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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>
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