HEDGE FUNDS & RISK MANAGEMENT

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Risk Management

Contents

Table of Contents:

Risk in the Marketplace 3

Risk Types

Volatility Risk 4

Commodity Risk 5

Event Risk 6

Tail Risk 7

Hedge Funds & Risk Management 8

Hedge Funds’ Evolving Approach to Risk 9

In the financial markets, risk has always been a

factor. Hedge funds’ main objective and unique

attribute is their ability to minimize risk while

maximizing returns.

Over the past few years, hedge funds’ approach

to risk management has evolved and

strengthened.

This presentation provides an overview of the

ways hedge funds deal with certain risk types as

well as hedge funds’ new and evolving internal

protocol for risk management.

Executive Summary:

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Risk Management

Risk in the Marketplace

Risk has always been a factor in

financial markets, and risk management

has never been as important as it is

today.

Hedge funds originated as an

investment platform to manage risk and

deliver reliable returns over time.

The following slides provide examples

of types of risk in the marketplace and

the ways hedge funds help manage

those risks.

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Risk Management

Risk Types

Volatility Risk

Increased price fluctuations in the marketplace

cause volatility risk.

Volatility risk is usually managed through portfolio

diversification by asset class, geography, market

sector, and strategy.

It can emerge on different levels under extreme

market conditions in which correlations between

asset classes and strategies tend to change and

often converge. Managers may hedge volatility risk

through use of financial derivatives.

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Risk Management

Risk Types

Commodity Risk

Commodity risk refers to the risk of rising or falling

commodity prices that may result from supply and

demand imbalances, changing spending patterns, or

changing input costs.

Commodity risk can be hedged through futures and

forward commodity contracts. Futures and forward

contracts have the same basic function: both types of

contracts allow people to buy or sell a specific type of

asset at a specific time at a given price. The

difference is that futures contracts are standardized

contracts that are exchange-traded, and forward

contracts are private agreements between two

parties.

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Risk Management

Risk Types

Event Risk

Event risks are those unusual circumstances in which large-scale

swings occur in capital markets. These may arise from unpredictable

events such as terrorist attacks, natural disasters, unusual weather

patterns, or oil supply shocks.

To analyze extreme event risk, a hedge fund manager should employ a

series of hypothetical scenarios that are relevant to the particular

portfolio.

Examples of market stress events may include rapid equity declines

and credit-spread widening or a period of rapid equity advances and

credit tightening. Mangers should conduct appropriate stress testing

based on the current portfolio exposures and specifics.

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Risk Management

Risk Types

Tail Risk

Tail risk is the risk of an asset - or portfolio of assets –

experiencing a significant change from its current price.

Tail-risk strategies are basically designed to thrive in the

worst market conditions.

Tail risk hedging can be an appropriate strategy to help

investors pursue their objectives, without having to

significantly adjust their risk and/or return expectations

after a market crisis.

There are a number of ways investors can employ tail risk

hedging, including:

• limiting the risk in your asset allocation by weighting

your portfolio to less volatile sectors

• holding your asset allocation constant and

complementing it with lower-risk strategies.

Source: Pimco Education Series

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Risk Management

Hedge Funds & Risk Management

In addition to developing unique methods for combatting risk

in the marketplace, hedge funds have also strengthened their

internal risk management protocol.

A 2012 report by BNY Mellon, HedgeMark, and the Managed

Funds Association surveyed hedge funds and their investors

about their evolving approach to risk.

The following slides detail some of the important risk

management practices employed by hedge funds today.

Source: BNY Mellon 2012

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Risk Management

Hedge Funds’ Evolving Approach to Risk

Hedge funds have increasingly strengthened their internal risk management

protocols, for example:

• Today, 79% of firms separate their risk manager and fund manager

functions to ensure independent oversight.

• 84% of hedge funds now use off-the-shelf risk analytics that form part of

the portfolio management or trading system – hedge funds are looking to

a wider array of sources to model their portfolios and protect against risk

of all types.

• Over 91% of hedge funds rely on a third-party risk management

administrator for fund reporting and safe keeping to help boost investor

confidence in these areas.

Source: BNY Mellon 2012

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Risk Management

Hedge Funds’ Evolving Approach to Risk

• 60% of larger hedge fund managers now have an employee (or

employees) dedicated solely to risk management - many

managers stated that before 2008 this role was not a separate

function.

• Many funds have elevated risk officers and designated them

with the position of Chief Risk Officer, placing them on par with

other senior executive positions like the General Counsel and

Chief Financial Officer.

• Better firm-wide consolidated risk reporting has become a top

priority. In 2011, hedge funds spent more than $2 billion on

implementing risk systems and infrastructure.

• The financial crisis of 2008 provided managers with a new body

of historical data to create relevant, authentic “what if”

scenarios. As a result, risk systems now have more data

available that includes numerous examples of highly volatile

risk periods to inform strategies moving forward.

Source: BNY Mellon 2012