Slide 1: Theory and Practice of Risk Management in Hedge Funds
Barry Schachter
Slide 2: Overview & Summary
What goes on in hedge funds Landscape of risks Risk Measurement Risk Management
Slide 3: What Is a Hedge Fund
Portfolios – long/short, total return Legal – Unregulated? Variety – many funds, many strategies
Slide 4: Hedge Fund Returns
Slide 5: Legal - Unregulated?
SEC
Investment Advisors – Fraud/Fiduciary Exemption- <15 Investors; Not offering to public Regulatory Filings - ownership
CFTC
Commodity Trading Advisor Speculative position limits
Slide 6: Legal
Mutual Fund Timing/Late Trading
Canary Capital Partners LLC AUM $700MM Millenium Partners AUM $4B
SEC Hedge Fund Study
Registration Disclosure
Slide 7: Many Funds, Many Strategies
Equity Long/Short Relative Value Fixed Income Global Macro Convertible Arbitrage Statistical Arbitrage Event Driven
Slide 8: Market Risk
The risk of monetary loss arising from an adverse move in market prices or rates
Slide 9: Market Risk Measures – Sensitivities I
Bonds
Duration and Convexity DV01 and Key Rate sensitivities Credit spread sensitivity Trading/Hedging
• Directional • Curve (steepener/flattener; butterfly) • Spread • Relative Value
Slide 10: Market Risk Measures – Sensitivities II
Equities
Notional (GMV, NMV) Beta (Bloomberg v. Barra) Factor models
Slide 11: Market Risk Measures – Sensitivities III
Options
Greeks (delta, gamma, vega, theta, rho) Trading/Hedging
• The long vol trader (love gamma, hate theta) • The short vol trader
Slide 12: Risk Measurement - VaR
Motivation for Definition of Types of Troubles with
Reliant on historical data Assumptions about factor returns Pricing models
Slide 13: VaR at Hedge Funds Challenges
Strategies that are flat at the close Market-neutral strategies Arbitrage/convergence strategies Merger arbitrage strategies Liquidity risk for “chunky” positions Collateral-at-risk
Slide 14: Risk Measurement – Stress Testing
Motivation (complement VaR) Types of stress tests Examples of scenarios Potential Pitfalls Relation to VaR
Slide 15: Operational Risk
The risk of monetary loss resulting from inadequate internal processes.
Slide 16: Operational Risk Example
Phoenix Research and Trading
$125MM losses – January 2002 Trading US Treasuries
Slide 17: Operational Risk Example
Allfirst Financial – John Rusnak
$690MM losses – February 2002 Trading major currencies
Slide 18: Operational Risk Example
Lipper Convertibles LP (2/21/02)
Convertible arb fund Assets plunged 40%, not up “a few” percent Revised managers’ valuations after they left Delta hedges not adequate
Slide 19: From Measurement to Management
Be proactive not reactive Create risk management culture Align interests (the “free put”) Have independence and authority Establish credibility and trust
Slide 20: Elements of Risk Management
Understand range and magnitude of risks Know what you don’t know Communicate issues clearly
Slide 21: Getting Inside a Trader’s Head
Entry (timing, catalyst, technicals) Sizing (look for confirmation, scaling in) Position management Exit (stops vs. price targets)
Slide 22: What Worries Me - Options
Unmeasured risks (pin, knockout, corr.) No marks (price/vol) Dealer/trader supplied marks Trader risk management “It’s a lottery ticket” “I sold the option to reduce my cost” “I can trade out of a short vol position” “The most I can lose is the premium” “I exercised, because I want to exit” “I sell calls to cut my risk”
Slide 23: What Worries Me - Liquidity
Volume Firm position Market players Short interest Technical stops and the rush to exit When the market stops trading
Slide 24: What Worries Me - Traders
Hubris
“I have never lost money before” “There are a million reasons for this to work” Market view takes over Losers become long-term trade ideas Doubling-down “I will just allocate 1% of capital” “I don’t want to hedge the FX exposure”
Style drift
Focus
Slide 25: Managing Up
Communication
Keep message simple Be clear (accuracy less important)
Overview
Monitor risk appetite Evaluate performance
Slide 26: Managing Out - Investor Risk Disclosures
Requirements/Practice Issues with disclosure
Disclosure dissipates private information Only position level disclosure makes aggregation possible “Snapshots” of risk are misleading Fund risks have option characteristics
Slide 27: Conclusion
Successful risk management is in the details Subjective component of risk management looms large The only constant is change
thank you