Measuring Hedge Fund Risk
Bernard Minsky, Margin Risk Manager
Graham Jung, Prime Brokerage Sales
20 February 2003
Measuring Hedge Fund Risk
Topics For Discussion
How are hedge funds different?
Common myths
Who are the interested parties?
The Prime Broker’s view of risk
Measuring Hedge Fund Risk
Traditional Funds Hedge Funds
Long only
Benchmark awareness
Diversified portfolios
Performance measured over quarters and years
Little or no leverage
Derivative use not widespread
Prop Desks
Separate risk function
Sophisticated ‘client base’
Long and short positions
Absolute return focus
Concentrated portfolios
Performance measured over days, weeks and months
Ability to use leverage
Significant derivative use
Limited risk resources
Wide range of investors
Measuring Hedge Fund Risk
Common Myths
‘Hedge funds are highly leveraged vehicles’
‘Hedge funds make extensive use of derivative products’
‘Hedge fund assets are illiquid and prices are stale, smoothing the returns’
‘Hedge fund managers are highly secretive’
The vast majority of funds, by number and assets, operate with minimal leverage, especially in the current environment.
It depends on the strategy, many funds trade stock options and index futures at the most. Even strategies that use more derivatives tend to stick to listed, liquid instruments
Again, it depends on the strategy, most funds have good liquidity and clean prices.
It depends on the manager. Many new managers are prepared to disclose positions if they are assured of confidentiality.
Measuring Hedge Fund Risk
Who Are The Interested Parties?
Competitors
Other Brokers
SERVICESSuppliers
Administrator /
CustodianPress / Public opinion
Hedge Fund
Manager
Prime BrokerRegulators
Investors
HEDGE FUND
Measuring Hedge Fund Risk
The Hedge Fund Manager – Outsourcing the Risk Infrastructure
Use the Prime Broker:
All serious Prime Brokers offer risk analysis tools Most will be only work on assets held on the Prime Broker’s custody accounts
Develop an in-house system:
Certainly possible for the less-complex strategies Usually as part of an integrated analysis and position management system
Adopt a vendor solution::
The usual out-sourcing pros and cons Large and complex systems can overwhelm a hedge fund’s resources Pricing policy is crucial – these are small, fast growing businesses
Measuring Hedge Fund Risk
Non Market Risk – A Matter Of Perspective
From the Investor’s Point of View:
Poor performance Operational risk Fraud Illiquidity Style drift
From the Manager’s Point of View:
Poor economics, either through poor performance or low asset size Operational risk
From the Prime Broker’s Point of View:
Counterparty risk Fraud
Measuring Hedge Fund Risk
Who Are the Interested Parties?
Competitors
Brokers
SERVICESSuppliers
Administrator /
CustodianPress / Public opinion
Hedge Fund
Manager
Prime BrokerRegulators
Investors
HEDGE FUND
Measuring Hedge Fund Risk
Prime Broker As Finance Provider
The Prime Broker provides leverage
By lending the hedge fund cash to purchase securities; and
By lending the hedge fund securities to sell short
Converting Credit Risk to Market and Liquidity Risk
All Prime Brokers’ loans are collateralised - margin loans
Accept many types of collateral – cash, equities, bonds
Determining the margin
Too much and the hedge fund returns are too low
Too little and the Prime Broker takes credit risk
The Prime Broker only makes a loss
if the value of the collateral in liquidation is less than the loans advanced
not necessarily as soon the hedge fund makes losses
Measuring Hedge Fund Risk
Margin Policy
Collateral and funding
Perfecting a security interest
Collateral is only as good as the security interest obtained
Depends on where the collateral is issued or clears
Depends on where the hedge fund is domiciled
Depends on the the contract law of the agreement
Title Transfer
Title transfer allows re-hypothecation and funding
May be against local regulations – segregation of assets
May be a taxable event – UK stamp duty
Charge over Assets
Avoids taxable events
Does not necessarily allow re-hypothecation
Measuring Hedge Fund Risk
Margin Rate Setting
Discretionary or Regulated
US margin rules set in Reg T and NYSE rules
One size fits all
Not risk-based
UK margin rules are discretionary
Depends on collateral and trading portfolio
Can recognise the risk reducing effect of hedges
Can use risk models to determine collateral requirements – VaR, Stress Tests
Can be customised for specific funds, such as
Long/Short Equity
Convertible Arbitrage
Statistical Arbitrage
Risk Arbitrage
Measuring Hedge Fund Risk
Risk Monitoring
What are the risks we really worry about?
Directionality
Exposure to market jump risk – crashes
Metric – Net Assets/Net Market Value
Concentration
History teaches us – never bet the house
Metrics – MV as % of Total MV, Margin as % of Total Margin
Liquidity
Mark-to-market assumes the position is liquid
Metrics – Position as # Days Trading, Bid/Offer Spread
Portfolio changes
Trading strategy, funding
Portfolio P&L
Measuring Hedge Fund Risk
Risk Management Tools
Operational Reports
Daily Margin Reports
Daily Collateral Call Summary
Risk Analytics
Directionality report – 30% stress
Liquidity report – weighted average liquidity greater than 1 day
Concentration report
One position market value greater than net assets
One position margin greater than 20% of total margin
Portfolio changes report
From trading
From market moves
From cash movements (redemptions, investments, etc)
Measuring Hedge Fund Risk
Risk Management Tools
Risk Testing
Value at Risk
Linear Portfolios using Covariance Matrix
Backtesting against P&L attributed to market moves
Scenario Analysis
Non-linear portfolios such as Convertibles
Worst case loss across a small number of disaster scenarios
Portfolio statistics
Event Risk
Merger Risk stress
Bond maturity risk – weighted average time to maturity/next put
Measuring Hedge Fund Risk
In Summary
Prime Broker Objective
To lend cash and securities against excess good collateral
To avoid exposure to credit and reputational risk
To manage resultant market and liquidity exposure
Risk Manager Responsibility
To set reasonable collateral requirements
To identify potential exposures before they become critical
To ensure risks are commensurate with returns
To protect our capital and our reputation
Prime Broker view vs Hedge Fund view
Prime Broker’s payoff is asymmetric – earn spreads, lose capital
Hedge Fund’s payoff depends on returns and overrides
Prime Broker allies to Hedge Fund goals, but does not adopt them
Measuring Hedge Fund Risk
Disclaimer
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