Sources of Non-Normality
Specific Trading strategies: Hedging, arbitrage
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Downside protection: Protection against declining markets by using hedging strategies and investmetn styles.
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Use of leverage and derivative instruments (-> leverage and/or asymmetrical payoff profiles) contributes to low correlation with traditional asset classes.
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Regulation of short selling: weaker restrictions on short selling lead to higher performance at a lower volatility.
Market inefficiencies & market frictions
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Illiquidity: illiquid assets do not allow trying any volume size with immediate execution and/or price impact. Proxy for illiquidity: autocorrelation of returns. Illiquidity distortes risk measures like volatility and beta (values will turn out too low -> underestimation of riskiness).
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Lack of divisibility: divisibility means that investors can take a) any position in an investment, regardless of investment size (-> minimum investment -> entry barrier for retail clients -> opportunity cost of exiting / undertaking short-run trading strategies) b) at any time (number of entry and exit days of a fund, for example).
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Information transparency: market efficiencies due to opaque or asymmetrical information.
Related readings:
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A. Ranaldo, L. Favre: "How to Price Hedge Funds: From Two- to Four-Moment CAPM", Working Paper, EDHC Business School, October 2003.
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Amihud, Y., 2002, “Illiquidity and stock returns: Cross-section and time-series effects,” Journal of Financial Markets, 5, 31–56.
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Pastor, L., and R. F. Stambaugh, 2003, “Liquidity risk and expected stock returns,” Journal of Political Economy, 111, 642–685.
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