Derivatives Use and Risk and Return in Hedge Funds

Table 12 presents the results of a multivariate analysis for the impact of the use of derivatives on the mean, standard deviation, VaR, MVaR, and downside volatility estimates of hedge funds. The results in Table 12 do not directly relate to any hy-pothesis of this study but rather provide additional information.

In Table 12, it is a slightly puzzling finding that the asset specialized use of

op-tions does not have a statistically significant and positive impact on the mean

re-turn of a hedge fund since informed trading could yield higher rere-turns. However,

risk adjusted return is more important as mean returns are not sufficient to judge

the performance. The use of equity index futures, instead, is associated with lower

mean return of a hedge fund. This result may be related to the lower illiquidity

risk premium of the return of a hedge fund which is a finding supportive of

Hy-pothesis 2.

Table 12. Regression Statistics of Mean Return and Risk Measures on De-rivatives Use

This table presents the parameter estimates of the cross-sectional analysis for the mean return and risk estimates of hedge funds. The model for the cross-sectional analysis is the following (Model 2):

MEASURE

_ji

= +

_j

CONTROL

_ji

j=1 N

⁺

^j

^DERIVATIVE

^ji

^{+ e}

j=1 N

^,

where MEASURE

_ji

defines a mean return or a risk measure j of fund i; CONTROL

_ji

^defines

an additional control variable j of fund i, and DERIVATIVE

_ji

defines a dummy variable for the use of a derivative j by fund i (1 if the derivative is used, otherwise 0). Asset dummies include controls for assets and primary assets in which hedge funds report investing. This table also pre-sents the Durbin-Watson test for the first-order serial correlation. The standard errors are White (1980) heteroskedasticity robust t-statistics are given in italics. See Table 1 for definitions of the variables.

* refers to a statistical significance at the 10% level; ** refers to a statistical significance at the 5% level; *** refers to a statistical significance at the 1% level

Options use for fixed-income has a negative and statistically significant impact on the mean return in the sample of all funds. This impact is also evident in the sub-samples of equity, fixed-income, and commodity specialized funds. Also, in the samples of both equity and fixed-income specialized funds, the use of other de-rivatives than options and warrants for equity and commodity have a statistically significant and negative impact on the mean return of a hedge fund. The result is consistent with the view that the use of these derivatives may be costly, as the returns are net-of-fee returns although the transaction costs are usually low for derivatives. In contrast, the use of other fixed-income derivatives than options has a statistically significant and positive impact on the mean return. In conclusion, the use of options and other derivatives of a hedge fund is not associated with higher returns but fixed-income derivatives may be cost effective.

Table 12. Continued

* refers to a statistical significance at the 10% level; ** refers to a statistical significance at the 5% level; *** refers to a statistical significance at the 1% level

The regression statistics of standard deviation on derivatives use provide partial support for risk management consistent use of derivatives by hedge funds. How-ever, the results show contradictory evidence for equity options and warrants is-sued with equity securities. The results are also mixed for different samples. For instance, the use of equity options increases standard deviation of a fund by 1.769

% for funds specialized in currency. But the use of these options by funds that are equity specialized decreases standard deviation by 0.425 %. The latter result is consistent with those of Aragon et al. (2008) and Chen (2009). The mixed results suggest that, after accounting for the heterogeneity of derivatives, the impact of the use of derivatives on the standard deviation of a hedge fund is not conclusive.

Moreover, the result suggests that asset specialized use of equity options may decrease the risk of a hedge fund.

Table 12. Continued

Dep..: D All Equity Fixed-Income Commodity Currency Variable Coef. t Coef. t Coef. t Coef. t Coef. t

* refers to a statistical significance at the 10% level; ** refers to a statistical significance at the 5% level; *** refers to a statistical significance at the 1% level

In Table 12, there are some contradictions between the standard deviation and

downside volatility. The impact of the asset specialized use of options for equity

is -0.425 % and statistically significant (5 % level) on standard deviation while

the impact on the downside deviation is weaker -0.296 % (10 % level) while the

fit of the estimated model is better for downside volatility than the standard devia-tion (R: 34 % vs. 23 %). The same characteristic also applies to the asset special-ized use of warrants for equity. Moreover, incentive fee seems to have a stronger impact on the standard deviation than the downside volatility of a hedge fund for the samples of all, equity, fixed-income-, commodity, and currency hedge funds.

For the sample of equity specialized funds, the coefficient for incentive fee is sta-tistically significant and positive when the standard deviation is fitted while the coefficient is not statistically significant when the downside volatility is fitted.

Table 12. Continued

Dep.: VAR All Equity Fixed-Income Commodity Currency Variable Coef. t Coef. t Coef. t Coef. t Coef. t

* refers to a statistical significance at the 10% level; ** refers to a statistical significance at the 5% level; *** refers to a statistical significance at the 1% level.

The results for MVaR and VaR are contradictiory. Specifically, the asset

special-ized use of options for equity decreases risk in terms of VaR estimate by 1.001 %

and the statistical significance is at the 5 % level. However, the impact is not

sta-tistically significant when the MVaR estimate, which accounts for asymmetry and

fat tails of hedge fund returns, is used instead of VaR estimate. The asset

special-ized use of warrants issued with equity securities also has a negative and

statisti-cally significant impact on the VaR estimates at the 5 % level but the impact on

the MVaR estimate is not statistically significant. The results suggest that the

re-lation between the use of options and hedge fund risk is altered by the choice of risk measures accounting for skewness and kurtosis of returns.

In general, the use of options by a hedge fund, except for asset specialized use of options for equity and currency does not support the view that the use of deriva-tives for risk management or that they otherwise coincidence with lower risk. The results for the use of the above-mentioned two derivatives also hold for the VaR measure, which assumes that the returns are normally distributed and does not account for skewness and kurtosis of the returns. This finding is significantly in-consistent with the results of Chen (2009) for risk management motivated use of derivatives.

Table 12. Continued

Dep.: MVAR All Equity Fixed-Income Commodity Currency Variable Coef. t Coef. t Coef. t Coef. t Coef. t

* refers to a statistical significance at the 10% level; ** refers to a statistical significance at the 5% level; *** refers to a statistical significance at the 1% level.

In document Do investors benefit from the use of options and complexity of derivative strategy of a hedge fund? (sivua 118-123)