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Abstract
Many hedge funds that claim to be market-neutral produce returns that are highly correlated with the returns of market benchmarks. Fast-changing correlations among asset classes make it difficult to construct market-neutral portfolios intended to reduce overall risk while generating positive alpha. This article examines methods of constructing actively managed portfolios of Chicago Board Options Exchange (CBOE) Volatility Index derivatives that reduce portfolio correlation with the equity market. The authors find that the Kalman filter–based dynamic capital asset pricing model (CAPM) produces the best results. This approach is capable of constructing equity market–neutral portfolios with positive alpha. In addition, dynamic CAPM provides a way to estimate the equivalent option “Greeks” for VIX derivatives.
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