The Present Value

ISDA highlights a selection of research papers on derivatives and risk management         


Unmasking Mutual Fund Derivatives Use During the COVID-19 Crisis

By Ron Kaniel and Pingle Wang

The paper examines derivatives use by domestic equity mutual funds in the US and the impact of derivatives trades on fund performance. It also focuses on how fund managers traded derivatives during the COVID-19 pandemic. As most mutual fund managers are restricted from taking short equity positions, trading derivatives is essential for fund managers that want to trade on the short side of the market.

The study uses a dataset from the US Securities and Exchange Commission’s Form N-PORT, which contains detailed quarterly derivatives holdings and monthly derivatives performance. Mutual funds, except for money market funds and small business investment companies, are required to file a monthly Form N-PORT.

The study finds that fund managers’ derivatives use almost doubled from December 2019 to March 2020. In response to the initial outbreak of COVID-19, funds traded more heavily on short derivatives positions. This behavior was more prevalent among managers residing in states with early state-level stay-at-home orders.

The analysis shows that over 50% of active funds that use derivatives have a derivative weight of less than 0.1%. Among the funds that use derivatives extensively, there are significant differences in performance.

The study finds that funds that used derivatives for hedging purposes before the crisis significantly outperformed non-users during the initial outbreak of COVID-19. Conversely, funds that used derivatives to amplify market exposure underperformed non-users.

The authors classify funds into amplifying or hedging categories based on the correlation between derivative and non-derivative returns. The correlation of amplifying funds ranges between 0.78 and 1, whereas the correlation of hedging funds ranges between -1 and -0.08. The study finds that most funds use derivatives to amplify their market exposure, rather than for hedging.

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Emerging Markets Sovereign Spreads and Country Specific Fundamentals During COVID-19

NBER Working Paper No. w27903
By Timo Daehler, Joshua Aizenman, and Yothin Jinjarak

The study examines the relative importance of country specific and global factors in determining sovereign credit default swaps (CDS) spreads of emerging market (EM) countries during the COVID-19 pandemic.

The authors estimate a multi-factor model for changes in EM CDS spreads over several years before the outbreak of COVID-19, between January 2014 through June 2019. Then they use the estimated coefficients from the first stage to extrapolate model-implied changes in CDS spreads from July 2019 through June 2020.

The authors derive the ‘COVID residual’ – the difference between actual CDS changes and the changes implied by the model – and explain this residual by COVID-related factors from three different areas: epidemiological, economic and political.

The study finds that in March 2020, divergence in CDS spreads was partly accounted for by traditional determinants of sovereign risk pricing, such as fiscal space, economic activity, actions by the Federal Reserve and the European Central Bank and the change in oil prices, rather than COVID-specific risks and associated policies. COVID infections, mortalities and virus containment policies were not significant drivers of CDS spread adjustments over this period.

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What is Certain About Uncertainty?

FRB International Finance Discussion Paper No. 1294

This paper reviews a broad set of measures of risk, uncertainty and volatility related to global and country specific macroeconomic and financial outcomes. It explains what these measures capture and how they are calculated. The authors plot the time series of all measures to show their dynamics around key events, such as the 2008 global financial crisis, the recent trade disputes between China and the US and the outbreak of COVID-19.

The study divides the measures into three types: (1) news, survey, and econometric indicators; (2) asset-market indicators; and (3) Knightian uncertainty.

Some examples of news, survey and econometric indicators include economic policy uncertainty, monetary policy uncertainty, trade policy uncertainty, a world uncertainty index, geopolitical risk, and survey based macroeconomic and inflation uncertainty.

The study draws several conclusions. First, it is essential to define the nature of risk instead of using broad terms about uncertainty and risk. Second, all measures are limited to characterize particular types of uncertainty at particular horizons. Finally, the transmission of risks is substantial, both across sectors and across countries.

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