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Gauging Liquidity Risk in Emerging Market Bond Index Funds

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Date
2016
Dewey
Organisation et finances d'entreprise
Sujet
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 code
G.G1.G15; G.G1.G12; G.G0.G01; C.C3.C32; C.C0.C01
Journal issue
Annals of Economics and Statistics
Volume
123/124
Publication date
12-2016
Article pages
p. 247-269
DOI
http://dx.doi.org/10.15609/annaeconstat2009.123-124.0247
URI
https://basepub.dauphine.fr/handle/123456789/16472
Collections
  • DRM : Publications
Metadata
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Author
Darolles, Serge
1032 Dauphine Recherches en Management [DRM]
Dudek, Jérémy
Le Fol, Gaëlle
1032 Dauphine Recherches en Management [DRM]
Type
Article accepté pour publication ou publié
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

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