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Theory and Practice of Risk Management in Hedge Funds

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

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

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

3 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 Copyright 2005 Barry Schachter

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

5 Copyright 2005 Barry Schachter
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 isn’t 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 Copyright 2005 Barry Schachter

6 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) Reg. Filings - Speculative position limits Copyright 2005 Barry Schachter

7 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 Copyright 2005 Barry Schachter

8 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 Copyright 2005 Barry Schachter

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

10 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 Copyright 2005 Barry Schachter

11 On the Desk (cont’d) - 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 Copyright 2005 Barry Schachter

12 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) Copyright 2005 Barry Schachter

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

14 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 don’t want to hedge the FX exposure” Wanting the last quarter point of a trade “Another PM got me into it” Copyright 2005 Barry Schachter

15 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 Copyright 2005 Barry Schachter

16 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 Copyright 2005 Barry Schachter

17 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) Copyright 2005 Barry Schachter

18 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 Copyright 2005 Barry Schachter

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

20 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 Copyright 2005 Barry Schachter

21 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 Copyright 2005 Barry Schachter

22 Fundamentals of (Independent) Risk Management cont’d
Understand range and magnitude of risks Hidden risks (e.g. equity factors) Know what you don’t know Vol swap Economic derivatives Communicate issues clearly How to say “no” Speaking the language Copyright 2005 Barry Schachter

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

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

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

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 Copyright 2005 Barry Schachter

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

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