2. Risk Management
Contents
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Table of Contents:
Risk in the Marketplace 3
Risk Types
Volatility Risk
Commodity Risk
Event Risk
Tail Risk
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5
6
7
Hedge Funds & Risk Management 8
Hedge Funds’ EvolvingApproach 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:
3. 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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4. 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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5. 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 typesof
contracts allow people to buy or sell a specific typeof
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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6. 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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7. 7
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
8. 8
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
9. Risk Management
Hedge Funds’ Evolving Approach to Risk
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Source: BNY Mellon 2012
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.
10. 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.
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Source: BNY Mellon 2012
