theory and practice of risk management in hedge funds barry schachter
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Theory and Practice of Risk Management in
Hedge FundsBarry Schachter
2005.12.05 Copyright 2005 Barry Schachter 2
Overview & SummaryOverview & SummaryWhat goes on in hedge fundsLandscape of risksRisk MeasurementRisk Management
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Tradewinds InternationalTradewinds International Charles L. Harris Raised from 30 investors $10MM between 1995/2001 and 2004 Made false statements (K-1) about NAV ($30MM vs $1.1MM in 2003) Used investor funds ($2.4MM) for
Personal expensesTo repay investors at inflated NAVs
Losses: Commodity futures/options 2003-2004 SEC/CFTC civil actions 2004/09/02 DoJ criminal suit 2004/09/09 Sentenced to 168 months/$13.9MM 2005/10/06 Pirate? 1723/07/19
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Operational RiskOperational RiskDefn: Loss from failure of ordinary business
processes (getting business done)Causes: poor process, poor training, poor
alignment of incentives, serendipity
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Op Risk RemediesOp Risk RemediesInternal Solutions
Prudent actionsInvestor-Manager contractIndustry Guidance (CRMPGII, IAFE Op Risk)
External Solution – RegulationPrime Directive – ‘Break glass’ only if internal solution isn’t
socially optimal and incremental costs do not exceed benefitsPerception that HFs are ‘lightly regulated’
Relative to what?Light is equated with poor in perception
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US HF Regulation Overview
US HF Regulation Overview
SECRegistration required (Feb 2006) (2Yr lock-up exception) Form
ADVFraud/FiduciaryReg. Filings – Form 13DIndirect – Prudential Supervision of PB (‘CSE’)
CFTCRegistration required (CTA/CPO)Fraud/FiduciaryReg. Filings - Speculative position limits
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HF Risk Management – Big Picture
HF Risk Management – Big Picture
Op Risk is not the first concernMarket RiskCredit RiskLiquidity, Concentration, Reputation
No regulation demandsNo standard risk management modelLimited independence
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Brief Aside on Risk Measurement
Brief Aside on Risk Measurement
Quantification Helps Risk ControlSome Measures
Value at Risk (VaR)Stress TestingSensitivities (e.g., bpv, options)Notionals (e.g., GMV, NMV)P/L volatilityDrawdown
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Market RiskMarket RiskThe risk of monetary loss arising from an
adverse move in market prices or rates (includes traded credit risk)
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Market Risk Management – On the Desk
Market Risk Management – On the Desk
Trading limitsRisk-based (VaR, Stress)Nominal (Gross/Net positions, Concentration,
LiquidityP/L related (portfolio stop and drawdown)
Dialogue – more important than limits
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On the Desk (cont’d) - Dialogue
On the Desk (cont’d) - Dialogue
Asking Good QuestionsIs that really correlated?Does that data change your thesis?Is it in the price already?
Reducing Trader ErrorsDrunk with successDoubling downFear of failureDeer in the headlights (stops)Options trading problems
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On the Desk (cont’d) – Options Trading Mistakes
On the Desk (cont’d) – Options Trading Mistakes
The short vol game (Caxton ED)Implied leverage near expiry (BAM biotech)Exercise to exit (SAC healthcare)The lottery ticket
Buy OTM near expiry (BAM equity)Ignore MV vs Intrinsic (Caxton EUR)
Fair value vs. Quote (Caxton exotic)Buy/Write to protect profit (BAM retail)
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Getting Inside a Trader’s Head
Getting Inside a Trader’s Head
Entry (timing, catalyst, technicals)Sizing (look for confirmation, scaling in)Position managementExit (stops vs. price targets)
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What Worries Me - TradersWhat Worries Me - TradersHubris
“I have never lost money before”“There are a million reasons for this to work”
Style driftMarket view takes over (becoming a macro trader)Losers become long-term trade ideas
Focus“I will just allocate 1% of capital”“I don’t want to hedge the FX exposure”Wanting the last quarter point of a trade“Another PM got me into it”
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Portfolio Risk ManagementPortfolio Risk ManagementMeasurement Problems are Everywhere
Flat at the closeArbitrage/convergence (OTR vs off-the-run; liquidity bet)Merger arbitrageLiquidity risk for “chunky” positionsCollateral-at-risk
Valuation ProblemsOperational Risks
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Operational Risk Example – Bayou (2005)
Operational Risk Example – Bayou (2005)
Raised $400MM, ‘lost’ $300MMHigh risk trades to try to make up lossesCFO owned ‘independent’ auditorAffiliated broker made $50MM commissions from
BayouMisreported NAVs, commission exp.Principal, Samuel Israel III, lied about
background in marketing
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Operational Risk Example – Wood River (2005)
Operational Risk Example – Wood River (2005)
No auditor/audits (contrary to marketing materials)
PPM stated max position 10% capitalPlaced 65% of capital in one small cap (not
disclosed to investors)
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Operational Risk Example – Lipper Convertibles
(2002)
Operational Risk Example – Lipper Convertibles
(2002)
Convertible arb fundAssets plunged 40%, not up “a few” percentRevised managers’ valuations after they leftDelta hedges not adequate
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Operational Risk ExampleOperational Risk ExamplePhoenix Research and Trading
$125MM losses – January 2002Trading US Treasuries
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Operational Risk Example (Sell-side Lessons)
Operational Risk Example (Sell-side Lessons)
Allfirst Financial – John Rusnak$690MM losses – February 2002Trading major currencies
National Australia Bank – Jan ‘04Almost identical story
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Fundamentals of (Independent) Risk Management
Fundamentals of (Independent) Risk Management
Be proactive not reactiveCreate risk management cultureAlign interests (the “free put”)Have independence and authorityEstablish credibility and trust
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Fundamentals of (Independent) Risk Management cont’d
Fundamentals of (Independent) Risk Management cont’d
Understand range and magnitude of risksHidden risks (e.g. equity factors)
Know what you don’t know Vol swapEconomic derivatives
Communicate issues clearlyHow to say “no”Speaking the language
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What Worries Me - OptionsWhat Worries Me - OptionsUnmeasured risks (pin, knockout, corr.)No marks (price/vol)Dealer/trader supplied marksLiquidity
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What Worries Me - Liquidity
What Worries Me - Liquidity
VolumeFirm positionMarket playersShort interestTechnical stops and the rush to exitWhen the market stops trading
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Managing UpManaging UpCommunication
Keep message simpleBe clear (accuracy less important)
OverviewMonitor risk appetiteEvaluate performance
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Managing Out - Investor Risk Disclosures
Managing Out - Investor Risk Disclosures
Requirements/PracticeIssues with disclosure
Disclosure dissipates private informationOnly position level disclosure makes aggregation
possible“Snapshots” of risk are misleadingFund risks have option characteristics
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ConclusionConclusionSuccessful risk management is in the detailsSubjective component of risk management
looms largeThe only constant is change
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