Hedge Funds and Dynamic Risk Modeling

Purpose – This research pinpoints the limitations of conventional models for evaluating the performance of hedge funds and attempts to provide a new framework for modeling the dynamics of risk structures of hedge funds. Methodology/approach – This chapter aims to explore how the systematic risk exposures of hedge funds vary over time and depend on exogenous variables that managers are supposed to use in their dynamic investment strategies. To achieve this, we used a Bayesian time-varying CAPM-based beta model within a state space technology. Findings – The results showed that the volatility, term spread rate, and shocks in liquidity influence significantly on the time variation of hedge funds. Besides, the dynamics of beta indicates that the transmission channels of systematic risk are mainly the leverage levels of hedge funds and liquidity shocks. Originality/value of chapter – These results are original because they help to explain how expected and unexpected hedge fund returns are correlated with the systematic risk factors via the beta dynamics.