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 