Hedge Fund (2v2 - Theory and Practice of Risk Management in Hedge Funds)

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Theory and Practice of 

Risk Management inHedge Funds

Barry Schachter

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Overview & Summary What goes on in hedge funds

Landscape of risks

Risk Measurement

Risk Management

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What Is a Hedge Fund Portfolios ± long/short, total return

Legal ± Unregulated?

Variety ± many funds, manystrategies

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Hedge Fund Returns

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Legal - Unregulated? SEC

Investment Advisors ± Fraud/Fiduciary

Exemption- <15 Investors; Not offeringto public

Regulatory Filings - ownership

CFTC Commodity Trading Advisor

Speculative position limits

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Legal Mutual Fund Timing/Late Trading

Canary Capital Partners LLC

AUM $700MM Millenium Partners

AUM $4B

SEC Hedge Fund Study Registration

Disclosure

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Many Funds, Many

Strategies Equity Long/Short

Relative Value Fixed Income

Global Macro

Convertible Arbitrage

Statistical Arbitrage

Event Driven

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Market Risk The risk of monetary loss arising

from an adverse move in market

prices or rates

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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

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Market Risk Measures ±

Sensitivities II Equities

Notional (GMV, NMV)

Beta (Bloomberg v. Barra)

Factor models

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Market Risk Measures ±

Sensitivities III Options

Greeks (delta, gamma, vega, theta,

rho) Trading/Hedging

� The long vol trader (love gamma, hatetheta)

� The short vol trader

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Risk Measurement - VaR Motivation for

Definition of 

Types of 

Troubles with

Reliant on historical data

Assumptions about factor returns

Pricing models

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VaR at Hedge Funds -

Challenges Strategies that are flat at the close

Market-neutral strategies

Arbitrage/convergence strategies

Merger arbitrage strategies

Liquidity risk for ³chunky´ positions

Collateral-at-risk

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Risk Measurement ± Stress

Testing Motivation (complement VaR)

Types of stress tests

Examples of scenarios

Potential Pitfalls

Relation to VaR

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Operational Risk The risk of monetary loss resulting

from inadequate internal processes.

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Operational Risk Example Phoenix Research and Trading

$125MM losses ± January 2002

Trading US Treasuries

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Operational Risk Example Allfirst Financial ± John Rusnak

$690MM losses ± February 2002

Trading major currencies

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Operational Risk Example Lipper Convertibles LP (2/21/02)

Convertible arb fund

Assets plunged 40%, not up ³a few´ percent

Revised managers¶ valuations after

they left Delta hedges not adequate

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From Measurement to

Management Be proactive not reactive

Create risk management culture

Align interests (the ³free put´)

Have independence and authority

Establish credibility and trust

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Elements of Risk

Management Understand range and magnitude of 

risks

Know what you don¶t know

Communicate issues clearly

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Getting Inside a Trader¶s

Head Entry (timing, catalyst, technicals)

Sizing (look for confirmation, scaling

in)

Position management

Exit (stops vs. price targets)

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What Worries Me - Options Unmeasured risks (pin, knockout, corr.)

No marks (price/vol)

Dealer/trader supplied marks Trader risk management

 ³It¶s a lottery ticket´ 

 ³I sold the option to reduce my cost´ 

 ³I can trade out of a short vol position´ 

 ³The most I can lose is the premium´ 

 ³I exercised, because I want to exit´ 

 ³I sell calls to cut my risk´ 

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What Worries Me - Liquidity Volume

Firm position

Market players

Short interest

Technical stops and the rush to exit

When the market stops trading

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What Worries Me - Traders Hubris

 ³I have never lost money before´ 

 ³There are a million reasons for this to work´  Style drift

Market view takes over

Losers become long-term trade ideas

Doubling-down

Focus ³I will just allocate 1% of capital´ 

 ³I don¶t want to hedge the FX exposure´ 

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Managing Up Communication

Keep message simple

Be clear (accuracy less important)

Overview

Monitor risk appetite

Evaluate performance

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Conclusion Successful risk management is in

the details

Subjective component of riskmanagement looms large

The only constant is change