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    1. 1. Measuring Hedge Fund Risk Bernard Minsky, Margin Risk Manager Graham Jung, Prime Brokerage Sales 20 February 2003
    2. 2. Topics For Discussion <ul><li>How are hedge funds different? </li></ul><ul><li>Common myths </li></ul><ul><li>Who are the interested parties? </li></ul><ul><li>The Prime Broker’s view of risk </li></ul>
    3. 3. Traditional Funds Hedge Funds <ul><li>Long only </li></ul><ul><li>Benchmark awareness </li></ul><ul><li>Diversified portfolios </li></ul><ul><li>Performance measured over quarters and years </li></ul><ul><li>Little or no leverage </li></ul><ul><li>Derivative use not widespread </li></ul><ul><li>Prop Desks </li></ul><ul><li>Separate risk function </li></ul><ul><li>Sophisticated ‘client base’ </li></ul><ul><li>Long and short positions </li></ul><ul><li>Absolute return focus </li></ul><ul><li>Concentrated portfolios </li></ul><ul><li>Performance measured over days, weeks and months </li></ul><ul><li>Ability to use leverage </li></ul><ul><li>Significant derivative use </li></ul><ul><li>Limited risk resources </li></ul><ul><li>Wide range of investors </li></ul>
    4. 4. Common Myths <ul><li>‘ Hedge funds are highly leveraged vehicles’ </li></ul><ul><li>‘ Hedge funds make extensive use of derivative products’ </li></ul><ul><li>‘ Hedge fund assets are illiquid and prices are stale, smoothing the returns’ </li></ul><ul><li>‘ Hedge fund managers are highly secretive’ </li></ul><ul><li>The vast majority of funds, by number and assets, operate with minimal leverage, especially in the current environment. </li></ul><ul><li>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 </li></ul><ul><li>Again, it depends on the strategy, most funds have good liquidity and clean prices. </li></ul><ul><li>It depends on the manager. Many new managers are prepared to disclose positions if they are assured of confidentiality. </li></ul>
    5. 5. Who Are The Interested Parties? Competitors Other Brokers SERVICES Suppliers Administrator / Custodian Press / Public opinion Hedge Fund Manager Prime Broker Regulators Investors HEDGE FUND
    6. 6. <ul><li>The Hedge Fund Manager – Outsourcing the Risk Infrastructure </li></ul><ul><li>Use the Prime Broker: </li></ul><ul><ul><li>All serious Prime Brokers offer risk analysis tools </li></ul></ul><ul><ul><li>Most will be only work on assets held on the Prime Broker’s custody accounts </li></ul></ul><ul><li>Develop an in-house system: </li></ul><ul><ul><li>Certainly possible for the less-complex strategies </li></ul></ul><ul><ul><li>Usually as part of an integrated analysis and position management system </li></ul></ul><ul><li>Adopt a vendor solution:: </li></ul><ul><ul><li>The usual out-sourcing pros and cons </li></ul></ul><ul><ul><li>Large and complex systems can overwhelm a hedge fund’s resources </li></ul></ul><ul><ul><li>Pricing policy is crucial – these are small, fast growing businesses </li></ul></ul>
    7. 7. <ul><li>Non Market Risk – A Matter Of Perspective </li></ul><ul><li>From the Investor’s Point of View: </li></ul><ul><ul><li>Poor performance </li></ul></ul><ul><ul><li>Operational risk </li></ul></ul><ul><ul><li>Fraud </li></ul></ul><ul><ul><li>Illiquidity </li></ul></ul><ul><ul><li>Style drift </li></ul></ul><ul><li>From the Manager’s Point of View: </li></ul><ul><ul><li>Poor economics, either through poor performance or low asset size </li></ul></ul><ul><ul><li>Operational risk </li></ul></ul><ul><li>From the Prime Broker’s Point of View: </li></ul><ul><ul><li>Counterparty risk </li></ul></ul><ul><ul><li>Fraud </li></ul></ul>
    8. 8. Who Are the Interested Parties? Competitors Brokers SERVICES Suppliers Administrator / Custodian Press / Public opinion Hedge Fund Manager Prime Broker Regulators Investors HEDGE FUND
    9. 9. The Prime Broker’s View of Risk
    10. 10. Prime Broker As Finance Provider <ul><li>The Prime Broker provides leverage </li></ul><ul><ul><li>By lending the hedge fund cash to purchase securities; and </li></ul></ul><ul><ul><li>By lending the hedge fund securities to sell short </li></ul></ul><ul><li>Converting Credit Risk to Market and Liquidity Risk </li></ul><ul><ul><li>All Prime Brokers’ loans are collateralised - margin loans </li></ul></ul><ul><ul><li>Accept many types of collateral – cash, equities, bonds </li></ul></ul><ul><li>Determining the margin </li></ul><ul><ul><li>Too much and the hedge fund returns are too low </li></ul></ul><ul><ul><li>Too little and the Prime Broker takes credit risk </li></ul></ul><ul><ul><li>The Prime Broker only makes a loss </li></ul></ul><ul><ul><ul><li>if the value of the collateral in liquidation is less than the loans advanced </li></ul></ul></ul><ul><ul><ul><li>not necessarily as soon the hedge fund makes losses </li></ul></ul></ul>
    11. 11. How Much Risk?
    12. 12. Margin Policy <ul><li>Collateral and funding </li></ul><ul><ul><li>Perfecting a security interest </li></ul></ul><ul><ul><ul><li>Collateral is only as good as the security interest obtained </li></ul></ul></ul><ul><ul><ul><li>Depends on where the collateral is issued or clears </li></ul></ul></ul><ul><ul><ul><li>Depends on where the hedge fund is domiciled </li></ul></ul></ul><ul><ul><ul><li>Depends on the the contract law of the agreement </li></ul></ul></ul><ul><ul><li>Title Transfer </li></ul></ul><ul><ul><ul><li>Title transfer allows re-hypothecation and funding </li></ul></ul></ul><ul><ul><ul><li>May be against local regulations – segregation of assets </li></ul></ul></ul><ul><ul><ul><li>May be a taxable event – UK stamp duty </li></ul></ul></ul><ul><ul><li>Charge over Assets </li></ul></ul><ul><ul><ul><li>Avoids taxable events </li></ul></ul></ul><ul><ul><ul><li>Does not necessarily allow re-hypothecation </li></ul></ul></ul>
    13. 13. Margin Rate Setting <ul><li>Discretionary or Regulated </li></ul><ul><ul><li>US margin rules set in Reg T and NYSE rules </li></ul></ul><ul><ul><ul><li>One size fits all </li></ul></ul></ul><ul><ul><ul><li>Not risk-based </li></ul></ul></ul><ul><ul><li>UK margin rules are discretionary </li></ul></ul><ul><ul><ul><li>Depends on collateral and trading portfolio </li></ul></ul></ul><ul><ul><ul><li>Can recognise the risk reducing effect of hedges </li></ul></ul></ul><ul><ul><ul><li>Can use risk models to determine collateral requirements – VaR, Stress Tests </li></ul></ul></ul><ul><ul><ul><li>Can be customised for specific funds, such as </li></ul></ul></ul><ul><ul><ul><ul><li>Long/Short Equity </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Convertible Arbitrage </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Statistical Arbitrage </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Risk Arbitrage </li></ul></ul></ul></ul>
    14. 14. Monitoring The Risk
    15. 15. Risk Monitoring <ul><li>What are the risks we really worry about? </li></ul><ul><ul><li>Directionality </li></ul></ul><ul><ul><ul><li>Exposure to market jump risk – crashes </li></ul></ul></ul><ul><ul><ul><li>Metric – Net Assets/Net Market Value </li></ul></ul></ul><ul><ul><li>Concentration </li></ul></ul><ul><ul><ul><li>History teaches us – never bet the house </li></ul></ul></ul><ul><ul><ul><li>Metrics – MV as % of Total MV, Margin as % of Total Margin </li></ul></ul></ul><ul><ul><li>Liquidity </li></ul></ul><ul><ul><ul><li>Mark-to-market assumes the position is liquid </li></ul></ul></ul><ul><ul><ul><li>Metrics – Position as # Days Trading, Bid/Offer Spread </li></ul></ul></ul><ul><ul><li>Portfolio changes </li></ul></ul><ul><ul><ul><li>Trading strategy, funding </li></ul></ul></ul><ul><ul><ul><li>Portfolio P&L </li></ul></ul></ul>
    16. 16. Risk Management Tools
    17. 17. Risk Management Tools <ul><li>Operational Reports </li></ul><ul><ul><li>Daily Margin Reports </li></ul></ul><ul><ul><li>Daily Collateral Call Summary </li></ul></ul><ul><li>Risk Analytics </li></ul><ul><ul><li>Directionality report – 30% stress </li></ul></ul><ul><ul><li>Liquidity report – weighted average liquidity greater than 1 day </li></ul></ul><ul><ul><li>Concentration report </li></ul></ul><ul><ul><ul><li>One position market value greater than net assets </li></ul></ul></ul><ul><ul><ul><li>One position margin greater than 20% of total margin </li></ul></ul></ul><ul><ul><li>Portfolio changes report </li></ul></ul><ul><ul><ul><li>From trading </li></ul></ul></ul><ul><ul><ul><li>From market moves </li></ul></ul></ul><ul><ul><ul><li>From cash movements (redemptions, investments, etc) </li></ul></ul></ul>
    18. 18. Risk Management Tools <ul><li>Risk Testing </li></ul><ul><ul><li>Value at Risk </li></ul></ul><ul><ul><ul><li>Linear Portfolios using Covariance Matrix </li></ul></ul></ul><ul><ul><ul><li>Backtesting against P&L attributed to market moves </li></ul></ul></ul><ul><ul><li>Scenario Analysis </li></ul></ul><ul><ul><ul><li>Non-linear portfolios such as Convertibles </li></ul></ul></ul><ul><ul><ul><li>Worst case loss across a small number of disaster scenarios </li></ul></ul></ul><ul><ul><ul><li>Portfolio statistics </li></ul></ul></ul><ul><ul><li>Event Risk </li></ul></ul><ul><ul><ul><li>Merger Risk stress </li></ul></ul></ul><ul><ul><ul><li>Bond maturity risk – weighted average time to maturity/next put </li></ul></ul></ul>
    19. 19. The Prime Broker’s Perspective
    20. 20. In Summary <ul><li>Prime Broker Objective </li></ul><ul><ul><li>To lend cash and securities against excess good collateral </li></ul></ul><ul><ul><li>To avoid exposure to credit and reputational risk </li></ul></ul><ul><ul><li>To manage resultant market and liquidity exposure </li></ul></ul><ul><li>Risk Manager Responsibility </li></ul><ul><ul><li>To set reasonable collateral requirements </li></ul></ul><ul><ul><li>To identify potential exposures before they become critical </li></ul></ul><ul><ul><li>To ensure risks are commensurate with returns </li></ul></ul><ul><ul><li>To protect our capital and our reputation </li></ul></ul><ul><li>Prime Broker view vs Hedge Fund view </li></ul><ul><ul><li>Prime Broker’s payoff is asymmetric – earn spreads, lose capital </li></ul></ul><ul><ul><li>Hedge Fund’s payoff depends on returns and overrides </li></ul></ul><ul><ul><li>Prime Broker allies to Hedge Fund goals, but does not adopt them </li></ul></ul>
    21. 21. Disclaimer <ul><li>© 2002 Goldman Sachs International. All rights reserved. </li></ul><ul><li>This material is for your private information, and we are not soliciting any action based upon it. It does not take into account the particular investment objectives, financial situation or needs of individual clients. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any security and positions may be increased or decreased at any time. Past performance is no indication of future results, which may vary. . The material is based upon information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such. Opinions expressed are our current opinions as of the date appearing on this material only. While we endeavour to update on a reasonable basis the information discussed in this material, there may be regulatory, compliance, or other reasons that prevent us from doing so. We and our affiliates, officers, directors, partners, and employees, including persons involved in the preparation or issuance of this material may, from time to time, have long or short positions in, and buy or sell, the securities, or derivatives (including options) thereof, of companies mentioned herein. </li></ul><ul><li>This material has been issued by Goldman Sachs International, regulated by The Securities and Futures Authority and by Goldman Sachs Canada in connection with its distribution in Canada. This material is distributed in Hong Kong by Goldman Sachs (Asia) L.L.C. and in Japan by Goldman Sachs (Japan) Ltd. Goldman Sachs International and its non-US affiliates may, to the extent permitted under applicable law, have acted upon or used this research, to the extent it relates to non-US issuers, prior to or immediately following its publication. Foreign-currency-denominated securities are subject to fluctuations in exchange rates that could have an adverse effect on the value or price of or income derived from the investment. In addition, investors in securities such as ADRs, the values of which are influenced by foreign currencies, effectively assume currency risk. </li></ul><ul><li>Further information on any of the securities mentioned in this material may be obtained upon request, and for this purpose persons in Italy should contact Goldman Sachs S.I.M.S.p.A. in Milan, or at its London branch office at 133 Fleet Street, and persons in Hong Kong should contact Goldman Sachs L.L.C. at 3 Garden Road.Unless governing law permits otherwise, you must contact a Goldman Sachs entity in your home jurisdiction if you want to use our services in effecting a transaction in the securities mentioned in this material. </li></ul>

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