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Alternative Investments - June 24, 2008

Exclusive preview of the Summer 2008 issue of the Journal of Alternative Investments

As part of a partnership between the EDHEC Risk and Asset Management Research Centre and the Journal of Alternative Investments, we are pleased to be able to offer our readers an exclusive preview of the contents of the Summer 2008 issue of this respected academic journal.

The Journal of Alternative Investments provides cutting-edge research and expert analysis on managing investments in hedge funds, private equity, distressed debt, commodities, futures, energy, funds of funds, and other non-traditional instruments.

The Summer issue covers a wide range of topics spanning factor analysis, risk management, taxation and perspectives. A full list of the featured papers can be found below.

Risk-Arbitrage Spreads and Performance of Risk Arbitrage Ben Branch and Jia Wang

This article explores the cross sectional variation in risk arbitrage spreads. Factors that are relevant to the probability of deal success (i.e., target termination fees, target resistance, target price run-up, relative size of the target, and arbitrageurs’ activity), bid revision (i.e., target’s growth opportunity), potential loss when a deal fails (i.e., bid premium and bidder’s systematic risk) and transaction costs for risk arbitrageurs (i.e., bidder’s return volatility and low priced shares) are found to be significant in developing a prediction model for risk arbitrage spreads. Risk arbitrage portfolios are created by comparing predicted arbitrage spreads with actual arbitrage spreads.The results show that deals whose actual spreads exceed the predicted spreads tend to be more attractive investments.The model may be used by risk arbitrageurs to identify attractive risk arbitrage opportunities.

The Distressed Corporate Debt Cycle from a Hedge Fund Investor's Perspective Ping Chen, José F. González-Heres and Steven S. Shin

This article analyzes the distressed corporate debt cycle from the perspective of a hedge fund investor rather than a hedge fund manager.The authors find that the distressed cycle has an element of memory (repeatability) and can be categorized into three distinct states within a cycle.The authors also find that the Distressed Ratio, which measures the available supply of distressed debt within the high-yield universe, serves as the key factor in predicting distressed hedge fund manager returns. Furthermore, evidence is presented that indicates that regime-switching analytical techniques can be useful in identifying trigger (or inflection) points that lead to state transitions within the cycle.The authors conclude that investors can improve their odds of enhancing return expectations by tactically adjusting their exposure to the strategy based on an understanding of the opportunities and risks afforded by each state within the cycle.

Are the U.S. Stock Market and Credit Default Swap Market Related? Evidence from the CDX Indices Hung-Gay Fung, Gregory E. Sierra, Jot Yau and Gaiyan Zhang

This article examines the market-wide relations between the U.S. stock market and the credit default swap (CDS) market for the period 2001–2007. Results indicate that the lead-lag relationship between the U.S. stock market and the CDS market depends on the credit quality of the underlying reference entity. Specifically, this article finds significant mutual feedback of information between the stock market and the high-yield CDS market in terms of pricing and volatility, while the stock market leads the investment-grade CDS index in the pricing process.The CDS market seems to play a more significant role in volatility spillover than the stock market.That is,volatilities of both the investment-grade and high-yield CDS indices seem to lead the stock market volatility, while the latter has a feedback effect to that of the high-yield CDS market only. Overall, the implication is that market participants should seek information in both markets when they are about to engage in trading and/or hedging.

The Impact of Increasing Carried Interest Tax Rates on the U.S. Economy John Rutledge

This article examines recent congressional proposals to increase the tax rate on the general partner’s share of a limited partnership’s profits,known as carried interest, from the long-term capital gains rate of 15% to ordinary income tax rates of 35%. Specifically, the article shows that carried interest impacts approximately $15.3 trillion in partnership capital employed by 16.2 million Americans across every sector of the U.S. economy engaged in capital formation. Increasing the tax rate on carried interest would lead to changes in the structure of partnership agreements; incremental tax collections would be small.To the extent the tax increases could not be avoided by restructuring, the costs would be borne by all the members within the investment process, including general partners, limited partners and their beneficiaries, and owners and employees of portfolio companies. Increasing carried interest taxes would reduce the amount of long-term capital available to the U.S. economy and undermine investment, innovation, entrepreneurial activity, productivity, growth, and the ability of U.S. companies to compete in the global market.

Impact of Fund Size and Fund Flows on Hedge Fund Performance Manuel Ammann and Patrick Moerth

Capacity issues based on large inflows in well-performing hedge funds are among the most frequently discussed concerns in the hedge fund industry. In this article the impact of asset flows and fund sizes on hedge fund and CTA performance is investigated.The findings confirm the legitimacy of investor concerns regarding capacity issues in the hedge fund industry.The results of the empirical study suggest a strong negative relationship between fund sizes and hedge fund returns, standard deviations, Sharpe ratios, and alphas derived from an asset class multi-factor model.

Competition and Innovation in U.S. Futures Markets Don M. Chance

This article employs data on current volume and contracts approved by the Commodity Futures Trading Commission to document the history of approvals, launches, and successes of all contracts in U.S. futures and futures options markets. Approximately 59 percent of futures contracts and 73 percent of options that have been launched, no longer trade. Futures contracts on financial instruments have been the most successful futures, while options on financial futures have been the least successful options. For exchanges with at least 20 launches, the most successful in launching futures has been the New York Cotton Exchange, while the most successful in launching options has been the New York Mercantile Exchange.The article examines 13 cases in which competing products were launched nearly simultaneously and finds no clear-cut winner in head-to-head competition. In the majority of cases, both contracts failed.