Risk and Return in Fixed Income Arbitrage: Nickels in front of a Steamroller?

Duarte, Jefferson; Longstaff, Francis A.; Yu, Fan

doi:10.2139/ssrn.872004

Cited by 109 publications

(149 citation statements)

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“…Our paper contributes to the growing literature on identifying risk factors that drive different hedge fund strategies' returns such as trend-following strategy (Fung and Hsieh (2001)), merger arbitrage strategy (Mitchell and Pulvino (2001)), equity-oriented hedge fund strategies (Agarwal and Naik (2004)), equity pairs trading strategy (Gatev et al (2006)), and fixed income arbitrage strategy (Duarte et al (2007);Fung and Hsieh (2004)). Our empirical findings complement the recent work of Choi et al (2009) andChoi et al (2010).…”

Section: Introductionmentioning

confidence: 97%

Risk and return in convertible arbitrage: Evidence from the convertible bond market

Agarwal

Fung

Loon

et al. 2011

Journal of Empirical Finance

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In this paper, we identify and document the empirical characteristics of the key drivers of convertible arbitrage as a strategy and how they impact the performance of convertible arbitrage hedge funds. We show that the returns of a buy-and-hedge strategy involving taking a long position in convertible bonds ("CBs") while hedging the equity risk alone explains a substantial amount of these funds' return dynamics. In addition, we highlight the importance of non-price variables such as extreme market-wide events and the supply of CBs on performance. Out-ofsample tests provide corroborative evidence on our model's predictions. At a more micro level, larger funds appear to be less dependent on directional exposure to CBs and more active in shorting stocks to hedge their exposure than smaller funds. They are also more vulnerable to supply shocks in the CB market. These findings are consistent with economies of scale that large funds enjoy in accessing the stock loan market. However, the friction involved in adjusting the stock of risk capital managed by a large fund can negatively impact performance when the supply of CBs declines. Taken together, our findings are consistent with convertible arbitrageurs collectively being rewarded for playing an intermediation role of funding CB issuers whilst distributing part of the equity risk of CBs to the equity market.Keywords: Hedge funds, Convertible Bonds, Convertible arbitrage, Supply, Risk Factors JEL classification: G10, G19, G23 1 IntroductionAt the turn of the century, capitalization of the global convertible bond ("CB") market stood at just under $300 billion while the US equity market was more than 50 times higher at over $1.5 trillion. Yet during the difficult market conditions between 2000 and 2002 (with events such as end to the dotcom bubble, September 11, and the accounting scandals at Worldcom and Enron), the new issues in both these markets were of similar orders of magnitude-close to $300 billion. Even during the financial crisis of [2007][2008], firms managed to raise about $118 billion in the US CB market. 1 This underscores the importance of the CB market as a source of capital for corporations during adverse economic conditions. 2To smooth the placement of such a large-scale issuance of CBs, economic agents willing to assume the inventory risk are clearly needed. Coincident to these macro events, the last decade has witnessed a rapid growth of convertible arbitrage ("CA 1 Equity data are from Federal Reserve Bulletin (various issues). We thank Jeff Wurgler for making it available on his website http://pages.stern.nyu.edu/~jwurgler/. CB estimate is from the public and private proceeds of convertible debt from Thomson Reuters Financial's SDC Platinum database, which we also use later on for our out-of-sample analysis. 2 Apart from being a useful source of liquidity to issuers during adverse market conditions, the issuance of CBs depends also on the costs and benefits compared to other forms of securities issuance. Firms selling CBs incur costs inclu...

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Section: Introductionmentioning

confidence: 97%

Risk and return in convertible arbitrage: Evidence from the convertible bond market

Agarwal

Fung

Loon

et al. 2011

Journal of Empirical Finance

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“…In a later study (2004) they focused on the systematic risk exposures of hedge funds that practise buyand-hold and option-based strategies. A more recent study that we discuss is from Duarte, Longstaff, and Yu (2007) that focuses on fixed income strategies, showing that "market neutral" strategies impose substantial risk exposures on investors. Agarwal and Naik (2000) suggested a general asset factor model consisting of excess returns on passive option-based strategies and on buy-and-hold strategies.…”

Section: Option-based Buy and Hold Strategiesmentioning

confidence: 99%

“…A more recent study using the ABS approach was from Duarte, Longstaff, and Yu (2007) that examined the return and risk characteristic of fixed-income strategies using the CSFB/Tremont and HFR databases from 1994-2004. Implementing isotonic regression and linear-kernel regressions, they found all five strategies exhibited positive excess returns.…”

Section: Option-based Buy and Hold Strategiesmentioning

confidence: 99%

“…Their findings were consistent with Fung and Hsieh (1997) concerning the payoff style of some hedge fund strategies. Duarte, Longstaff and Yu (2007) found that the so called market neutral strategies were not so neutral for investors and some fixed income strategies required the most "intellectual capital" to implement.…”

Section: Option-based Buy and Hold Strategiesmentioning

confidence: 99%

“…A short position in a put option on the market index delivers a significant left-tailed risk that is not captured sufficiently in the mean variance framework. The expected tail losses of mean-variance optimal portfolios can be underestimated and the performance during the last decade is not representative of hedge fund long-term performance Duarte, Longstaff, and Yu (2007) CSFB/ Tremont, HFR, 1994-2004 Bottom-Up/Isotonic regression, Linear-Kernel regression In general, fixed income arbitrage strategies deliver positive excess returns which are positively skewed. However, they expose investors to substantial levels of market risk.…”

Section: Studymentioning

confidence: 99%

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Recent advances in explaining hedge fund returns: Implicit factors and exposures

Stafylas

Anderson

Uddin

2017

Global Finance Journal

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We survey articles covering how hedge funds returns are explained, using largely nonlinear multifactor models that examine the non-linear pay-offs and exposures of hedge funds. We provide an integrated view of the implicit factor and statistical factor models that are largely able to explain the hedge fund return-generating process. We present their evolution through time by discussing pioneering studies that made a significant contribution to knowledge, and also recent innovative studies that examine hedge funds exposures using advanced econometric methods. This is the first review that analyzes very recent studies that explain a large part of hedge fund variation. We conclude by presenting some gaps for future research. Recent Advances in Explaining Hedge Fund Returns: Implicit Factors and Exposures AbstractWe survey articles covering how hedge funds returns are explained, using largely nonlinear multifactor models that examine the non-linear pay-offs and exposures of hedge funds. We provide an integrated view of the implicit factor and statistical factor models that are largely able to explain the hedge fund return-generating process. We present their evolution through time by discussing pioneering studies that made a significant contribution to knowledge, and also recent innovative studies that examine hedge funds exposures using advanced econometric methods. This is the first review that analyzes very recent studies that explain a large part of hedge fund variation. We conclude by presenting some gaps for future research.Keywords: hedge fund performance; implicit factors; statistical factors; linear and non-linear multi-factor models; alpha and beta returns 1

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