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Gauging Liquidity Risk in Emerging Market Bond Index Funds

Darolles, Serge; Dudek, Jérémy; Le Fol, Gaëlle (2016), Gauging Liquidity Risk in Emerging Market Bond Index Funds, Annals of Economics and Statistics, 123/124, p. p. 247-269. 10.15609/annaeconstat2009.123-124.0247

Type
Article accepté pour publication ou publié
Date
2016
Journal name
Annals of Economics and Statistics
Volume
123/124
Pages
p. 247-269
Publication identifier
10.15609/annaeconstat2009.123-124.0247
Metadata
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Author(s)
Darolles, Serge
Dauphine Recherches en Management [DRM]
Dudek, Jérémy

Le Fol, Gaëlle
Dauphine Recherches en Management [DRM]
Abstract (EN)
ETFs and index funds have grown at very rapid rates in recent years. Originally launched totrack some large liquid indices in developed markets, they now also concern less liquid assetclasses such as emerging market bonds. Illiquidity certainly affects the quality of the replication,and in particular, liquidity might increase the tracking error of any index fund, i.e., thedifference between the fund and the benchmark returns. The tracking error is then the firstcharacteristic that investors consider when they select index funds. In this paper, we beginfrom the CDS-bond basis to simulate the tracking error (TE) of a hypothetical well-diversifiedfund investing in the emerging market bond universe. We compute the CDS-bond basis andthe tracking error for 9 emerging market sovereign entities: Brazil, Chile, Hungary, Mexico,Poland, Russia, South Africa, Thailand and Turkey. All of these countries are included inthe MSCI Emerging Market Debt in Local Currency index. Our sample period ranges fromJanuary 1, 2007 to March 26, 2012. Using a Regime Switching for Dynamic Correlations(RSDC) model, we show that the country-by-country tracking error is reduced by the diversificationat the fund level. Moreover, we show that this diversification effect is less effectiveduring crisis periods. This loss of diversification benefits is the main risk of index funds when they are designed to create a liquid exposure to illiquid asset classes
Subjects / Keywords
Emerging Markets; Sovereign Debt Market; Liquidity Risk Management; Dynamic Correlation; Regime Switching Models Index funds; Bond markets; Liquidity; Liquidity risk; Economic statistics; Correlations; Portfolio diversification; Investment risk; Liquids
JEL
G15 - International Financial Markets
G12 - Asset Pricing; Trading Volume; Bond Interest Rates
G01 - Financial Crises
C32 - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
C01 - Econometrics

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