MFE 230H: Financial Risk Management

Homework 11

Dieter Dijkstra Geoff Simmons

October 4, 2013

1 Optimal Hedge Fund Weighting

- We are given that both the magnitude and variance of a hedge fund’s returns can be represented as follows

rHF = rf + α + βHF (rM − rf ) + 

2 2 2
σHF = βHF σM + σ2

If we were to construct a fully-invested portfolio of both the hedge fund and market, or

rP = wHF rHF + wM rM

where
wHF + wM = 1
the minimum-variance optimal weight of the hedge fund can be found by expanding the portfolio variance
2 2
Var[rP ] = wHF Var[rHF ] + wM Var[rM ] + 2wHF wM Cov[rHF , rM ]
2 2 2 2 2 2 2


σP = wHF βHF σM + σ + wM σM + 2wHF wM βHF Var[rM ]
2 2 2 2

2 2 2
= wHF βHF σM + σ + (1 − wHF ) σM + 2wHF (1 − wHF ) βHF σM

and then taking the first derivative and setting it equal to zero

∂σP2 2 2
+ σ2 − 2 (1 − wHF ) σM
2 2


= 2wHF βHF σM + 2 (1 − 2wHF ) βHF σM
∂wHF

∗
 2 2
+ 2σ2 + 2σM
2 2 2
  
wHF 2βHF σM − 4βHF σM + 2σM βHF − 1 = 0
σ2
 
2 ∗ 2 2
 
2σM wHF βHF + 2 + 1 − 2βHF = 2σM 1 − βHF
σM

Therefore, the optimal weight can be represented as follows

∗ 1 − βHF
wHF = σ2 2
2
σM
+ (βHF − 1)

In order to ensure a long-only portfolio, the following conditionality must be set


 0, if βHF > 1
∗ ∗
wHF = wHF , if βHF ≤ 1 and σ2 > βHF (1 − βHF )σM 2
2 2
1, if σ ≤ βHF (1 − βHF )σM


1
- In order to ensure that there is diversification benefit to investing in the hedge fund, the resulting portfolio
variance must be smaller than that of the market, or

σP2 < σM
2

Expanding this relationship gives

2 2 2 2 2
+ σ2 + (1 − wHF ) σM 2 2


wHF βHF σM + 2wHF (1 − wHF ) βHF σM < σM
σ2
 
2
2
wHF 2
βHF + 2 + (1 − wHF ) + 2wHF (1 − wHF ) βHF <1
σM
σ2
 
2
wHF 2
βHF + 2 + wHF 2
− 2wHF + 2wHF (1 − wHF ) βHF <0
σM
σ2
 
wHF βHF 2
+ 2 + wHF + 2 (1 − wHF ) βHF <2
σ
 M
σ2

wHF βHF 2
+ 2 + 1 − 2βHF + 2βHF <2
σM

The result is an inequality constraint on the hedge fund holdings

2(1 − βHF ) ∗
wHF < σ2 2
= 2wHF
2
σM
+ (βHF − 1)

- It is clear that any hedge fund weighting less than two times the optimal weight will provide a diversification
benefit for a fully invested portfolio, and this portfolio will be long only if the beta of the hedge fund is
less than one. In addition, any positive weighting will provide exposure to the hedge fund’s return, and
consequently its alpha. Therefore, it can be concluded that it is possible for hedge funds to be both
an alpha generator and a risk diversifier for long-only fully invested portfolios as long as βHF < 1 and
∗
wHF < 2wHF .