“Correlation Factor” may allow risk managers to treat the disease, not just the symptoms
| Aug 8th, 2010 | Filed under: Academic Research, Hedge Fund Operations and Risk Management, Performance, Analytics & Metrics, Today's Post | By: Alpha Male |
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Critics of Modern Portfolio Theory often point to the fact that correlations – the foundation upon which MPT’s diversification arguments are built – are non-linear. In times of distress, they say, “correlations go to one.” Amir Khandani and Andrew Lo’s paper “What Happened to Quants in August 2007?” (now part of the CAIA curriculum) is a case study in the folly of assuming correlations are stable over time. Regulators have learned this lesson too. Essentially, the much debated “systemic risk” is really just the risk resulting from correlations changing rapidly, resulting in a breakdown of diversification’s benefit .
Today’s focus on “tail risk management” (TRM) is a response to this realization. TRM often takes the form of downside hedges like buying market puts or volatility-based derivatives (see our previous “Tail Risk Management…”) . But a new paper essentially suggests that such a hedge treats the symptom, not the cause, of tail risks. In “When there is no place to hide: Correlation risk and the cross-section of hedge fund returns” Andrea Buraschi and Robert Kosowski of Imperial College Business School in London and Fabio Trojani of the University of Lugano propose a new risk factor called “correlation risk.” They also conclude that much of the alpha of hedge fund returns can be explained by this new factor.
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[...] management to the top of the agenda for hedge funds and risk managers alike.View original here: AllAboutAlpha: Hedge Fund Trends & Alternative Investment Analysis …Related postsAllAboutAlpha: Hedge Fund Trends & Alternative Investment Analysis … (0)The [...]
A very interesting post, thanks for promoting this academic paper!
James
http://www.market-melange.com/2010/08/08/outlook-review-9-august-2010/