Risk Management by Barry

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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2005.12.05 Copyright2005Barry Schachter 2

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)


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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Lipper Convertibles (2002)


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


Management

Beproactive not reactive

Create risk management culture

Align interests (the freeput)

Have independence and authority

Establish credibility and trust


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Management contd


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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Risk Management by Barry