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Theory and Practice of Risk Management in Hedge Funds Barry Schachter.

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Presentation on theme: "Theory and Practice of Risk Management in Hedge Funds Barry Schachter."— Presentation transcript:

1 Theory and Practice of Risk Management in Hedge Funds Barry Schachter

2 Copyright 2005 Barry Schachter2 Overview & Summary What goes on in hedge funds Landscape of risks Risk Measurement Risk Management

3 Copyright 2005 Barry Schachter3 Tradewinds 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 expenses To repay investors at inflated NAVs Losses: Commodity futures/options 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

4 Copyright 2005 Barry Schachter4 Operational Risk Defn: Loss from failure of ordinary business processes (getting business done) Causes: poor process, poor training, poor alignment of incentives, serendipity

5 Copyright 2005 Barry Schachter5 Op Risk Remedies Internal Solutions Prudent actions Investor-Manager contract Industry Guidance (CRMPGII, IAFE Op Risk) External Solution – Regulation Prime Directive – Break glass only if internal solution isnt socially optimal and incremental costs do not exceed benefits Perception that HFs are lightly regulated Relative to what? Light is equated with poor in perception

6 Copyright 2005 Barry Schachter6 US HF Regulation Overview SEC Registration required (Feb 2006) (2Yr lock-up exception) Form ADV Fraud/Fiduciary Reg. Filings – Form 13D Indirect – Prudential Supervision of PB (CSE) CFTC Registration required (CTA/CPO) Fraud/Fiduciary Reg. Filings - Speculative position limits

7 Copyright 2005 Barry Schachter7 HF Risk Management – Big Picture Op Risk is not the first concern Market Risk Credit Risk Liquidity, Concentration, Reputation No regulation demands No standard risk management model Limited independence

8 Copyright 2005 Barry Schachter8 Brief Aside on Risk Measurement Quantification Helps Risk Control Some Measures Value at Risk (VaR) Stress Testing Sensitivities (e.g., bpv, options) Notionals (e.g., GMV, NMV) P/L volatility Drawdown

9 Copyright 2005 Barry Schachter9 Market Risk The risk of monetary loss arising from an adverse move in market prices or rates (includes traded credit risk)

10 Copyright 2005 Barry Schachter10 Market Risk Management – On the Desk Trading limits Risk-based (VaR, Stress) Nominal (Gross/Net positions, Concentration, Liquidity P/L related (portfolio stop and drawdown) Dialogue – more important than limits

11 Copyright 2005 Barry Schachter11 On the Desk (contd) - Dialogue Asking Good Questions Is that really correlated? Does that data change your thesis? Is it in the price already? Reducing Trader Errors Drunk with success Doubling down Fear of failure Deer in the headlights (stops) Options trading problems

12 Copyright 2005 Barry Schachter12 On the Desk (contd) – 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)

13 Copyright 2005 Barry Schachter13 Getting Inside a Traders Head Entry (timing, catalyst, technicals) Sizing (look for confirmation, scaling in) Position management Exit (stops vs. price targets)

14 Copyright 2005 Barry Schachter14 What Worries Me - Traders Hubris I have never lost money before There are a million reasons for this to work Style drift Market view takes over (becoming a macro trader) Losers become long-term trade ideas Focus I will just allocate 1% of capital I dont want to hedge the FX exposure Wanting the last quarter point of a trade Another PM got me into it

15 Copyright 2005 Barry Schachter15 Portfolio Risk Management Measurement Problems are Everywhere Flat at the close Arbitrage/convergence (OTR vs off-the-run; liquidity bet) Merger arbitrage Liquidity risk for chunky positions Collateral-at-risk Valuation Problems Operational Risks

16 Copyright 2005 Barry Schachter16 Operational Risk Example – Bayou (2005) Raised $400MM, lost $300MM High risk trades to try to make up losses CFO owned independent auditor Affiliated broker made $50MM commissions from Bayou Misreported NAVs, commission exp. Principal, Samuel Israel III, lied about background in marketing

17 Copyright 2005 Barry Schachter17 Operational Risk Example – Wood River (2005) No auditor/audits (contrary to marketing materials) PPM stated max position 10% capital Placed 65% of capital in one small cap (not disclosed to investors)

18 Copyright 2005 Barry Schachter18 Operational Risk Example – Lipper Convertibles (2002) Convertible arb fund Assets plunged 40%, not up a few percent Revised managers valuations after they left Delta hedges not adequate

19 Copyright 2005 Barry Schachter19 Operational Risk Example Phoenix Research and Trading $125MM losses – January 2002 Trading US Treasuries

20 Copyright 2005 Barry Schachter20 Operational Risk Example (Sell- side Lessons) Allfirst Financial – John Rusnak $690MM losses – February 2002 Trading major currencies National Australia Bank – Jan 04 Almost identical story

21 Copyright 2005 Barry Schachter21 Fundamentals of (Independent) Risk Management Be proactive not reactive Create risk management culture Align interests (the free put) Have independence and authority Establish credibility and trust

22 Copyright 2005 Barry Schachter22 Fundamentals of (Independent) Risk Management contd Understand range and magnitude of risks Hidden risks (e.g. equity factors) Know what you dont know Vol swap Economic derivatives Communicate issues clearly How to say no Speaking the language

23 Copyright 2005 Barry Schachter23 What Worries Me - Options Unmeasured risks (pin, knockout, corr.) No marks (price/vol) Dealer/trader supplied marks Liquidity

24 Copyright 2005 Barry Schachter24 What Worries Me - Liquidity Volume Firm position Market players Short interest Technical stops and the rush to exit When the market stops trading

25 Copyright 2005 Barry Schachter25 Managing Up Communication Keep message simple Be clear (accuracy less important) Overview Monitor risk appetite Evaluate performance

26 Copyright 2005 Barry Schachter26 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

27 Copyright 2005 Barry Schachter27 Conclusion Successful risk management is in the details Subjective component of risk management looms large The only constant is change

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