Replicating the Properties of Hedge Fund Returns

Abstract

In this paper, we implement a multi-variate extension of Dybvig (1988) Payoff Distribution Model that can be used to replicate not only the marginal distribution of most hedge fund returns but also their dependence with other asset classes. In addition to proposing ways to overcome the hedging and compatibility inconsistencies in Kat and Palaro (2005), we extend the results of Schweizer (1995) and adapt American options pricing techniques to evaluate the model and also derive an optimal dynamic trading (hedging) strategy. The proposed methodology can be used as a benchmark for evaluating fund performance, as well as to replicate hedge funds or generate synthetic funds.