Razvan Pascalau

Unit Root Tests with Smooth Breaks: An Application to the Nelson-Plosser Data Set

This paper reconsiders the nature of the trends (i.e. deterministic or stochastic) in macroeconomic time series. For this purpose, the paper employs two new tests that display robustness to structural breaks of unknown forms, irrespective of the date and/or location of the breaks. These tests approximate structural changes as smooth processes via Flexible Fourier transforms. The tests deliver strong evidence in favor of a nonlinear deterministic trend for real GNP, real per capita GNP, employment, the unemployment rate, and stock prices. Further, the two tests confirm the existence of stochastic trends in nominal GNP, consumer prices, real wages, monetary aggregates, velocity, and bond yields. In general, it appears that real variables are stationary while nominal ones have a unit root.

Diversification in Funds of Hedge Funds: Is it Possible to Overdiversify?

Samuelson (1967) argues that as a general matter it is easy to show that investors should be maximally diversified. For this reason many institutions are attracted to diversified portfolios of hedge funds, referred to as Funds of Hedge Funds (FOFs). In this paper we examine a new database that separates out for the first time the effects of diversification (the number of underlying hedge funds) from scale (the magnitude of assets under management). We find with others that the variance reducing effects of diversification peter out once FOFs hold more than 20 underlying hedge funds. Yet the majority of FOFs are more diversified than this. We find a new and surprising result that this excess diversification actually increases the left tail risk exposure of FOFs particularly once we account for the extent to which hedge fund returns are smoothed. Furthermore the average FOF in our sample is more exposed to left tail risk than are naïve 1/N randomly chosen portfolios. This increase in tail risk is accompanied by lower returns which we attribute to the cost of necessary due diligence which increases with the number of underlying hedge funds in the FOFs .

A joint survival analysis of hedge funds and funds of funds using copulas

Purpose - The purpose of this paper is to propose that simple measures of linear association are unable to capture accurately the dependence between the survival of hedge funds and funds of funds, respectively. The paper then aims to advocate the use of copulas to model the joint survival of hedge funds and funds of funds managed by the same manager. Design/methodology/approach - The paper uses both a one-step approach where the margins and the copula parameters are estimated jointly, and a two-step approach where the margins are fitted first and the copula parameter is estimated thereafter given the fixed margins. The margins are estimated non-parametrically, semi-parametrically, and parametrically, respectively. Findings - First, the paper finds that Kendalls tau and Spearmans rho are anywhere between three and eight times larger than the corresponding sample based measures when various families of copulas are employed. Second, additional tests show that the two survival functions are strongly dependent, with the degree of nonlinear association increasing in the lower left quadrant. Originality/value - This is the first paper to use copulas to model the joint survival of hedge funds and funds of funds. The results highlight the asymmetric dependence between hedge funds and funds of funds, which has implications for risk management practices.

Recruitment of Seemingly Overeducated Personnel: Insider-Outsider Effects on Fair Employee Selection Practices

We analyze a standard employee selection model given two institutional constraints: First, professional experience perfectly substitutes insufficient formal education for insiders while this substitution is imperfect for outsiders. Second, in the latter case the respective substitution rate increases with the advertised minimum educational requirement. Optimal selection implies that the expected level of formal education is higher for outsider than for insider recruits. Moreover, this difference in educational attainments increases with lower optimal minimum educational job requirements. Investigating data of a large US public employer confirms both of the above theoretical implications. Generally, the econometric model exhibits a �good fit�.

Unconditional Mean, Volatility and the Fourier-GARCH Representation

This paper proposes a new model called Fourier-GARCH that is a modification of the popular GARCH(1,1). This modification allows for time-varying first and second moments via means of Flexible Fourier transforms. A nice feature of this model is its ability to capture both short and long run dynamics in the volatility of the data, requiring only that the proper frequencies of the Fourier transform be specified. Several simulations show the ability of the Fourier series to approximate breaks of an unknown form, irrespective of the time or location of breaks. The paper shows that the main cause of the long run memory effect seen in stock returns is the result of a time varying first moment. In addition, the study suggests that allowing only the second moment to vary over time is not sufficient to capture the high persistence observed in lagged returns.

An Empirical Analysis of U.S. Dollar-Trading Newcits

The present article uses a sample of 66 U.S. dollar-trading undertakings for collective investment in transferable securities (UCITS) to find that the risk-adjusted performance of some strategies (i.e., equity long-biased, FOF, fixed income and sector specific) outperformed the corresponding traditional hedge fund indices over the January 2006 to March 2010 period. However, with the exception of the fixed-income strategy, all other strategies produced a volatility that was higher than that of the index. The funds of funds (FOF) classification had a risk similar to that of the index. More worryingly, during the crisis it appears that some strategies (i.e., emerging markets and equity long/short) delivered a lower risk-adjusted performance than that of their benchmarks. Further evidence shows that sector-specific strategies produced stronger risk-adjusted returns than their benchmarks albeit at a higher cost of volatility. Overall, the fixed income and FOF newcits delivered superior risk-adjusted performance at a lower or comparable risk to that of similar traditional hedge funds.

Nonlinear Financial Econometrics: Forecasting Models, Computational and Bayesian Models

1. The Yield of Constant Maturity 10-Year US Treasury Notes: Stumbling Toward an Accurate Forecast Rafael Weißbach, Wladyslaw Poniatowski, and Guido Zimmermann This chapter assesses three simple transformation methods to achieve the best fit for forecasting constant maturity yields of 10-year US Treasury notes (T-notes) with the self-exciting threshold autoregressive (SETAR) model. It shows that the Box–Cox transformation proves to be superior to the difference filter. However, dividing the sample of T-note yields, dating from 1962 to 2009 into a training sample and a test sample reveals the forecast to be biased. A new bias-corrected version of the SETAR model is developed, and forecasts for March 2008 to February 2009 are delivered. In addition to point estimates, forecast limits are also given. 2. Estimating the Arbitrage Pricing Theory Factor Sensitivities Using Quantile Regression Zeno Adams, Roland Füss, Philipp Grüber, Ulrich Hommel, and Holger Wohlenberg In this chapter, we apply the quantile regression technique within an arbitrage pricing theory (APT) framework to show that risk premiums may not only be negative but may also have different signs depending on the quantile of the return distribution, that is, they depend on the asset return relative to the return of the overall market. When bearing additional risk to a common factor, investors should therefore not only concentrate on the shifting of their risk exposure but also draw their attention to the selection of assets that (1) yield a positive risk premium on average and (2) still generate a positive risk premium when underperforming the market to ensure partial compensation for investors. In addition, we can also show that by replacing OLS with the quantile regression approach leads to a much better model fit of the APT for the lower-end quantiles. The usage of this estimation technique is therefore particularly advisable for periods of high volatility such as the 2007/2008 financial crisis.

Congestion in Commodity Trading Advisors

Abstract Congestion is often used in the operations area to investigate the excessive effect of inputs on outputs. In finance, and more specifically in the derivatives area, leverage is embedded in options and futures contracts. Commodity Trading Advisors (CTAs) use leverage (margin-to-equity ratio) to magnify returns through the use of these futures contracts. However, excessive leverage may hamper performance. This paper aims to show that a related data envelopment analysis (DEA) called the “congestion model” can offer a more precise picture of identifying CTAs suffering from congestion. In other words, if congestion is present then a reduction in input(s) may generate an increase in output. However, the opposite effect can arise. Although traditional DEA does an excellent job at ranking efficient CTAs, congestion on the other hand sizes up which CTAs are using too much (overuse) of each input, thereby reducing their performance/compound return (output). We measure the congestion of the largest (in terms of capital) live 50 CTAs and identify which ones exhibit congestion. The evidence shows that the probability of experiencing congestion increases with the size, minimum purchase requirements, and the incentive fees a CTA operates. In contrast, this probability decreases with the age of the CTA.

Selecting Prior Year’s Top Fund of Hedge Funds as This Year’s Choice

Can investors select winning funds of hedge funds (FOFs) by merely assuming a simple trading strategy? Can historical information present insight on future returns? Financial theory presumes that stock markets are efficient and using any type of trading strategy will not be successful in the long-run. This article investigates a pure simple trading strategy to see if selecting last year’s top-performing FOFs as this year’s choice can outperform three FOF indexes and the S&P 500 Index. We further apply the strategy to the top-performing onshore and offshore funds, respectively, and compare them to the HFR Onshore and HFR Offshore indices, respectively. We generally find that selecting (up to) the six best performing FOFs is a winning strategy that outperforms both the market and the benchmark FOFs indices. There appears to be little benefit to over-diversifying in excess of this number. This finding applies both to onshore and offshore FOFs.

Productivity Shocks, Unemployment Persistence, and the Adjustment of Real Wages

This paper applies a set of unit root and cointegration tests with non-linear error-correction mechanisms to a subset of the OECD countries to investigate the empirical conclusions of some of the labor market models in the literature. I generally find that the unemployment rate, productivity, and real wages have a unit root even if one controls for threshold effects. This finding justifies the use of a cointegration approach to assess the existence of a long-run equilibrium among the variables of interest. For roughly half of the OECD countries in the sample, the unemployment rate, real wages, and productivity trend together over time. For four countries (i.e, Germany, Japan, Sweden, and the US) the adjustment to the long run relationship appears mostly asymmetric. Also, an impulse response function analysis suggests that real wages and productivity adjust faster to the long-run equilibrium, while shocks to unemployment take longer to extinguish. Also, according to the sign of the shocks, the unemployment rates respond differently. These findings suggest that a proper analysis of the behavior of productivity, real wages, and unemployment should consider non-linear adjustment mechanisms to long-run equilibrium since a liner approach would be biased.