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October 17, 2003 at 08:00 PM
NEW YORK (HedgeWorld.com)? Fund blowups slant hedge fund performance measures, causing ?fat tails? in the distribution of returns. Methods that take account of this issue give better results in estimating value-at-risk, but some are difficult to use, a new study shows.
Suleyman Gokcan, vice president and head quantitative analyst at Citigroup?s fund of funds unit, and Turan Bali, associate professor of finance at Baruch College of the City University of New York, compared four models, including the common ?thin-tailed? normal distribution, using strategy-level monthly index data.
?We tested if the return distributions of the strategies are normal. For most of them, we found that they are not normal. There is strong skewness, mostly negative, as well as kurtosis,? explained Mr. Gokcan. ?So, you should not assume the distribution is normal in estimating VaR. The other distributions take into account this skewness and kurtosis, in one way or another.?
Two of the alternatives to the normal distribution performed best. But one, the Cornish-Fisher expansion in computing VaR thresholds for hedge fund index returns, is easier to obtain.
Catastrophic Market Risk
Value-at-Risk shows how much the investor likely will lose if something goes wrong. It is a measure of the maximum expected loss on a portfolio over a given period with a certain degree of probability. This metric became popular especially after the Long-Term Capital Management episode, which drew attention to the effect of catastrophic market risk on hedge funds.
