Some Econometric Issues on the Evaluation of Hedge Fund Risk-taking Cycles

The US financial system has been hit by a wave of financial innovations since the start of the 1980s which has led to the spread of new kinds of financial instruments such as options and structured products like CLO (collateralized loan obligations) and CDO (collateralized debt obligations). Securitization is also a new kind of financial activity which has registered a very quick growth since the 1990s. These developments have led to the rise of new forms of banking which, in contrast to the traditional business lines of banks, are market-based like shadow banking. Moreover, the growth of hedge funds has been very important since the start of the 1990s and especially during the period stretching from 2000 to 2007—i.e., just before the occurrence of the subprime crisis. Indeed, confronted by a structural decrease in interest rates, investors were in “search of yield” and the products engineered by hedge funds provided an attractive return compared to other securities available on financial markets. However, investors often forget that yield and risk are two sides of the same coin. Indeed, these funds are involved in optionlike strategies which embed substantial higher moment risk—especially risk related to negative return skewness and high return excess kurtosis.