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8/6/2019 Risk Management by Barry
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Theory and Practice of Risk
Management in Hedge Funds
Barry Schachter
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Overview & SummaryOverview & SummaryWhat goes on in hedge funds
Landscape of risksRisk Measurement
Risk Management
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Tradewinds InternationalTradewinds International Charles L. Harris
Raised from 30investors $10MM between1995/2001 and2004
Made false statements (K-1) about NAV ($30MMvs $1.1MM in2003)
Used investor funds ($2.4MM) forPersonal expenses
To repay investors at inflated NAVs
Losses: Commodity futures/options 2003-2004
SEC/CFTCcivil actions 2004/09/02
DoJcriminal suit2004/09/09 Sentenced to168months/$13.9MM2005/10/06
Pirate? 1723/07/19
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Operational RiskOperational RiskDefn: Loss from failure ofordinary business
processes (getting business done)
Causes:poorprocess,poor training,pooralignmentof incentives, serendipity
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Op Risk RemediesOp Risk Remedies Internal Solutions
Prudent actions
Investor-Manager contractIndustry Guidance (CRMPGII, IAFE Op Risk)
External Solution RegulationPrime Directive Break glassonly if internal solution
isnt sociallyoptimal and incremental costs donot exceedbenefits
Perception that HFs are lightly regulatedRelative to what?
Light is equated withpoor inperception
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US HF Regulation OverviewUS HF Regulation OverviewSEC
Registration required (Feb 2006) (2Yr lock-up exception)
Form ADVFraud/Fiduciary
Reg.Filings Form 13D
Indirect Prudential Supervisionof PB (CSE)
CFTCRegistration required (CTA/CPO)
Fraud/Fiduciary
Reg.Filings - Speculativeposition limits
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HF Risk Management Big
Picture
HF Risk Management Big
PictureOp Risk is not the first concern
Market Risk
Credit Risk
Liquidity, Concentration, Reputation
No regulation demands
No standard risk management model
Limited independence
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Brief Aside on Risk MeasurementBrief Aside on Risk MeasurementQuantification Helps RiskControl
Some MeasuresValue at Risk (VaR)
Stress Testing
Sensitivities (e.g., bpv, options)
Notionals (e.g., GMV, NMV)P/L volatility
Drawdown
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Market RiskMarket RiskThe riskof monetary loss arising from an
adverse move in marketprices or rates
(includes traded credit risk)
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Market Risk Management On
the Desk
Market Risk Management On
the DeskTrading limits
Risk-based (VaR, Stress)
Nominal (Gross/Netpositions, Concentration,Liquidity
P/L related (portfolio stop and drawdown)
Dialogue more important than limits
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On the Desk (contd) - DialogueOn the Desk (contd) - DialogueAsking GoodQuestions
Is that really correlated?
Does that data change your thesis?Is it in theprice already?
Reducing Trader ErrorsDrunk with success
Doubling downFearof failure
Deer in the headlights (stops)
Options tradingproblems
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On the Desk (contd) Options
Trading Mistakes
On the Desk (contd) Options
Trading MistakesThe shortvol game (Caxton ED)
Implied leverage near expiry (BAM biotech)
Exercise to exit (SAChealthcare)
The lottery ticket
Buy OTMnear expiry (BAM equity)
Ignore MVvs Intrinsic (Caxton EUR)Fairvalue vs.Quote (Caxton exotic)
Buy/Write toprotectprofit (BAM retail)
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Getting Inside a Traders HeadG
etting Inside a Traders HeadEntry (timing, catalyst, technicals)
Sizing (look for confirmation, scaling in)
Position management
Exit (stops vs.price targets)
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WhatWorries Me - TradersWhatWorries Me - Traders Hubris
Ihave never lost money before
There are a million reasons for this to work
Style driftMarketview takes over (becoming a macro trader)
Losers become long-term trade ideas
Focus
Iwill just allocate 1%of capital Idont want to hedge the FXexposure
Wanting the last quarterpointof a trade
Another PM got me into it
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Portfolio Risk ManagementPortfolio Risk ManagementMeasurement Problems are Everywhere
Flat at the close
Arbitrage/convergence (OTRvs off-the-run; liquidity bet)Merger arbitrage
Liquidity risk for chunkypositions
Collateral-at-risk
Valuation Problems
Operational Risks
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Operational Risk Example
Bayou (2005)
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 commissionsfrom Bayou
Misreported NAVs, commission exp.Principal, SamuelIsraelIII, lied about
background in marketing
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Operational Risk Example
Lipper Convertibles (2002)
Operational Risk Example
Lipper Convertibles (2002)
Convertible arb fund
Assetsplunged40%, not up a fewpercent
Revised managersvaluations after they left
Delta hedges not adequate
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Operational Risk ExampleOperational Risk ExamplePhoenix Research and Trading
$125MM losses January2002
Trading US Treasuries
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Operational Risk Example (Sell-
side Lessons)
Operational Risk Example (Sell-
side Lessons)AllfirstFinancial John Rusnak
$690MM losses February2002
Trading major currencies
National Australia Bank Jan 04
Almost identical story
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Fundamentals of (Independent) Risk
Management
Fundamentals of (Independent) Risk
Management
Beproactive not reactive
Create risk management culture
Align interests (the freeput)
Have independence and authority
Establish credibility and trust
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Fundamentals of (Independent) Risk
Management contd
Fundamentals of (Independent) Risk
Management contd
Understand range and magnitude of risksHidden risks (e.g. equity factors)
Know what you dont knowVol swap
Economic derivatives
Communicate issues clearlyHow to say no
Speaking the language
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WhatWorries Me - OptionsWhatWorries Me - OptionsUnmeasured risks (pin, knockout, corr.)
No marks (price/vol)
Dealer/trader supplied marks
Liquidity
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WhatWorries Me - LiquidityWhatWorries Me - LiquidityVolume
Firmposition
Marketplayers
Short interest
Technical stops and the rush to exitWhen the market stops trading
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ManagingUpManagingUpCommunication
Keep message simple
Be clear (accuracy less important)
Overview
Monitor risk appetite
Evaluateperformance
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Managing Out - Investor Risk
Disclosures
Managing Out - Investor Risk
DisclosuresRequirements/Practice
Issues with disclosure
Disclosure dissipatesprivate information
Onlyposition level disclosure makes aggregationpossible
Snapshotsof risk are misleadingFund risks have option characteristics
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ConclusionConclusionSuccessful risk management is in the details
Subjective componentof risk managementlooms large
The only constant is change
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