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• W1592576600 abstract "1.1 Problem descriptionInvestors seek to maximise returns and to minimise risk. As risk is man-ageable but returns are not, these objectives can best be achieved throughrisk measurement/management techniques. In this regard, the concept ofdiversification plays a central role in modern portfolio theory. It followsthat investors' welfare can be improved by allocating wealth among a largenumber of different assets. Ideally, any poorly performing asset can even-tually be compensated by for positive performance from other assets in theportfolio. To put it differently, the idiosyncratic risk of a single asset canbe diversified away leading to lower portfolio risk and thus a higher riskadjusted portfolio return. Obviously, a necessary condition for risk diversi-fication to work is that asset returns do not depend on each other. Underthe assumption of normally distributed returns, a standard assumption infinance, risk and dependence can be expressed by volatility and correlationrespectively.Low volatility and low correlation with other assets offers diversificationbenefits to investors. These two features, together with historically goodperformance may explain the increasing attractiveness of hedge funds amonginstitutional and retail investors in recent years. In the last decade the hedgefund industry has been the fastest growing asset class in the financial sector.Despite the decade-long bull market in the 1990s and liquidity/credit crisesin the late 1990s, hedge fund investing has been gaining popularity amongvarious types of investors. HFR (2007) estimates that the total net assetsin hedge funds are approximately USD 1.4 trillion as of the fourth quarter2006.As a result of this growth, an increasing number of studies describingthe various hedge fund characteristics, performance comparison with otherasset classes, and their overall contribution in institutional portfolios hasbeen produced. Some of the early works are the monographs of Ledermanand Klein (1995), Crerend (1998), Jaffer (1998), Lake (1999) as well as thestudies of Ackermann, McEnally, and Ravenscraft (1999) and Fung andHsieh (1997). Other monographs such as Jaffer (2003) focus entirely on theproperties of fund of hedge funds.The risk and diversification benefits of hedge funds have been studiedin many different ways. Two major events at the end of 1990s; the nearcollapse of Long-Term Capital Management and the Asian crisis, have ledregulatory authorities to focus more on studying the risk inherent in hedgefund strategies. Brown, Goetzmann, and Park (1998) examine the involve-ment of hedge funds in the Asian crisis of 1997-1998, and the Report of thePresident's Working Group on Financial Markets (1999) deals extensivelywith the Long-Term Capital Management incident in 1998 and highlightsthe potential risks of excessive use of leverage. The general role played byhedge funds in financial market dynamics has been studied in Eichengreen,Mathieson, Sharma, Chadha, Kodres, and Jansen (1998).The investment risk of hedge funds, their unique risk properties standalone as well as in portfolio context have been analysed with standard riskmanagement tools typically assuming implicitly or explicitly normally dis-tributed returns. For example, Edwards and Liew (1999) show that addinghedge funds to traditional portfolios increases the Sharpe ratio of those port-folios. Purcell and Crowley (1999) show that hedge funds outperform tra-ditional assets in times of down markets. Diversification benefits of addinghedge funds are also found in Crerend (1998) and Agarwal and Naik (2000)as well as in Gehin and Vaissie (2005). In these studies a significant upwardshift of efficient frontier and reduction in risk measures is observed.However, hedge funds pose a challenge to standard risk measures basedon normally distributed returns. Recent evidence (see e.g. Schmidhuber andMoix 2001, Brooks and Kat 2002) casts doubt on the validity of volatilityand correlation as appropriate risk measures for hedge funds. Indeed, thereturns of hedge fund indices are not normally distributed and have exhib-ited unusual levels of skewness and kurtosis. The asymmetric properties ofhedge fund returns are investigated in Anson (2002a), Ineichen and Johansen(2002), and Ineichen (2002). These characteristics are consistent with thecomplex trading strategies used by hedge funds which present option-likepayoffs (see e.g. Fung and Hsieh 1997, Fung and Hsieh 2001, Mitchel andPulvino 2001, Fung and Hsieh 2002c, Agarwal, Fung, Loon, and Naik 2004).Clearly, volatility and correlation do not provide su±cient informationabout risk and dependence when the normality assumption is violated. Asa consequence, applying symmetric measures on hedge funds may lead toerroneous conclusions. One potential solution to overcome the problem ofnon-normality in hedge fund returns is to apply methods that take the asym-metry in return distribution into account. For instance, Bacmann and Pache(2004) apply downside deviation, Keating and Shadwick (2002) make use ofthe Omega function and Favre and Signer (2002) propose the use of a mod-ified Value-at-Risk based on Cornish-Fisher expansion.In this thesis, the use of Extreme Value Theory (EVT) is advocated.This area of statistics enables the estimation of tail probabilities regardlessof the underlying distribution of hedge fund returns. The fact that it focuseson the tail returns rather than their means, makes modelling of the wholetime series of returns unnecessary. Consequently, the estimation of Value-at-Risk and Expected Shortfall can be done under fairly general types ofdistributions.This thesis contributes to the growing literature on risk associated withhedge funds in two main directions. Firstly, it carefully examines the tailrisk of individual hedge fund strategies and of portfolios built with stocks,bonds and hedge funds using EVT. Consequently, the first objective is toevaluate the size of return asymmetry in order to quantify a potential ten-dency for extreme losses among various hedge fund strategies. The secondobjective follows the first one as it attempts to quantify eventual benefitsof the inclusion of hedge funds in a traditional portfolio (stocks and bonds)depending on the initial composition of the portfolio and on the type ofhedge funds added. Several papers (Lhabitant 2001, Blum, Dacorogna, andJaeger 2003, Gupta and Liang 2003) have already used Value-at-Risk derivedfrom EVT in the context of single funds or hedge fund indices. Bacmannand Gawron (2005) evaluates portfolio risk by allocating fund of hedge fundsonly.Secondly, the thesis further measures the dependence between hedgefunds and traditional investments in periods of distressed markets. In suchperiods, correlation breaks down and investors' ability to diversify dimin-ishes because the asset dependence is much higher than in periods of marketquiescence. For this purpose the main objective is to test explicitly the ex-istence of asymptotic dependence among hedge funds as well as betweenhedge funds and traditional investments." @default.
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• W1592576600 date "2007-01-01" @default.
• W1592576600 modified "2023-09-26" @default.
• W1592576600 title "Tail risk of hedge funds: an extreme value application" @default.
• W1592576600 doi "https://doi.org/10.5451/unibas-004384663" @default.
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