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Measuring Hedge Fund Risk Bernard Minsky, Margin Risk Manager Graham Jung, Prime Brokerage Sales 20 February 2003

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Measuring Hedge Fund Risk

Bernard Minsky, Margin Risk Manager

Graham Jung, Prime Brokerage Sales

20 February 2003

Measuring Hedge Fund Risk

Topics For Discussion

How are hedge funds different?

Common myths

Who are the interested parties?

The Prime Broker’s view of risk

Measuring Hedge Fund Risk

Traditional Funds Hedge Funds

Long only

Benchmark awareness

Diversified portfolios

Performance measured over quarters and years

Little or no leverage

Derivative use not widespread

Prop Desks

Separate risk function

Sophisticated ‘client base’

Long and short positions

Absolute return focus

Concentrated portfolios

Performance measured over days, weeks and months

Ability to use leverage

Significant derivative use

Limited risk resources

Wide range of investors

Measuring Hedge Fund Risk

Common Myths

‘Hedge funds are highly leveraged vehicles’

‘Hedge funds make extensive use of derivative products’

‘Hedge fund assets are illiquid and prices are stale, smoothing the returns’

‘Hedge fund managers are highly secretive’

The vast majority of funds, by number and assets, operate with minimal leverage, especially in the current environment.

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

Again, it depends on the strategy, most funds have good liquidity and clean prices.

It depends on the manager. Many new managers are prepared to disclose positions if they are assured of confidentiality.

Measuring Hedge Fund Risk

Who Are The Interested Parties?

Competitors

Other Brokers

SERVICESSuppliers

Administrator /

CustodianPress / Public opinion

Hedge Fund

Manager

Prime BrokerRegulators

Investors

HEDGE FUND

Measuring Hedge Fund Risk

The Hedge Fund Manager – Outsourcing the Risk Infrastructure

Use the Prime Broker:

All serious Prime Brokers offer risk analysis tools Most will be only work on assets held on the Prime Broker’s custody accounts

Develop an in-house system:

Certainly possible for the less-complex strategies Usually as part of an integrated analysis and position management system

Adopt a vendor solution::

The usual out-sourcing pros and cons Large and complex systems can overwhelm a hedge fund’s resources Pricing policy is crucial – these are small, fast growing businesses

Measuring Hedge Fund Risk

Non Market Risk – A Matter Of Perspective

From the Investor’s Point of View:

Poor performance Operational risk Fraud Illiquidity Style drift

From the Manager’s Point of View:

Poor economics, either through poor performance or low asset size Operational risk

From the Prime Broker’s Point of View:

Counterparty risk Fraud

Measuring Hedge Fund Risk

Who Are the Interested Parties?

Competitors

Brokers

SERVICESSuppliers

Administrator /

CustodianPress / Public opinion

Hedge Fund

Manager

Prime BrokerRegulators

Investors

HEDGE FUND

The Prime Broker’s View of Risk

Measuring Hedge Fund Risk

Prime Broker As Finance Provider

The Prime Broker provides leverage

By lending the hedge fund cash to purchase securities; and

By lending the hedge fund securities to sell short

Converting Credit Risk to Market and Liquidity Risk

All Prime Brokers’ loans are collateralised - margin loans

Accept many types of collateral – cash, equities, bonds

Determining the margin

Too much and the hedge fund returns are too low

Too little and the Prime Broker takes credit risk

The Prime Broker only makes a loss

if the value of the collateral in liquidation is less than the loans advanced

not necessarily as soon the hedge fund makes losses

How Much Risk?

Measuring Hedge Fund Risk

Margin Policy

Collateral and funding

Perfecting a security interest

Collateral is only as good as the security interest obtained

Depends on where the collateral is issued or clears

Depends on where the hedge fund is domiciled

Depends on the the contract law of the agreement

Title Transfer

Title transfer allows re-hypothecation and funding

May be against local regulations – segregation of assets

May be a taxable event – UK stamp duty

Charge over Assets

Avoids taxable events

Does not necessarily allow re-hypothecation

Measuring Hedge Fund Risk

Margin Rate Setting

Discretionary or Regulated

US margin rules set in Reg T and NYSE rules

One size fits all

Not risk-based

UK margin rules are discretionary

Depends on collateral and trading portfolio

Can recognise the risk reducing effect of hedges

Can use risk models to determine collateral requirements – VaR, Stress Tests

Can be customised for specific funds, such as

Long/Short Equity

Convertible Arbitrage

Statistical Arbitrage

Risk Arbitrage

Monitoring The Risk

Measuring Hedge Fund Risk

Risk Monitoring

What are the risks we really worry about?

Directionality

Exposure to market jump risk – crashes

Metric – Net Assets/Net Market Value

Concentration

History teaches us – never bet the house

Metrics – MV as % of Total MV, Margin as % of Total Margin

Liquidity

Mark-to-market assumes the position is liquid

Metrics – Position as # Days Trading, Bid/Offer Spread

Portfolio changes

Trading strategy, funding

Portfolio P&L

Risk Management Tools

Measuring Hedge Fund Risk

Risk Management Tools

Operational Reports

Daily Margin Reports

Daily Collateral Call Summary

Risk Analytics

Directionality report – 30% stress

Liquidity report – weighted average liquidity greater than 1 day

Concentration report

One position market value greater than net assets

One position margin greater than 20% of total margin

Portfolio changes report

From trading

From market moves

From cash movements (redemptions, investments, etc)

Measuring Hedge Fund Risk

Risk Management Tools

Risk Testing

Value at Risk

Linear Portfolios using Covariance Matrix

Backtesting against P&L attributed to market moves

Scenario Analysis

Non-linear portfolios such as Convertibles

Worst case loss across a small number of disaster scenarios

Portfolio statistics

Event Risk

Merger Risk stress

Bond maturity risk – weighted average time to maturity/next put

The Prime Broker’s Perspective

Measuring Hedge Fund Risk

In Summary

Prime Broker Objective

To lend cash and securities against excess good collateral

To avoid exposure to credit and reputational risk

To manage resultant market and liquidity exposure

Risk Manager Responsibility

To set reasonable collateral requirements

To identify potential exposures before they become critical

To ensure risks are commensurate with returns

To protect our capital and our reputation

Prime Broker view vs Hedge Fund view

Prime Broker’s payoff is asymmetric – earn spreads, lose capital

Hedge Fund’s payoff depends on returns and overrides

Prime Broker allies to Hedge Fund goals, but does not adopt them

Measuring Hedge Fund Risk

Disclaimer

© 2002 Goldman Sachs International. All rights reserved.

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