Valuation of Collateralized Funds of Hedge Fund Obligations: A Basket Option Pricing Approach

Abstract

The purpose of the present contribution is to provide an extension to a model developed by Tassinari and Corradi [7] to price equity and debt tranches of collateralized funds of hedge fund obligations (CFOs). The key idea is to price each CFO liability as an option on the underlying basket of hedge funds. The proposed model is able to reproduce the empirical characteristics observed in the distribution of hedge funds’ returns: skewness, excess kurtosis and dependence in the tails. Additionally, it can be easily calibrated to the empirical correlation matrix and it requires only historical information to be estimated and implemented. The result is a scheme that can be useful in structuring a CFO. In particular, we believe that the approach described in this work can be helpful to rating agencies and to deal structures to evaluate various capital structures, test levels, liquidity profiles, coupons and equity distribution rules.