBS, and TR/J CRB attracted sgnfcant nvestment assets. Fgure 13 shows the growth of commodty ETF assets, as well as the steady ncrease n correlaton between varous commodtes over the past ten years. Correlaton between ndvdual commodtes was weak n the 1990s, but started ncreasng steadly n the 000s. Ths s lkely the result of ncreased nvestment allocaton to commodtes and commodty ndces. Correlaton between commodtes and equtes was on average negatve n the 1990s and early 000s. However, followng the collapse of Lehman Brothers, commodty/equty correlaton turned postve (Fgure 14). There are several reasons that caused ths quck reversal. Frstly, commodtes sold off alongsde equtes and other rsky assets n the bg rsk-off event of 008/009. As nvestors de-levered and de-rsked, any speculatve premum bult nto commodtes was erased. Alongsde de-rskng, the recesson that followed the crss reduced demand for commodtes, causng a postve correlaton between equtes and commodtes (e.g., a drop n GDP expectatons translates nto reduced demand for ol and lower equty valuatons at the same tme). Another sgnfcant drver of postve commodty/equty correlaton s the negatve correlaton of USD to equtes descrbed n the Currences secton of ths report (see Fgures 5 and 8). As commodtes are prced n USD, currency/equty correlaton splls over to commodty/equty correlaton. For nstance, a 1% ncrease n equtes wll, on average, concde wth a 0bps drop n USD. As commodtes are prced n USD, ths wll mechancally lead to a 0bps ncrease n commodty prces on account of USD/equty correlaton. Currently, about 4 of the postve commodty/equty correlaton can be attrbuted to the (negatve) correlaton of USD to equtes. The ncrease of commodty/equty correlaton snce 008 and the commodty/equty correlaton adjusted for USD prcng of commodtes s shown n Fgure Strategc Asset Allocaton and Commodtes, Ibbotson Assocates,

13 Fgure 13: Correlaton Between Varous Commodtes and Growth of Commodty ETFs Fgure 14: Commodty/Equty Correlaton and the Spllover of Equty/FX Correlaton % 3 5% Average Correlaton Between All Commodtes (LHS) Commodty ETF Assets $Bn (RHS) Average Correlaton of all Commodtes to Equtes 15% % 0 Feb, 91 Dec, 93 Oct, 96 Aug, 99 Jun, 0 Apr, 05 Feb, 08 Dec, May, 91 Oct, 94 Mar, 98 Aug, 01 Jan, 05 Jun, 08 Adjusted for USD Fluctuatons Currently ~4 of Commodty/Equty Correl s a Spllover from USD/Equty Correl Fgure 15 provdes more detals on the shft n commodty/equty correlaton that occurred n 008. The bggest reverson was experenced by Ol/Equty correlaton whch spked from roughly -1 to current levels of over 6. Industral metals and soft commodtes experenced smlar correlaton shfts. Gold/Equty correlatons ntally dropped as nvestors sold equtes and rushed nto the perceved relatve securty of gold. However, correlaton quckly turned postve fueled by speculatve demand and strong negatve correlaton of USD to equtes. Fgure 15: Commodty/Equty Correlaton for Energy, Precous Metals, Industral Metals, and Soft Commodtes Fgure 16: Some Commodtes Are Prone to the Creaton of Bubbles Correlaton of Commodtes to Equtes Energy Slver Thursday Hunts Brothers Collapse 4/8/ Industral Metals Precous Metals Energy Soft Commodtes Precous Metals Jan, 95 Nov, 97 Sep, 00 Jul, 03 May, 06 Mar, Jul, 75 Jun, 80 May, 85 Apr, 90 Mar, 95 Feb, 00 Jan, 05 Dec, 09 The ncrease of commodty/equty correlaton snce 008 dmnshed some of the dversfcaton value to a cross-asset portfolo. At least part of the correlaton ncrease can lkely be attrbuted to the nvestment demand for commodtes. As nvestors ncrease or decrease exposure to all rsky assets (ncludng commodtes and equtes), commodtes/equty correlaton ncreases. More precarous than the reduced dversfcaton beneft s the rsk of creaton and burstng of speculatve bubbles. The burst of an asset bubble can reduce returns and erase dversfcaton benefts acheved over tme. Fgure 16 shows the prce of Slver over the past 35 years. There are two promnent features of the chart. The frst one s the speculatve bubble engneered by the Hunt Brothers and ts burst on Slver Thursday n March 1980, and the second one s the prce of slver at the tme of wrtng of ths report. 13

14 Asde from market rsk, there are ntrgung socal and macroeconomc aspects of commodty nvestng. Some of these ssues were publcly dscussed followng a decson by Calforna State Teachers Retrement System aganst a large nvestment nto commodtes. In the run-up of slver prces durng the Hunt Brothers scheme, Tffany publshed a full-page add n The New York Tmes statng: We thnk t s unconsconable for anyone to hoard several bllon, yes bllon, dollars worth of slver and thus drve the prce up so hgh that others must pay artfcally hgh prces for artcles made of slver. Replacng Slver wth Food or Gas reveals the socoeconomc rsk of potental commodty bubbles. In addton to asset allocaton, commodty/equty correlaton plays an mportant role n valuatons and volatlty estmates for Materals and Energy sector stocks. 1 As dscussed n the Rates secton, nvestors trade hybrd optons based on equty and commodty prces. Two examples of such hybrd opton trades are explaned n the Hybrd Dervatves Trades secton. 1 For further dscusson of Ol/Equty correlaton, and ts mpact on Energy Sector Volatlty, please see our paper Energy Sector Volatlty Fundamentals of Volatlty and Relatve Value Ideas from

15 Credt Captal Structure Arbtraged Correlaton between credt spreads and equtes has been steadly ncreasng over the past ten years. Fgure 17 shows the correlaton of changes n 5-year Hgh Yeld credt spreads and S&P 500 returns, as well as the correlaton between changes n HY credt spreads and changes n VIX levels. Wth correlaton of ~8, credt, equtes, and equty volatlty are currently the most closely correlated assets. There are many theoretcal reasons behnd the strong credt/equty correlaton. Structural models of credt provde prces for both bonds and the stock of a company based on the value and volatlty of the company s assets. If the value of the assets drops below the level of debt, the equty prce s zero. For hgher levels of assets, equty s prced as a call opton on assets struck at the debt level. J.P. Morgan Equty Dervatves Research mantans a smple structural model that can ndentfy dvergences between credt, equty volatlty, and equty levels for ndvdual stocks. 13 Asde from the theoretcal relatonshp, a hgh correlaton between credt and equtes s realzed through relatve-value tradng. Captal structure arbtrage trades and cross-asset hedgng tend to closely algn these three assets. An example of a captal structure arbtrage trade s a relatve-value trade between CDS and equty put optons. 14 Perhaps more mportant drvers of credt and equty correlaton are cross-asset hedges whch are usually mplemented at an ndex level. Due to the lqudty and transparency of the equty optons market, many nvestors hedge ther credt exposure va equty ndex optons and volatlty products (e.g., put spreads and put-spread collars on equty ndces, VIX futures, calls/call spreads and ndex varance). In addton to lqudty and transparency, an advantage of usng equty nstruments for credt hedgng s hedge dversfcaton. Investors dversfy ther hedges to avod potentally crowded postons n credt hedges (such as outrght shortng, or buyng puts on CDX prce ndex). If a hedge s crowded, nvestors that rush to monetze the payoff may mpact the prce of the hedgng nstrument and thus reduce the effectveness of the hedge. For ths reason t may be prudent to have hedges dversfed across lqud nstruments and thus mnmze the mpact of hedge unwnds. Another advantage of usng equty hedges for credt s the potental prcng advantage. Due to hgh levels of equty skew, prcng of equty putspreads and put-spread collars n some nstances may be more attractve than outrght purchases of CDX optons or shortng CDX. An obvous rsk of credt/equty hedges (and more generally cross-asset hedges) s the trackng error between the two assets. The sze of ths trackng error s typcally comparable to or greater than potental savngs n the opton prcng. However, the trackng rsk can also provde great opportuntes for nvestors hedgng credt wth equty (or vce versa). The reason s that credt and equty prces can exhbt sgnfcant dvergence n the short term. Investors who can correctly dentfy a dvergence can buy protecton on the expensve asset to hedge the one that appears laggng. Fgure 18 shows the cumulatve dvergence of HY Credt spreads over equtes and volatlty (S&P 500 and VIX) based on a smple multple regresson model. Ths smple approach can help nvestors dentfy hedgng relatve-value opportuntes. For nstance, the fgure shows a wdenng of credt relatve to equtes n the aftermath of GM s downgrade n the sprng of 005. Another epsode of credt/equty dvergence occurred when the VIX declned to mult-year lows at the end of A Framework for Credt-Equty Investng, Credt and Equty Volatlty Relatve Value Opportuntes,

16 Fgure 17: Correlaton of 5Y HY Credt Spreads to S&P 500 and VIX Fgure 18: Credt/Equty Dvergences over the Past Ten Years HY CDS to S&P 500 (Inverse) HY CDS to VIX Credt Rsk Hgher/Lower Than Equtes (% 75% 5 5% -5% -5 GM VIX Declnes BSAM LEH Equtes Drop Credt Rally Jul, 0 Oct, 03 Jan, 05 Apr, 06 Jul, 07 Oct, 08 Jan, 10 Apr, 11-75% Nov, 0 Mar, 04 Jul, 05 Nov, 06 Mar, 08 Jul, 09 Nov, 10 Perhaps the bggest dvergence and hence credt/equty hedgng opportunty occurred n the summer of 007, followng the collapse of BSAM credt hedge funds. Durng ths epsode, equty markets faled to react to the deteroraton n credt markets leadng nto the 008 fnancal crss. In all of these cases, holdng equty hedges would have been more proftable than holdng credt hedges, as credt ether wdened ahead of equtes or equty volatlty was lower than credt spreads. However, equty hedges are not always more attractve. At the end of 009, credt spreads tghtened more than what would have been expected based on the regresson aganst equtes and the VIX (buyng credt protecton may have been more effectve leadng nto the market correcton that happened n May 010). Despte the recent wdenng of credt spreads relatve to equty volatlty, currently we do not see a large dscrepancy between the two assets. 16

17 Equtes Why We Have a Correlaton Bubble As wth other asset classes, correlaton between varous equty markets and sectors has been trendng hgher over the past 0 years. 15 The equty correlatons most nterestng to nvestors are the correlaton between dfferent regonal markets (e.g., the correlaton between developed world ndces), the correlaton between varous ndustry sectors, and the correlaton between ndvdual stocks. Fgure 19 shows the correlaton between developed and emergng markets and the correlaton between dfferent emergng market country benchmarks (n addton, Fgure 1 shows the regonal correlaton between all country benchmarks). We note that the ncrease of cross-regonal equty correlaton s largely a secular trend (and only to a smaller extent drven by macro volatlty). As explaned n the frst secton of the report, ths trend has been caused by the globalzaton of economes and fnancal markets. We beleve ths globalzaton, and hence the hgh cross-regonal correlaton trend, s not reversble. Whle regon-specfc events such as the recent earthquake n Japan may soften cross-regonal correlatons, markets are not lkely to revert to the levels observed n the md-1990s, when the average correlaton between EM benchmarks was close to zero and EM/DM correlaton was only ~5%. Ths trend of rsng cross-regonal correlaton sgnfcantly dmnshed the once mportant dversfcaton beneft of nvestng across emergng and developed markets. It appears that n the case of crossregonal nvestng, the only free lunch n fnance (a common reference to dversfcaton) has been eaten. The correlatons between ndustry sectors are currently at ther hghest levels. Fgure 0 shows a trend of ncreasng sector correlatons over the past ten years, n partcular the ncrease due to market volatlty n 008. Asde from market volatlty, sector-specfc market trends can have a large mpact on cross-sector equty correlaton. The most promnent s the large drop n sector correlaton durng the creaton and burst of the nternet bubble n 001 as Technology stocks frst ralled and then crashed relatve to old economy sectors. 16 Fgure 0 also shows average correlaton between S&P 500 stocks. The recent ncrease of equty correlaton has largely been drven by the ncreased macro volatlty snce 007. However, other structural reasons contrbuted to ncreased levels of equty correlaton. The wdespread use of ndex products (e.g., futures) and hgh-frequency tradng strateges, such as statstcal arbtrage and ndex arbtrage, are lkely contrbutng to ncreased levels of correlaton. 17 Whle the levels of correlaton should decrease wth reduced macro volatlty (correlaton has already sgnfcantly decreased over the past sx months), the new normal for equty correlaton wll lkely be hgher due to the aforementoned structural developments. The hstorcal average level of correlaton was 8%, and our estmate for the future long-term average s ~35% (sgnfcantly lower than correlaton durng the peak of market crss, but hgher than the hstorcal average). In addton to ncreased longterm average levels, correlaton wll probably be more prone to spkes due to the alpha depleton dscussed n the frst secton. 15 For a detaled dscusson of equty correlatons see our report Why we have a correlaton bubble, For a more detaled dscusson of sector correlatons and ther mpact on market volatlty, see our report New Framework for Tradng Correlaton, Ths was dscussed n detal n our report Why we have a correlaton bubble. 17

18 Fgure 19: Secular Increase of Cross-Regonal Equty Correlaton Fgure 0: Sector and Stock Equty Correlaton 9 8 Between DM and EM Countres 9 8 Between S&P 500 Sectors Between EM Countres 1 Between S&P 500 Stocks Dec, 88 Jan, 9 Feb, 95 Mar, 98 Apr, 01 May, 04 Jun, 07 Jul, 10 Jan, 90 Dec, 9 Nov, 95 Oct, 98 Sep, 01 Aug, 04 Jul, 07 Jun, 10 Equty correlatons are an mportant nput to manage the rsk of a mult-asset portfolo or an equty-only long-short portfolo. More drectly, equty correlatons are used to prce varous dervatves nstruments as descrbed below. Correlaton between markets n dfferent regons s used to prce optons on baskets of global ndces. These World Basket optons are used by both retal and nsttutonal nvestors. An example s a put opton on the best-performng ndex out of the S&P 500, EuroStoxx 50, and Nkke. The buyer of a Best-of put s buyng correlaton,.e., countng that f the markets go down, correlaton between these ndces wll ncrease, causng them all to fall by a smlar amount. Best-of optons can sgnfcantly reduce the cost of hedgng as they cost less than the cheapest put opton on one ndex. Another popular nstrument s outperformance optons. An example s an opton on the outperformance of Emergng Markets (e.g., MSCI EM ndex) over DM (e.g., S&P 500). Prcng of ths opton depends on the projected correlaton between EM and DM, and the nstrument can provde a relatvely secure and levered exposure to strong EM performance (see Hybrd Dervatve Trades secton). Both sector and average stock equty correlatons can be traded through relatve-value tradng of ndex, sector (e.g., ETF), and stock optons. Sellng equty correlaton entals sellng ndex optons and buyng optons on the ndvdual ndex consttuents (stocks) n a specfc rato. Sophstcated nvestors should be aware of the prce of correlaton (mpled correlaton) they are payng when buyng ndex optons (e.g., buyng ndex puts). Due to excessve demand and a lack of supply of ndex optons, equty correlaton typcally trades above ts far value. In many cases, nvestors may be better off buyng optons on ndvdual stocks or sectors than ndex optons. When the prce of equty correlaton s much hgher than levels realzed by stock prces, arbtrage nvestors step n and sell ndex correlaton For more detals see Why we have Correlaton Bubble, Tal Rsk Relatve Value, and New Framework for Correlaton Tradng. 18

19 Alternatve Assets Hedge Funds and Correlaton Throughout ths report we showed examples of ncreasng cross-asset correlaton levels. One may ask f there s an asset class that dd not experence a secular ncrease of correlaton durng recent years. An asset that could consstently generate postve alpha (outperformance) and not have a sgnfcant exposure to market rsk (beta) would be uncorrelated to market rsk. Many hedge funds seek to generate pure alpha through an absolute return mandate and should therefore be less correlated to other rsky assets. Hedge funds are usually classfed as Alternatve Assets, alongsde prvate equty and venture captal. There are varous types of hedge funds ncludng Merger Arbtrage, Global Macro, Dstressed, Equty Market Neutral, Convertble Arbtrage, and others. These hedge fund strateges show relatvely low correlaton between one another. Fgure 1 shows the average correlaton between Hedge Fund Research Indces over the past eght years. 19 Correlaton between varous hedge fund strateges has been low, and s not showng a secular ncreasng trend as we see wth equtes, commodtes, and currences. Correlaton between the average performance of hedge funds (as measured by the HFRXGL Index) and the S&P 500 has been n a 0-8 range. Ths shows that, on average, hedge funds do have a sgnfcant exposure to equty markets. An attractve feature of hedge fund/equty correlaton s that t tends to declne wth an ncrease of market rsk. In other words, on average, hedge funds show the ablty to scale down market exposure n perods of hgh macro volatlty. Ths s shown n Fgure whch plots hedge fund/equty correlaton vs. levels of equty correlaton. Fgure 1: Correlaton Between Hedge Fund Indces 9 8 Fgure : Hedge Fund/Equty Correlaton Declnes n Tmes of Hgh Macro Volatlty Correlaton Between Hedge Funds HF to Equty Correlaton HF/Equty Corr.= -0.5*Equty Corr Dec, 03 Feb, 05 Apr, 06 Jun, 07 Aug, 08 Oct, 09 Dec, Equty Correlaton The low correlaton between hedge fund strateges and lower correlatons to other rsky assets n perods of stress make hedge funds an attractve asset class. Over the past ten years, hedge fund assets ncreased sgnfcantly, both n absolute terms as well as n terms of percentage of global equty market captalzaton. Ths s shown n Fgure 3. Hedge fund managers usually have a dscplned approach to rsk management and neutralze rsk exposures wth the use of ndex-based and leveraged products such as futures and optons. These rsk-management technques, alongsde hgher-thanaverage turnover, can contrbute to ncreased levels of correlaton. 0 Addtonally, hedge funds seek to extract alpha through relatve-value (hedged) tradng. In the frst secton of ths report, we showed that dmnshed levels of alpha ncrease the 19 1M average par-wse correlaton between the followng Hedge Fund Research ndces: HFRXMA, HFRXDS, HFRXEH, HFRXCA, HFRXRVA, HFRXGL, HFRXM, HRXEMN, HFRXCOM, HFRXCRED, and HFRXTEM. 0 See Why we have correlaton bubble,

20 level of correlaton and make markets more susceptble to correlaton spkes. It s a possblty that the growth of hedge fund assets (shown n Fgure 3) contrbuted to the secular ncrease of correlatons over the past ten years (e.g., global macro and emergng market strateges may have contrbuted to an ncrease of cross-regonal correlatons, captal structure arbtrage strateges to credt/equty correlaton, statstcal arbtrage strateges to equty correlaton, etc.). Fgure 3: Growth of Hedge Fund Assets Over the Past 15 Years 8% 6% HF Assets as % of Global Equty Markets (Left),500,000 4% 1,500 1,000 % HF Assets n $Bn (Rght) 500 Dec-97 Jan-00 Feb-0 Mar-04 Apr-06 May-08 Jun-10 Source: J.P. Morgan Equty Dervatves Strategy, BarclayHedge LTD Alternatve Investments database. 0 In ths report we have dscussed structural changes n the market that have led to an ncrease of correlaton levels. Whle the ncrease of correlatons over the past three years s largely drven by macro volatlty, secular market changes are causng a rsng trend n cross-asset correlatons. These changes nclude the ntegraton of global economes and captal markets, and nnovatons n the fnancal ndustry. Advancement of rsk-management technques, such as hedgng and dynamc asset allocaton, use of US Treasures as rsk-free storage, as well as more ntensve extracton of alpha, have lkely contrbuted to a secular ncrease n cross-asset correlatons. Compared to 0 years ago, markets are currently more correlated and there s more pronounced Alpha/Beta separaton. General market rsk or beta s managed more effcently and at sgnfcantly lower cost (e.g., lqud dervatve nstruments and electronc tradng), whle large pools of assets are seekng alpha va relatve-value and arbtrage tradng necessary for the proper functonng of captal markets. 0

An Alternative Way to Measure Private Equity Performance

An Alternative Way to Measure Private Equity Performance An Alternatve Way to Measure Prvate Equty Performance Peter Todd Parlux Investment Technology LLC Summary Internal Rate of Return (IRR) s probably the most common way to measure the performance of prvate

More information

Answer: A). There is a flatter IS curve in the high MPC economy. Original LM LM after increase in M. IS curve for low MPC economy

Answer: A). There is a flatter IS curve in the high MPC economy. Original LM LM after increase in M. IS curve for low MPC economy 4.02 Quz Solutons Fall 2004 Multple-Choce Questons (30/00 ponts) Please, crcle the correct answer for each of the followng 0 multple-choce questons. For each queston, only one of the answers s correct.

More information

Course outline. Financial Time Series Analysis. Overview. Data analysis. Predictive signal. Trading strategy

Course outline. Financial Time Series Analysis. Overview. Data analysis. Predictive signal. Trading strategy Fnancal Tme Seres Analyss Patrck McSharry patrck@mcsharry.net www.mcsharry.net Trnty Term 2014 Mathematcal Insttute Unversty of Oxford Course outlne 1. Data analyss, probablty, correlatons, vsualsaton

More information

THE DISTRIBUTION OF LOAN PORTFOLIO VALUE * Oldrich Alfons Vasicek

THE DISTRIBUTION OF LOAN PORTFOLIO VALUE * Oldrich Alfons Vasicek HE DISRIBUION OF LOAN PORFOLIO VALUE * Oldrch Alfons Vascek he amount of captal necessary to support a portfolo of debt securtes depends on the probablty dstrbuton of the portfolo loss. Consder a portfolo

More information

The Short-term and Long-term Market

The Short-term and Long-term Market A Presentaton on Market Effcences to Northfeld Informaton Servces Annual Conference he Short-term and Long-term Market Effcences en Post Offce Square Boston, MA 0209 www.acadan-asset.com Charles H. Wang,

More information

IN THE UNITED STATES THIS REPORT IS AVAILABLE ONLY TO PERSONS WHO HAVE RECEIVED THE PROPER OPTION RISK DISCLOSURE DOCUMENTS.

IN THE UNITED STATES THIS REPORT IS AVAILABLE ONLY TO PERSONS WHO HAVE RECEIVED THE PROPER OPTION RISK DISCLOSURE DOCUMENTS. http://mm.pmorgan.com European Equty Dervatves Strategy 4 May 005 N THE UNTED STATES THS REPORT S AVALABLE ONLY TO PERSONS WHO HAVE RECEVED THE PROPER OPTON RS DSCLOSURE DOCUMENTS. Correlaton Vehcles Technques

More information

Chapter 15: Debt and Taxes

Chapter 15: Debt and Taxes Chapter 15: Debt and Taxes-1 Chapter 15: Debt and Taxes I. Basc Ideas 1. Corporate Taxes => nterest expense s tax deductble => as debt ncreases, corporate taxes fall => ncentve to fund the frm wth debt

More information

Chapter 15 Debt and Taxes

Chapter 15 Debt and Taxes hapter 15 Debt and Taxes 15-1. Pelamed Pharmaceutcals has EBIT of $325 mllon n 2006. In addton, Pelamed has nterest expenses of $125 mllon and a corporate tax rate of 40%. a. What s Pelamed s 2006 net

More information

Solution: Let i = 10% and d = 5%. By definition, the respective forces of interest on funds A and B are. i 1 + it. S A (t) = d (1 dt) 2 1. = d 1 dt.

Solution: Let i = 10% and d = 5%. By definition, the respective forces of interest on funds A and B are. i 1 + it. S A (t) = d (1 dt) 2 1. = d 1 dt. Chapter 9 Revew problems 9.1 Interest rate measurement Example 9.1. Fund A accumulates at a smple nterest rate of 10%. Fund B accumulates at a smple dscount rate of 5%. Fnd the pont n tme at whch the forces

More information

Chapter 11 Practice Problems Answers

Chapter 11 Practice Problems Answers Chapter 11 Practce Problems Answers 1. Would you be more wllng to lend to a frend f she put all of her lfe savngs nto her busness than you would f she had not done so? Why? Ths problem s ntended to make

More information

Multiple-Period Attribution: Residuals and Compounding

Multiple-Period Attribution: Residuals and Compounding Multple-Perod Attrbuton: Resduals and Compoundng Our revewer gave these authors full marks for dealng wth an ssue that performance measurers and vendors often regard as propretary nformaton. In 1994, Dens

More information

Analysis of Premium Liabilities for Australian Lines of Business

Analysis of Premium Liabilities for Australian Lines of Business Summary of Analyss of Premum Labltes for Australan Lnes of Busness Emly Tao Honours Research Paper, The Unversty of Melbourne Emly Tao Acknowledgements I am grateful to the Australan Prudental Regulaton

More information

Interest Rate Futures

Interest Rate Futures Interest Rate Futures Chapter 6 6.1 Day Count Conventons n the U.S. (Page 129) Treasury Bonds: Corporate Bonds: Money Market Instruments: Actual/Actual (n perod) 30/360 Actual/360 The day count conventon

More information

Time Value of Money. Types of Interest. Compounding and Discounting Single Sums. Page 1. Ch. 6 - The Time Value of Money. The Time Value of Money

Time Value of Money. Types of Interest. Compounding and Discounting Single Sums. Page 1. Ch. 6 - The Time Value of Money. The Time Value of Money Ch. 6 - The Tme Value of Money Tme Value of Money The Interest Rate Smple Interest Compound Interest Amortzng a Loan FIN21- Ahmed Y, Dasht TIME VALUE OF MONEY OR DISCOUNTED CASH FLOW ANALYSIS Very Important

More information

The impact of hard discount control mechanism on the discount volatility of UK closed-end funds

The impact of hard discount control mechanism on the discount volatility of UK closed-end funds Investment Management and Fnancal Innovatons, Volume 10, Issue 3, 2013 Ahmed F. Salhn (Egypt) The mpact of hard dscount control mechansm on the dscount volatlty of UK closed-end funds Abstract The mpact

More information

Financial Mathemetics

Financial Mathemetics Fnancal Mathemetcs 15 Mathematcs Grade 12 Teacher Gude Fnancal Maths Seres Overvew In ths seres we am to show how Mathematcs can be used to support personal fnancal decsons. In ths seres we jon Tebogo,

More information

Multiple discount and forward curves

Multiple discount and forward curves Multple dscount and forward curves TopQuants presentaton 21 ovember 2012 Ton Broekhuzen, Head Market Rsk and Basel coordnator, IBC Ths presentaton reflects personal vews and not necessarly the vews of

More information

Simple Interest Loans (Section 5.1) :

Simple Interest Loans (Section 5.1) : Chapter 5 Fnance The frst part of ths revew wll explan the dfferent nterest and nvestment equatons you learned n secton 5.1 through 5.4 of your textbook and go through several examples. The second part

More information

STAMP DUTY ON SHARES AND ITS EFFECT ON SHARE PRICES

STAMP DUTY ON SHARES AND ITS EFFECT ON SHARE PRICES STAMP UTY ON SHARES AN ITS EFFECT ON SHARE PRICES Steve Bond Mke Hawkns Alexander Klemm THE INSTITUTE FOR FISCAL STUIES WP04/11 STAMP UTY ON SHARES AN ITS EFFECT ON SHARE PRICES Steve Bond (IFS and Unversty

More information

Using Series to Analyze Financial Situations: Present Value

Using Series to Analyze Financial Situations: Present Value 2.8 Usng Seres to Analyze Fnancal Stuatons: Present Value In the prevous secton, you learned how to calculate the amount, or future value, of an ordnary smple annuty. The amount s the sum of the accumulated

More information

A Model of Private Equity Fund Compensation

A Model of Private Equity Fund Compensation A Model of Prvate Equty Fund Compensaton Wonho Wlson Cho Andrew Metrck Ayako Yasuda KAIST Yale School of Management Unversty of Calforna at Davs June 26, 2011 Abstract: Ths paper analyzes the economcs

More information

The Investor Recognition Hypothesis:

The Investor Recognition Hypothesis: The Investor Recognton Hypothess: the New Zealand Penny Stocks Danel JP Cha, Department of Accountng and Fnance, onash Unversty, Clayton 3168, elbourne, Australa, and Danel FS Cho, Department of Fnance,

More information

Lecture 14: Implementing CAPM

Lecture 14: Implementing CAPM Lecture 14: Implementng CAPM Queston: So, how do I apply the CAPM? Current readng: Brealey and Myers, Chapter 9 Reader, Chapter 15 M. Spegel and R. Stanton, 2000 1 Key Results So Far All nvestors should

More information

Bond futures. Bond futures contracts are futures contracts that allow investor to buy in the

Bond futures. Bond futures contracts are futures contracts that allow investor to buy in the Bond futures INRODUCION Bond futures contracts are futures contracts that allow nvestor to buy n the future a theoretcal government notonal bond at a gven prce at a specfc date n a gven quantty. Compared

More information

ADVERSE SELECTION IN INSURANCE MARKETS: POLICYHOLDER EVIDENCE FROM THE U.K. ANNUITY MARKET *

ADVERSE SELECTION IN INSURANCE MARKETS: POLICYHOLDER EVIDENCE FROM THE U.K. ANNUITY MARKET * ADVERSE SELECTION IN INSURANCE MARKETS: POLICYHOLDER EVIDENCE FROM THE U.K. ANNUITY MARKET * Amy Fnkelsten Harvard Unversty and NBER James Poterba MIT and NBER * We are grateful to Jeffrey Brown, Perre-Andre

More information

Online Appendix Supplemental Material for Market Microstructure Invariance: Empirical Hypotheses

Online Appendix Supplemental Material for Market Microstructure Invariance: Empirical Hypotheses Onlne Appendx Supplemental Materal for Market Mcrostructure Invarance: Emprcal Hypotheses Albert S. Kyle Unversty of Maryland akyle@rhsmth.umd.edu Anna A. Obzhaeva New Economc School aobzhaeva@nes.ru Table

More information

Lecture 3: Force of Interest, Real Interest Rate, Annuity

Lecture 3: Force of Interest, Real Interest Rate, Annuity Lecture 3: Force of Interest, Real Interest Rate, Annuty Goals: Study contnuous compoundng and force of nterest Dscuss real nterest rate Learn annuty-mmedate, and ts present value Study annuty-due, and

More information

Fixed income risk attribution

Fixed income risk attribution 5 Fxed ncome rsk attrbuton Chthra Krshnamurth RskMetrcs Group chthra.krshnamurth@rskmetrcs.com We compare the rsk of the actve portfolo wth that of the benchmark and segment the dfference between the two

More information

Simon Acomb NAG Financial Mathematics Day

Simon Acomb NAG Financial Mathematics Day 1 Why People Who Prce Dervatves Are Interested In Correlaton mon Acomb NAG Fnancal Mathematcs Day Correlaton Rsk What Is Correlaton No lnear relatonshp between ponts Co-movement between the ponts Postve

More information

Small pots lump sum payment instruction

Small pots lump sum payment instruction For customers Small pots lump sum payment nstructon Please read these notes before completng ths nstructon About ths nstructon Use ths nstructon f you re an ndvdual wth Aegon Retrement Choces Self Invested

More information

Is the home bias in equities and bonds declining in Europe?

Is the home bias in equities and bonds declining in Europe? Drk Schoenmaker (Netherlands), Thjs Bosch (Netherlands) Is the home bas n equtes and bonds declnng n Europe? Abstract Fnance theory suggests that nvestors should hold an nternatonally dversfed portfolo.

More information

Staff Paper. Farm Savings Accounts: Examining Income Variability, Eligibility, and Benefits. Brent Gloy, Eddy LaDue, and Charles Cuykendall

Staff Paper. Farm Savings Accounts: Examining Income Variability, Eligibility, and Benefits. Brent Gloy, Eddy LaDue, and Charles Cuykendall SP 2005-02 August 2005 Staff Paper Department of Appled Economcs and Management Cornell Unversty, Ithaca, New York 14853-7801 USA Farm Savngs Accounts: Examnng Income Varablty, Elgblty, and Benefts Brent

More information

Forecasting the Direction and Strength of Stock Market Movement

Forecasting the Direction and Strength of Stock Market Movement Forecastng the Drecton and Strength of Stock Market Movement Jngwe Chen Mng Chen Nan Ye cjngwe@stanford.edu mchen5@stanford.edu nanye@stanford.edu Abstract - Stock market s one of the most complcated systems

More information

THE IMPLIED VOLATILITY OF ETF AND INDEX OPTIONS

THE IMPLIED VOLATILITY OF ETF AND INDEX OPTIONS The Internatonal Journal of Busness and Fnance Research Volume 5 Number 4 2011 THE IMPLIED VOLATILITY OF ETF AND INDEX OPTIONS Stoyu I. Ivanov, San Jose State Unversty Jeff Whtworth, Unversty of Houston-Clear

More information

Construction Rules for Morningstar Canada Target Dividend Index SM

Construction Rules for Morningstar Canada Target Dividend Index SM Constructon Rules for Mornngstar Canada Target Dvdend Index SM Mornngstar Methodology Paper October 2014 Verson 1.2 2014 Mornngstar, Inc. All rghts reserved. The nformaton n ths document s the property

More information

Macro Factors and Volatility of Treasury Bond Returns

Macro Factors and Volatility of Treasury Bond Returns Macro Factors and Volatlty of Treasury Bond Returns Jngzh Huang Department of Fnance Smeal Colleage of Busness Pennsylvana State Unversty Unversty Park, PA 16802, U.S.A. Le Lu School of Fnance Shangha

More information

HOUSEHOLDS DEBT BURDEN: AN ANALYSIS BASED ON MICROECONOMIC DATA*

HOUSEHOLDS DEBT BURDEN: AN ANALYSIS BASED ON MICROECONOMIC DATA* HOUSEHOLDS DEBT BURDEN: AN ANALYSIS BASED ON MICROECONOMIC DATA* Luísa Farnha** 1. INTRODUCTION The rapd growth n Portuguese households ndebtedness n the past few years ncreased the concerns that debt

More information

Number of Levels Cumulative Annual operating Income per year construction costs costs ($) ($) ($) 1 600,000 35,000 100,000 2 2,200,000 60,000 350,000

Number of Levels Cumulative Annual operating Income per year construction costs costs ($) ($) ($) 1 600,000 35,000 100,000 2 2,200,000 60,000 350,000 Problem Set 5 Solutons 1 MIT s consderng buldng a new car park near Kendall Square. o unversty funds are avalable (overhead rates are under pressure and the new faclty would have to pay for tself from

More information

DO LOSS FIRMS MANAGE EARNINGS AROUND SEASONED EQUITY OFFERINGS?

DO LOSS FIRMS MANAGE EARNINGS AROUND SEASONED EQUITY OFFERINGS? DO LOSS FIRMS MANAGE EARNINGS AROUND SEASONED EQUITY OFFERINGS? Fernando Comran, Unversty of San Francsco, School of Management, 2130 Fulton Street, CA 94117, Unted States, fcomran@usfca.edu Tatana Fedyk,

More information

Return decomposing of absolute-performance multi-asset class portfolios. Working Paper - Nummer: 16

Return decomposing of absolute-performance multi-asset class portfolios. Working Paper - Nummer: 16 Return decomposng of absolute-performance mult-asset class portfolos Workng Paper - Nummer: 16 2007 by Dr. Stefan J. Illmer und Wolfgang Marty; n: Fnancal Markets and Portfolo Management; March 2007; Volume

More information

benefit is 2, paid if the policyholder dies within the year, and probability of death within the year is ).

benefit is 2, paid if the policyholder dies within the year, and probability of death within the year is ). REVIEW OF RISK MANAGEMENT CONCEPTS LOSS DISTRIBUTIONS AND INSURANCE Loss and nsurance: When someone s subject to the rsk of ncurrng a fnancal loss, the loss s generally modeled usng a random varable or

More information

Portfolio Loss Distribution

Portfolio Loss Distribution Portfolo Loss Dstrbuton Rsky assets n loan ortfolo hghly llqud assets hold-to-maturty n the bank s balance sheet Outstandngs The orton of the bank asset that has already been extended to borrowers. Commtment

More information

Benefits and Risks of Alternative Investment Strategies*

Benefits and Risks of Alternative Investment Strategies* Benefts and Rsks of Alternatve Investment Strateges* Noël Amenc Professor of Fnance at Edhec Drector of Research and Development, Msys Asset Management Systems Lonel Martelln Assstant Professor of Fnance

More information

The OC Curve of Attribute Acceptance Plans

The OC Curve of Attribute Acceptance Plans The OC Curve of Attrbute Acceptance Plans The Operatng Characterstc (OC) curve descrbes the probablty of acceptng a lot as a functon of the lot s qualty. Fgure 1 shows a typcal OC Curve. 10 8 6 4 1 3 4

More information

SPECIALIZED DAY TRADING - A NEW VIEW ON AN OLD GAME

SPECIALIZED DAY TRADING - A NEW VIEW ON AN OLD GAME August 7 - August 12, 2006 n Baden-Baden, Germany SPECIALIZED DAY TRADING - A NEW VIEW ON AN OLD GAME Vladmr Šmovć 1, and Vladmr Šmovć 2, PhD 1 Faculty of Electrcal Engneerng and Computng, Unska 3, 10000

More information

Informational Content of Option Trading on Acquirer Announcement Return * National Chengchi University. The University of Hong Kong.

Informational Content of Option Trading on Acquirer Announcement Return * National Chengchi University. The University of Hong Kong. Informatonal Content of Opton Tradng on Acqurer Announcement Return * Konan Chan a, b,, L Ge b,, and Tse-Chun Ln b, a Natonal Chengch Unversty b The Unversty of Hong Kong Aprl, 2012 Abstract Ths paper

More information

7.5. Present Value of an Annuity. Investigate

7.5. Present Value of an Annuity. Investigate 7.5 Present Value of an Annuty Owen and Anna are approachng retrement and are puttng ther fnances n order. They have worked hard and nvested ther earnngs so that they now have a large amount of money on

More information

International Commodity Prices and the Australian Stock Market

International Commodity Prices and the Australian Stock Market Internatonal Commodty Prces and the Australan Stock Market Chrs Heaton, George Mlunovch and Anthony Passé-de Slva Abstract We propose a method for estmatng the earlest tme durng the tradng day when overnght

More information

Most investors focus on the management

Most investors focus on the management Long-Short Portfolo Management: An Integrated Approach The real benefts of long-short are released only by an ntegrated portfolo optmzaton. Bruce I. Jacobs, Kenneth. Levy, and Davd Starer BRUCE I. JACOBS

More information

An Empirical Study of Search Engine Advertising Effectiveness

An Empirical Study of Search Engine Advertising Effectiveness An Emprcal Study of Search Engne Advertsng Effectveness Sanjog Msra, Smon School of Busness Unversty of Rochester Edeal Pnker, Smon School of Busness Unversty of Rochester Alan Rmm-Kaufman, Rmm-Kaufman

More information

ADVERSE SELECTION IN INSURANCE MARKETS: POLICYHOLDER EVIDENCE FROM THE U.K. ANNUITY MARKET

ADVERSE SELECTION IN INSURANCE MARKETS: POLICYHOLDER EVIDENCE FROM THE U.K. ANNUITY MARKET ADVERSE SELECTION IN INSURANCE MARKETS: POLICYHOLDER EVIDENCE FROM THE U.K. ANNUITY MARKET Amy Fnkelsten Harvard Unversty and NBER James Poterba MIT and NBER Revsed May 2003 ABSTRACT In ths paper, we nvestgate

More information

Risk-Adjusted Performance: A two-model Approach Application in Amman Stock Exchange

Risk-Adjusted Performance: A two-model Approach Application in Amman Stock Exchange Internatonal Journal of Busness and Socal Scence Vol. 3 No. 7; Aprl 01 Rsk-Adjusted Performance: A two-model Approach Applcaton n Amman Stock Exchange Hussan Al Bekhet 1 Al Matar Abstract The purpose of

More information

The DAX and the Dollar: The Economic Exchange Rate Exposure of German Corporations

The DAX and the Dollar: The Economic Exchange Rate Exposure of German Corporations The DAX and the Dollar: The Economc Exchange Rate Exposure of German Corporatons Martn Glaum *, Marko Brunner **, Holger Hmmel *** Ths paper examnes the economc exposure of German corporatons to changes

More information

J. David Cummins* Gregory P. Nini. June 29, 2001

J. David Cummins* Gregory P. Nini. June 29, 2001 OPTIMAL CAPITAL UTILIZATION BY FINANCIAL FIRMS: EVIDENCE FROM THE PROPERTY-LIABILITY INSURANCE INDUSTRY By J. Davd Cummns* Gregory P. Nn June 29, 2001 J. Davd Cummns* Gregory P. Nn The Wharton School The

More information

Investors have traditionally equated volatility. Volatility Harvesting: Why Does Diversifying and Rebalancing Create Portfolio Growth?

Investors have traditionally equated volatility. Volatility Harvesting: Why Does Diversifying and Rebalancing Create Portfolio Growth? Volume 5 o. www.jwm.com Fall 0 Investment management s a hghly f ckle dscplne. There s plenty of room for successful nvestors to prosper. Those who do, have learned the need for humlty and adopted nvestment

More information

Management Quality, Financial and Investment Policies, and. Asymmetric Information

Management Quality, Financial and Investment Policies, and. Asymmetric Information Management Qualty, Fnancal and Investment Polces, and Asymmetrc Informaton Thomas J. Chemmanur * Imants Paegls ** and Karen Smonyan *** Current verson: December 2007 * Professor of Fnance, Carroll School

More information

Intra-year Cash Flow Patterns: A Simple Solution for an Unnecessary Appraisal Error

Intra-year Cash Flow Patterns: A Simple Solution for an Unnecessary Appraisal Error Intra-year Cash Flow Patterns: A Smple Soluton for an Unnecessary Apprasal Error By C. Donald Wggns (Professor of Accountng and Fnance, the Unversty of North Florda), B. Perry Woodsde (Assocate Professor

More information

Kiel Institute for World Economics Duesternbrooker Weg 120 24105 Kiel (Germany) Kiel Working Paper No. 1120

Kiel Institute for World Economics Duesternbrooker Weg 120 24105 Kiel (Germany) Kiel Working Paper No. 1120 Kel Insttute for World Economcs Duesternbrooker Weg 45 Kel (Germany) Kel Workng Paper No. Path Dependences n enture Captal Markets by Andrea Schertler July The responsblty for the contents of the workng

More information

Hedging Interest-Rate Risk with Duration

Hedging Interest-Rate Risk with Duration FIXED-INCOME SECURITIES Chapter 5 Hedgng Interest-Rate Rsk wth Duraton Outlne Prcng and Hedgng Prcng certan cash-flows Interest rate rsk Hedgng prncples Duraton-Based Hedgng Technques Defnton of duraton

More information

Understanding the Impact of Marketing Actions in Traditional Channels on the Internet: Evidence from a Large Scale Field Experiment

Understanding the Impact of Marketing Actions in Traditional Channels on the Internet: Evidence from a Large Scale Field Experiment A research and educaton ntatve at the MT Sloan School of Management Understandng the mpact of Marketng Actons n Tradtonal Channels on the nternet: Evdence from a Large Scale Feld Experment Paper 216 Erc

More information

Efficient Project Portfolio as a tool for Enterprise Risk Management

Efficient Project Portfolio as a tool for Enterprise Risk Management Effcent Proect Portfolo as a tool for Enterprse Rsk Management Valentn O. Nkonov Ural State Techncal Unversty Growth Traectory Consultng Company January 5, 27 Effcent Proect Portfolo as a tool for Enterprse

More information

Bank Credit Conditions and their Influence on Productivity Growth: Company-level Evidence

Bank Credit Conditions and their Influence on Productivity Growth: Company-level Evidence Bank Credt Condtons and ther Influence on Productvty Growth: Company-level Evdence Rebecca Rley*, Chara Rosazza Bondbene* and Garry Young** *Natonal Insttute of Economc and Socal Research & Centre For

More information

DI Fund Sufficiency Evaluation Methodological Recommendations and DIA Russia Practice

DI Fund Sufficiency Evaluation Methodological Recommendations and DIA Russia Practice DI Fund Suffcency Evaluaton Methodologcal Recommendatons and DIA Russa Practce Andre G. Melnkov Deputy General Drector DIA Russa THE DEPOSIT INSURANCE CONFERENCE IN THE MENA REGION AMMAN-JORDAN, 18 20

More information

Section 5.4 Annuities, Present Value, and Amortization

Section 5.4 Annuities, Present Value, and Amortization Secton 5.4 Annutes, Present Value, and Amortzaton Present Value In Secton 5.2, we saw that the present value of A dollars at nterest rate per perod for n perods s the amount that must be deposted today

More information

Moving Beyond Open Markets for Water Quality Trading: The Gains from Structured Bilateral Trades

Moving Beyond Open Markets for Water Quality Trading: The Gains from Structured Bilateral Trades Movng Beyond Open Markets for Water Qualty Tradng: The Gans from Structured Blateral Trades Tanl Zhao Yukako Sado Rchard N. Bosvert Gregory L. Poe Cornell Unversty EAERE Preconference on Water Economcs

More information

The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk

The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk The Cross Secton of Foregn Currency Rsk Prema and Consumpton Growth Rsk By HANNO LUSTIG AND ADRIEN VERDELHAN* Aggregate consumpton growth rsk explans why low nterest rate currences do not apprecate as

More information

arxiv:1109.1256v1 [q-fin.pm] 6 Sep 2011

arxiv:1109.1256v1 [q-fin.pm] 6 Sep 2011 WORKING PAPER December 2010 Fnancal Analysts Journal Volume 67, No. 4 July/August 2011, p. 42-49 arxv:1109.1256v1 [q-fn.pm] 6 Sep 2011 Dversfcaton Return, Portfolo Rebalancng, and the Commodty Return Puzzle

More information

What is Portfolio Diversification? What a CAIA Member Should Know

What is Portfolio Diversification? What a CAIA Member Should Know Research Revew CAIA What Member a CAIA Member Contrbuton Should Know What a CAIA Member Should Know What s Portfolo Dversfcaton? Apollon Fragkskos Vce Presdent, Analytcs, Head of Research, State Street

More information

Capital International Global Equities Fund (Hedged)

Capital International Global Equities Fund (Hedged) Captal Internatonal Global Equtes Fund (Hedged) Product dsclosure statement Contents 1. About Captal Group Investment Management Lmted 2. How Global Equtes Fund (Hedged) works 3. Benefts of nvestng n Global

More information

Hedge Fund Investing in the Aftermath of the Crisis: Where did the Money Go?

Hedge Fund Investing in the Aftermath of the Crisis: Where did the Money Go? Hedge Fund Investng n the Aftermath of the Crss: Where dd the Money Go? Gudo Bollger, Ivan Gudott, Florent Pochon Ths verson: July 2010 Abstract Ths paper nvestgates the determnants of hedge fund flows

More information

WORKING PAPER SERIES TAKING STOCK: MONETARY POLICY TRANSMISSION TO EQUITY MARKETS NO. 354 / MAY 2004. by Michael Ehrmann and Marcel Fratzscher

WORKING PAPER SERIES TAKING STOCK: MONETARY POLICY TRANSMISSION TO EQUITY MARKETS NO. 354 / MAY 2004. by Michael Ehrmann and Marcel Fratzscher WORKING PAPER SERIES NO. 354 / MAY 2004 TAKING STOCK: MONETARY POLICY TRANSMISSION TO EQUITY MARKETS by Mchael Ehrmann and Marcel Fratzscher WORKING PAPER SERIES NO. 354 / MAY 2004 TAKING STOCK: MONETARY

More information

Price Impact Asymmetry of Block Trades: An Institutional Trading Explanation

Price Impact Asymmetry of Block Trades: An Institutional Trading Explanation Prce Impact Asymmetry of Block Trades: An Insttutonal Tradng Explanaton Gdeon Saar 1 Frst Draft: Aprl 1997 Current verson: October 1999 1 Stern School of Busness, New York Unversty, 44 West Fourth Street,

More information

Can Auto Liability Insurance Purchases Signal Risk Attitude?

Can Auto Liability Insurance Purchases Signal Risk Attitude? Internatonal Journal of Busness and Economcs, 2011, Vol. 10, No. 2, 159-164 Can Auto Lablty Insurance Purchases Sgnal Rsk Atttude? Chu-Shu L Department of Internatonal Busness, Asa Unversty, Tawan Sheng-Chang

More information

Capital Emerging Markets Total. Opportunities Fund (Australia) Product disclosure statement. Contents

Capital Emerging Markets Total. Opportunities Fund (Australia) Product disclosure statement. Contents Captal Emergng Markets Total Opportuntes Fund (Australa) Product dsclosure statement Contents 1. About WHTM Captal Management Lmted 2. How Emergng Markets Total Opportuntes Fund (Australa) works 3. Benefts

More information

Management Quality and Equity Issue Characteristics: A Comparison of SEOs and IPOs

Management Quality and Equity Issue Characteristics: A Comparison of SEOs and IPOs Management Qualty and Equty Issue Characterstcs: A Comparson of SEOs and IPOs Thomas J. Chemmanur * Imants Paegls ** and Karen Smonyan *** Current verson: November 2009 (Accepted, Fnancal Management, February

More information

Variable Payout Annuities with Downside Protection: How to Replace the Lost Longevity Insurance in DC Plans

Variable Payout Annuities with Downside Protection: How to Replace the Lost Longevity Insurance in DC Plans Varable Payout Annutes wth Downsde Protecton: How to Replace the Lost Longevty Insurance n DC Plans By: Moshe A. Mlevsky 1 and Anna Abamova 2 Summary Abstract Date: 12 October 2005 Motvated by the rapd

More information

THE DETERMINANTS OF THE TUNISIAN BANKING INDUSTRY PROFITABILITY: PANEL EVIDENCE

THE DETERMINANTS OF THE TUNISIAN BANKING INDUSTRY PROFITABILITY: PANEL EVIDENCE THE DETERMINANTS OF THE TUNISIAN BANKING INDUSTRY PROFITABILITY: PANEL EVIDENCE Samy Ben Naceur ERF Research Fellow Department of Fnance Unversté Lbre de Tuns Avenue Khéreddne Pacha, 002 Tuns Emal : sbennaceur@eudoramal.com

More information

Hollinger Canadian Publishing Holdings Co. ( HCPH ) proceeding under the Companies Creditors Arrangement Act ( CCAA )

Hollinger Canadian Publishing Holdings Co. ( HCPH ) proceeding under the Companies Creditors Arrangement Act ( CCAA ) February 17, 2011 Andrew J. Hatnay ahatnay@kmlaw.ca Dear Sr/Madam: Re: Re: Hollnger Canadan Publshng Holdngs Co. ( HCPH ) proceedng under the Companes Credtors Arrangement Act ( CCAA ) Update on CCAA Proceedngs

More information

DB Global Short Maturity High Yield Bond Index

DB Global Short Maturity High Yield Bond Index 12 February 2015 DBIQ Index Gude DB Global Short Maturty Hgh Yeld Bond Index Summary The DB Global Short Maturty Hgh Yeld Bond Index ( Index ) tracks the performance of a selected basket of short term

More information

Implied (risk neutral) probabilities, betting odds and prediction markets

Implied (risk neutral) probabilities, betting odds and prediction markets Impled (rsk neutral) probabltes, bettng odds and predcton markets Fabrzo Caccafesta (Unversty of Rome "Tor Vergata") ABSTRACT - We show that the well known euvalence between the "fundamental theorem of

More information

Study on CET4 Marks in China s Graded English Teaching

Study on CET4 Marks in China s Graded English Teaching Study on CET4 Marks n Chna s Graded Englsh Teachng CHE We College of Foregn Studes, Shandong Insttute of Busness and Technology, P.R.Chna, 264005 Abstract: Ths paper deploys Logt model, and decomposes

More information

iavenue iavenue i i i iavenue iavenue iavenue

iavenue iavenue i i i iavenue iavenue iavenue Saratoga Systems' enterprse-wde Avenue CRM system s a comprehensve web-enabled software soluton. Ths next generaton system enables you to effectvely manage and enhance your customer relatonshps n both

More information

DEFINING %COMPLETE IN MICROSOFT PROJECT

DEFINING %COMPLETE IN MICROSOFT PROJECT CelersSystems DEFINING %COMPLETE IN MICROSOFT PROJECT PREPARED BY James E Aksel, PMP, PMI-SP, MVP For Addtonal Informaton about Earned Value Management Systems and reportng, please contact: CelersSystems,

More information

Evaluation and use of indicators of insurance companies investment activities

Evaluation and use of indicators of insurance companies investment activities Investment Management and Fnancal Innovatons, Volume 10, Issue 3, 2013 Olha Kozmenko (Ukrane), Vctora Roenko (Ukrane) Evaluaton and use of ndcators of nsurance companes nvestment actvtes Abstract The paper

More information

Integration Of Smaller European Equity Markets : A Time-Varying Integration Score Analysis

Integration Of Smaller European Equity Markets : A Time-Varying Integration Score Analysis IIIS Dscusson Paper No.136/Aprl 2006 Integraton Of Smaller European Equty Markets : A Tme-Varyng Integraton Score Analyss Gregory Brg School of Busness Studes and Insttute for Internatonal Integraton,

More information

This study examines whether the framing mode (narrow versus broad) influences the stock investment decisions

This study examines whether the framing mode (narrow versus broad) influences the stock investment decisions MANAGEMENT SCIENCE Vol. 54, No. 6, June 2008, pp. 1052 1064 ssn 0025-1909 essn 1526-5501 08 5406 1052 nforms do 10.1287/mnsc.1070.0845 2008 INFORMS How Do Decson Frames Influence the Stock Investment Choces

More information

Akira Yanagisawa Leader Energy Demand, Supply and Forecast Analysis Group Energy Data and Modelling Center

Akira Yanagisawa Leader Energy Demand, Supply and Forecast Analysis Group Energy Data and Modelling Center Background of Surgng Ol Prces and Market Expectaton Seen n Optons Akra Yanagsawa Leader Energy Demand, Supply and Forecast Analyss Group Energy Data and Modellng Center Summary The crude ol prces (WTI

More information

Journal of Empirical Finance

Journal of Empirical Finance Journal of Emprcal Fnance 16 (2009) 126 135 Contents lsts avalable at ScenceDrect Journal of Emprcal Fnance journal homepage: www.elsever.com/locate/jempfn Costly trade, manageral myopa, and long-term

More information

Module 2 LOSSLESS IMAGE COMPRESSION SYSTEMS. Version 2 ECE IIT, Kharagpur

Module 2 LOSSLESS IMAGE COMPRESSION SYSTEMS. Version 2 ECE IIT, Kharagpur Module LOSSLESS IMAGE COMPRESSION SYSTEMS Lesson 3 Lossless Compresson: Huffman Codng Instructonal Objectves At the end of ths lesson, the students should be able to:. Defne and measure source entropy..

More information

Working Paper Risk and return of illiquid investments: A trade-off for superannuation funds offering transferable accounts

Working Paper Risk and return of illiquid investments: A trade-off for superannuation funds offering transferable accounts Workng Paper Rsk and return of llqud nvestments: A trade-off for superannuaton funds offerng transferable accounts Dr James Rchard Cummngs and Dr Katrna Ells November 2011 www.apra.gov.au Australan Prudental

More information

Scale Dependence of Overconfidence in Stock Market Volatility Forecasts

Scale Dependence of Overconfidence in Stock Market Volatility Forecasts Scale Dependence of Overconfdence n Stoc Maret Volatlty Forecasts Marus Glaser, Thomas Langer, Jens Reynders, Martn Weber* June 7, 007 Abstract In ths study, we analyze whether volatlty forecasts (judgmental

More information

On the correct model specification for estimating the structure of a currency basket

On the correct model specification for estimating the structure of a currency basket On the correct model specfcaton for estmatng the structure of a currency basket Jyh-Dean Hwang Department of Internatonal Busness Natonal Tawan Unversty 85 Roosevelt Road Sect. 4, Tape 106, Tawan jdhwang@ntu.edu.tw

More information

Traffic-light a stress test for life insurance provisions

Traffic-light a stress test for life insurance provisions MEMORANDUM Date 006-09-7 Authors Bengt von Bahr, Göran Ronge Traffc-lght a stress test for lfe nsurance provsons Fnansnspetonen P.O. Box 6750 SE-113 85 Stocholm [Sveavägen 167] Tel +46 8 787 80 00 Fax

More information

Performance attribution for multi-layered investment decisions

Performance attribution for multi-layered investment decisions Performance attrbuton for mult-layered nvestment decsons 880 Thrd Avenue 7th Floor Ne Yor, NY 10022 212.866.9200 t 212.866.9201 f qsnvestors.com Inna Oounova Head of Strategc Asset Allocaton Portfolo Management

More information

The Role of Fixed Income Benchmarks. May 2007 Lev Dynkin, Managing Director Global Head of Quantitative Portfolio Strategies

The Role of Fixed Income Benchmarks. May 2007 Lev Dynkin, Managing Director Global Head of Quantitative Portfolio Strategies The Role of Fxed Income enchmarks May 2007 Lev Dynkn, Managng Drector Global Head of Quanttatve Portfolo Strateges Why use a benchmark? Is the portfolo manager addng value vs a nave ( zero skll ) nvestment

More information

Discount Rate for Workout Recoveries: An Empirical Study*

Discount Rate for Workout Recoveries: An Empirical Study* Dscount Rate for Workout Recoveres: An Emprcal Study* Brooks Brady Amercan Express Peter Chang Standard & Poor s Peter Mu** McMaster Unversty Boge Ozdemr Standard & Poor s Davd Schwartz Federal Reserve

More information

10.2 Future Value and Present Value of an Ordinary Simple Annuity

10.2 Future Value and Present Value of an Ordinary Simple Annuity 348 Chapter 10 Annutes 10.2 Future Value and Present Value of an Ordnary Smple Annuty In compound nterest, 'n' s the number of compoundng perods durng the term. In an ordnary smple annuty, payments are

More information

FINANCIAL MATHEMATICS

FINANCIAL MATHEMATICS 3 LESSON FINANCIAL MATHEMATICS Annutes What s an annuty? The term annuty s used n fnancal mathematcs to refer to any termnatng sequence of regular fxed payments over a specfed perod of tme. Loans are usually

More information

Gender differences in revealed risk taking: evidence from mutual fund investors

Gender differences in revealed risk taking: evidence from mutual fund investors Economcs Letters 76 (2002) 151 158 www.elsever.com/ locate/ econbase Gender dfferences n revealed rsk takng: evdence from mutual fund nvestors a b c, * Peggy D. Dwyer, James H. Glkeson, John A. Lst a Unversty

More information

LIFETIME INCOME OPTIONS

LIFETIME INCOME OPTIONS LIFETIME INCOME OPTIONS May 2011 by: Marca S. Wagner, Esq. The Wagner Law Group A Professonal Corporaton 99 Summer Street, 13 th Floor Boston, MA 02110 Tel: (617) 357-5200 Fax: (617) 357-5250 www.ersa-lawyers.com

More information