The last decade has seen an increase in the number of hedge funds and availability of hedge fund data both on individual hedge funds and on hedge fund indexes. Unlike mutual funds, hedge funds engage in dynamic strategies, use leverage, take concentrated bets and have non-linear payoffs. Colossal losses for hedge funds in Fixed Income strategy in 1998, Long/Short Equity and Global Macro strategies in 2002 and recent losses in Convertible Bond Arbitrage strategy are all attributed to different reasons and risk exposures. Therefore, it is important to understand and model time-varying risk exposures for various strategies and obtain reliable estimates for predicted exposures of hedge fund returns to various market risk factors in different market environments.
Hedge fund strategies greatly differ from each other and have different risk exposures. Fung and Hsieh (2001) analyzed a trend following" strategy and Mitchell and Pulvino (2001) studied a risk arbitrage" strategy. Both studies find the risk return characteristics of the hedge fund strategies to be nonlinear and stress the importance of taking into account option-like features while analyzing hedge funds. Moreover, Agarwal and Naik (2004) show that the non-linear option-like payoffs called also Asset-Based Style Factors (ABS-Factors introduced by Fung and Hsieh (2002a))are not restricted just to these two strategies, but are an integral part of payoffs of various hedge fund strategies.