Richard A. Brealey

Hedge Funds and Financial Stability: An Analysis of their Factor Exposures

In recent years, hedge funds and other highly leveraged institutions have attracted considerable criticism and have been accused of accentuating economic crises by taking large speculative positions in emerging markets. This paper examines how much information about hedge fund exposures can be inferred from fund returns. We provide supporting evidence that factor exposures are not constant and that funds exhibit herding. However, there are important difficulties in using returns data to identify speculative portfolio shifts and we show that considerable caution is needed in drawing inferences about hedge fund activities during crisis periods. Copyright 2001 by Blackwell Publishers Ltd.

Discrete exchange rate hedging strategies

Abstract In this paper we compare the effect of alternative currency hedging strategies on the variance of the terminal value of the firm. The main focus is on the time at which the hedge is put down and the frequency with which it is adjusted. We show that commonly used strategies, such as one-period cash flow hedges and long-term fixed hedges may leave them firm very exposed to foreign exchange risk. One possible explanation for the popularity of one-period cash flow hedges is that the firm may shift its operations in response to an exchange rate change. We argue that the opportunity for such shifts may help to explain the use of short term hedges.

The Asian Crisis: Lessons for Crisis Management and Prevention

The succession of financial crises that swept through Asia, Russia and Latin America in 1997 and 1998 led to considerable debate about both the role of the IMF and possible actions to limit further crises. Some have argued that international financial markets do not function well and are subject to periodic contagious panics that can be stemmed by an international lender of last resort. This paper argues that the IMF has neither the resources nor the superior information needed to fulfil such a role. However, there may be a need for an international financial institution that can use its leverage to secure policy changes in the affected countries. The paper also takes issue with the view that the IMF is simply bailing out imprudent international banks and that measures are needed to bail them back in again. The source of the Asian crisis lay in the real economy, but the effect of the crisis was greatly exacerbated by the financial structure of the affected countries. In particular, much of the risk was borne by domestic banks which borrowed dollars in the short-term interbank market and made longer-term loans in the local currency. Public policy needs to be directed to ensuring that the risks in emerging markets are distributed efficiently across both foreign and domestic investors. That involves greater use of equity finance and structured debt.

Basel II: The Route Ahead or Cul-de-Sac?

Despite the best efforts of regulators, banking crises throughout the world have been on the rise and proved costly both in terms of the burden on taxpayers and the effect on output. The revised Basel Accord establishes new procedures for measuring the risk of bank loans and for calculating the capital that needs to be held against these loans. But if these new rules are undoubtedly an improvement on the existing ones, their continued focus on the risk of individual loans suggests that bank regulation is heading down a cul-de-sac. 2006 Morgan Stanley.

Financial Stability and Central Banks: A Global Perspective

1: Financial stability and central banks: an introduction 2: Financial stability and the Bank: international evidence 3: The organizational structure of banking supervision 4: Alternative approaches to regulation and corporate governance in financial terms 5: Bank capital requirements and the control of bank failure 6: Crisis management, lender of the last resort and the changing nature of the banking industry 7: International capital movements and the international dimension to financial crises 8: Some concluding comments

How to combine active management with index funds

m \o ij; Treynor and Fischer Black suggested that it was conceptually useful to separate the selection of the common stock portfolio into two stages.’ First, the manager should place bets on specific stocks by taking long positions in those stocks that the manager expects to provide positive abnormal returns and by taking short positions in stocks that the nianager expects to give negative abnormal returns. Second, the manager should adjust the fund’s exposure to marketwide movements by buying or selling an index fund. Treynor-Black referred to the first step as the construction of the active portfolio and the second step as that of blending in the passive portfolio. Since the publication of the Treynor-Black paper, many pension schemes have invested part of their money in an index fund while putting the remainder in one or more actively managed funds, but the practice of active-passive management is linked only tenuously to the original theory. Of course, Treynor-Black assumed that the manager could freely sell short those stocks with negative expected abnormal returns. I shall argue that if managers are in fact unable to sell stocks short, a pension scheme would be justified in dividing its portfolio between an active and a passive fund only in very special circumstances. Indeed, if managers cannot sell short individual

International Propagation of the Credit Crisis

We use a large sample of non-US banks to examine the propagation of the 2007-2009 crisis. Using both stock market and structural variables we test whether the relative incidence of the crisis was better explained by crisis models or by the VaR-type analysis of the Basel system. Consistent with crisis models, we find that comovement, interbank linkages, leverage, and fragility of funding structure are related to crisis impact. Contrary to the assumptions of the Basel system, we find that asset risk, measured by the risk weightings of the Basel, has a perverse relationship with crisis impact when considered alone and no relationship when other variables are included. We provide evidence of both a direct linkage between banks and an indirect linkage which could either represent linkages in the real economy or common demands by investors for liquidity. We also investigate whether the relative impact of the crisis on banks was related to a shift in correlations and find that it was not. We discuss the implications of our findings for regulation.

The Behaviour of Sentiment-Induced Share Returns: Measurement When Fundamentals are Observable

We test the effect of sentiment on returns using a sample of upstream oil stocks where we have a good proxy for fundamental value. For this sample, the influence of sentiment is highly time-varying, appearing only after the post-2000 increased interest in oil-related assets. Contrary to the hard-to-arbitrage hypothesis, sentiment affects returns on these stocks principally through their fundamentals rather than through deviations from fundamentals. Retail investor sentiment predicts short-term momentum of fundamentals and Baker–Wurgler sentiment predicts mean reversion of fundamental factors. These effects appear in a portfolio that is long hard-to-arbitrage stocks and short easy-to-arbitrage stocks, but only because this portfolio has net exposure to fundamentals.

A Test of International Equity Market Integration using Evidence from Cross-border Mergers

We examine the changes in betas resulting from international mergers. We find that the beta with respect to the acquirers home market rises and that with respect to the targets home market falls. This effect is robust with respect to controls for changes in the operations of the companies involved and other robustness tests. It is consistent with the location of primary affecting betas with respect to different international equity markets. Such an effect can occur only if international equity markets are not fully integrated, and the risk that is generated by the stochastic discount factor in each country depends on the location of the primary listing of a company.

The Effect of Mergers on US Bank Risk in the Short Run and in the Long Run

We examine changes in risk following US bank mergers in the period 1981-2014. Short-run increases in acquirer risk following mergers occur only in the first few mergers undertaken by the same acquirer, and only in systematic risk. The equity volatility of acquirers does not increase. Using a new approach to measure the long-run effect we find that these results persist, consistent with banks maintaining a constant level of total equity risk in the long run. Constant acquirer risk means that all diversification benefits of the mergers are dissipated. We measure the loss of diversification associated with mergers and find it to be 40% of the risk level in 1981. Almost all of this occurred prior to 2004. In addition, there has been a large increase in correlations between the largest banks, much of which has come from sources other than mergers. The results are inconsistent with these mergers being motivated by the ‘too big to fail’ put. They suggest that if one wanted to reduce the risk of the banking system by demerging major banks one would have to reach back to the structure that existed before 2004. Simply reversing recent mergers would not have much effect on stock market measures of risk.