hedge fund

HEDGE FUNDS

05/01/2023 Hedge Funds & P-Notes

2FLOW OF PRESENTATION What are Hedge Funds History of Hedge Funds Advantages & Disadvantages of hedge funds Differences between Hedge Funds & Mutual Funds Investors in Hedge Funds Structure of Hedge Funds

Standealone structure Side by side Master Feeder

Fees of Hedge Funds


3 SEBI Alternate investments funds Current Regulations in India Registration Conditions for obtaining certificate Investment in AIF Investment Conditions Leverage Disclosure


4 Strategies employed by hedge funds Arbitrage

Relative value

Convertible arbitrage

Equity hedge Short selling

Distressed investments

Covered call

Delta hedging

Event driven

Tactical trading Global macro

Currency rate trading

CTA

Participatory Notes LTCM case study


HISTORY OF HEDGE FUNDS

1949 - Alfred Winslow Jones devised and implemented an investment strategy that would forever brand him as “the father of the hedge fund industry. “

Jones decided to launch his own fund and raised a total of $100,000.

Price movements of an asset Overall market Performance of the asset itself

To neutralize the effect of overall market movement, he balanced his portfolio.

The effect is to 'hedge' that part of the risk due to overall market movements.

5


The name "hedge fund" originated from the hedging techniques used by some of the funds.

A simple hedge fund definition is: a hedge fund is an alternative

investment that is designed to protect investment portfolios from market uncertainty, while generating absolute returns.

A hedge fund's purpose is to maximize investor returns and eliminate risk, hence the word "hedge.”

An alternative investment vehicle available only to sophisticated investors, such as institutions and individuals with significant assets.

A hedge fund uses a range of investment techniques and invests in a wide array of assets to generate a higher return for a given level of risk than what's expected of normal investments.

6


ADVANTAGES

Diversification Absolute Returns Alignment of interest Low correlation Downside protection Wider investment latitude

7


LIMITATIONS

Only open to "accredited" or qualified investors Fee structure High risk Unregulated or loosely regulated Lower Liquidity

8


9


10Industry Growth


INVESTORS IN A HEDGE FUND

Fund managers can only accept investment capital from accredited investors or qualified purchasers

11


ACCREDITED INVESTORSIn order for an individual to qualify as an accredited investor, he must accomplish at least one of the following:

1) Earn an individual income of more than $200,000 per year, or a joint income of $300,000, in each of the last two years and expect to reasonably maintain the same level of income.

2) Have a net worth exceeding $1 million, either individually or jointly with his or her spouse.

3) An employee benefit plan or a trust can be qualified as accredit investors if total assets are in excess of $5 million

12


QUALIFIED PURCHASERSTo be a qualified purchaser you must meet either of the following criteria:

a) Individuals who own $5 million in investments held for investment purposes.

b) Institutional investors who own $25 million in investments;

c) A family owned company that owns $5 million in investments

d) For trusts with less than $25 million, a trust where the trustee and each person who contributes assets to the trust is a Qualified Purchaser

13


WHO INVEST IN HEDGE FUNDS

66% of hedge fund assets are held by institutional investors.

These institutional investors include:

1. Public employee pension plans

2. Corporate employee pension plan

3. University and college endowments

4. Foundations and non-Profit Organizations

14


15


MAIN CATEGORIES OF INVESTORS 16

INVESTORS

U.S. INVESTORS

TAXABLE U.S.

INVESTORS

TAX EXEMPT U.S. INVESTORS

NON U.S. INVESTORS


TAX-EXEMPT U.S. INVESTORS

1. Government

2. Profit sharing plan

3. IRAs

4. Endowments funds

5. Pension funds

6. Other charitable organizations.

17


TAXABLE U.S. INVESTORS INCLUDE:

1. Natural persons

2. Partnerships

3. Corporations

4. Limited liability companies (LLCs)

5. Registered investment companies

18


19TYPES OF HEDGE FUNDS

ONSHORE (DOMESTIC)

HEDGE FUNDS

•Limited Partnership•Limited liability companies

OFFSHORE HEDGE FUNDS

•Corporation•Unit trust•Limited Partnership


ADVANTAGES OF GOING FOR OFFSHORE FUNDS

1. Exempt from federal tax but taxed on Unrelated Business Taxable Income(UBTI)

2. Avoids UBTI by investing in a Corporation Type offshore fund

3. Non U.S. investors can maintain anonymity with respect to the U.S.

20


HEDGE FUND STRUCTURES

1. Standalone structure

2. Side by side structure

3. Master feeder

21


STANDALONE STRUCTURE 22

Taxable US Investors

Domestic Hedge Fund LP

Investments

General partner LLC


SIDE BY SIDE STRUCTURE 23

General Partner LLC

Domestic hedge fund LP

Investments

Offshore hedge fund Ltd.

Investments

Taxable US Investors

Non US & tax exempt US investors


The side-by-side structure is a two-fund structure which includes a U.S. fund and an offshore fund

Addresses concerns of each type of investor

Different fund managers

May have different or same investments

24


MASTER FEEDER 25

General Partner LLC

Domestic hedge fund LP

Offshore hedge fund

Ltd.Taxable US Investors

Non US & tax exempt US investors

MASTER FUND (Ltd./LP)

Investments


In a master-feeder structure, like a side-by-side structure, a domestic fund and an offshore fund are established.

Feeder funds invest into the master fund

The master fund is a pass-through entity for U.S. tax purposes

Single investments

Efficient and cost effective

Conflicts of interest

26


Hedge Fund Fees

Management Fee(2%) Incentive Fee(20%)

35


High water mark- Incentive fee is not paid on gains that offset prior losses

Hurdle Rate – No performance fee until the performance exceeds a benchmark rate.

37


29

SECURITIES AND EXCHANGE BOARD OF INDIA (ALTERNATIVE INVESTMENT FUNDS) REGULATIONS, 2012

Regulation 2 (1) (b) defines “alternative investment fund” as:

Alternate investment fund means any fund established or incorporated in india in

the form of a trust or a company or a limited liability partnership or a body

corporate which

(i) is a privately pooled investment vehicle which collects funds from investors, whether

indian or foreign, for investing it in accordance with a defined investment policy for the

benefit of its investors; and

(ii) is not covered under the securities and exchange board of india (mutual funds)

regulations, 1996, securities and exchange board of india (collective investment schemes)

regulations, 1999 or any other regulations of the board to regulate fund management

activities”

The following have been kept out of the purview of the definition of AIF:

Family trusts set up for the benefit of ‘relatives’ as defined under Companies Act,

1956

ESOP Trusts

Employee welfare trusts or gratuity trusts

“Holding Companies” within the meaning of Section 4 of the Companies Act, 1956

Other special purpose vehicles not established by fund managers, including

securitization trusts, regulated under a specific regulatory framework

Funds managed by securitisation company or reconstruction company which is

registered with the Reserve Bank of India

Any such pool of funds which is directly regulated by any other regulator in India.

9/20/2015Hedge Funds & P-Notes

31

TERRITORIAL SCOPE OF THE REGULATIONS

Regulation 2(1)(o) defines an “investee company” as:

“any company, special purpose vehicle or limited liability partnership or body

corporate in which an Alternative Investment Fund makes an investment”

As a body corporate includes a company registered outside India, the scope of

these Regulations extends to:

Funds established in India and investing in India and/or abroad;

Funds established abroad and investing in India.


32

CURRENT REGULATIONS IN INDIA

SEBI Regulations, 2012 (Alternative Investment Funds – AIF)

3 categories:-

Category I – VCF, SME Funds, Social Venture Funds and Infrastructure

Funds.

Category II - Private Equity Funds, Debt Funds, Fund of Funds and such

other funds that are not classified as category I or

Category III - Hedge Funds that are considered to have risk through

leverage or complex trading strategies including listed or unlisted

derivatives.


33

Features:

Min size of AIF – 20 crore

Min investment – 1 cr OR

0.1% of fund size

Should not have more than 1000 investors

Continuing interest shall not be less than 2.5% of the corpus or 5cr whichever is ₹lower.

Cannot invest more than 10% of the corpus in one investee company


34

Trading in Secondary Market:

Units of HF may be listed on stock exchange subject to a minimum

tradable lot of Rs.1 crore. However, HF cannot raise funds through

Stock Exchange mechanism

It can open ended or close ended.

Hedge Fund should fully liquidate within 1 year

Extension of tenure – 2 Yrs subject to approval of 2/3rd of the unit

holders by value of their investment in the Hedge Funds.


35

REGISTRATION OF ALTERNATIVE INVESTMENT FUNDS

To operate a Hedge Fund certificate of registration must be obtained by the applicant, the

Board shall consider the following conditions for eligibility:

The memorandum of association, the Trust Deed or the Partnership deed should permit

to carry on the activity of an Alternative Investment Fund;

The applicant is prohibited by its memorandum/deed from making an invitation to the

public to subscribe to its securities;

The applicant, Sponsor and Manager are fit and proper persons based on the criteria

specified in Schedule II of SEBI Regulations, 2008


36

The key investment team of the manager should have adequate experience

At least 1 key personnel having not less than 5 years experience in advising or managing fund or asset or wealth or in the business of buying, selling and dealing of securities or

other financial assets and has relevant professional qualification

The applicant has clearly described at the time of registration:

The investment objective The targeted investors Proposed corpus Investment style or strategy Proposed tenure of the fund or scheme

Whether the applicant or any entity established by the sponsor or manager has earlier been refused

registration by the board


37

INFORMATION MEMORANDUM

As specified in sub-regulation (1) shall contain all material Information about the alternative investment fund:

The manager Background of key investment team of the manager Targeted investors Fees and all other expenses proposed to be charged Tenure of the alternative investment fund or scheme Conditions or limits on redemption Investment strategy Risk management tools and parameters employed Key service providers


38

Conflict of interest and procedures to identify and address them,

Terms and conditions on which the manager offers investment services,

Its affiliations with other intermediaries,

Manner of winding up of the alternative investment fund or the scheme

Any other information as may be necessary for the investor to take an

informed decision on whether to invest in the alternative investment fund.


39

CONDITIONS OF CERTIFICATE

The certificate granted under regulation shall be subject to the following

conditions:-

(a) it should abide by the provisions of the Act and these regulations

(b) it shall not carry on any other activity other than permitted activities

(c) it should inform the Board in writing, if any information or particulars previously

submitted to the Board are found to be false or misleading in any material particular or

if there is any material change in the information already submitted.

An Alternative Investment Fund registered under a particular category cannot change

its category subsequent to registration, except with the approval of the Board.


40

INVESTMENT IN ALTERNATIVE INVESTMENT FUND

Investment in hedge funds shall be subject to the following conditions:-

► The alternative investment fund may raise funds from any investor whether indian,

foreign or non-resident Indians by way of issue of units

► Each scheme of the hedge fund shall have corpus of atleast twenty crore rupees

The hedge fund shall not accept from an investor, an investment of value less than one

crore rupees


41

The manager or sponsor shall have a continuing interest in the hedge fund of not

less than 5% of the corpus or 10 crore rupees, whichever is lower, in the form of

investment in the hedge fund.

The manager or sponsor shall disclose their investment in the hedge fund to the

investors

Max no of investors permitted in a hedge fund is 1,000.

Hedge fund are allowed to collect only by way of private placement.


42

INVESTMENT CONDITIONS FOR HEDGE FUNDS

Hedge Funds may invest in securities of: 1) Listed or unlisted investee companies

2) Derivatives or complex or structured products;

3) Category I or Category II Alternative Investment Funds:

Hedge Funds may engage in leverage or borrow with consent from the investors in the fund, subject to a maximum limit and shall disclose information regarding: 1) the overall level of leverage employed

2) the level of leverage arising from borrowing of cash

3) the level of leverage arising from position held in derivatives or in any complex product.


43

LEVERAGE

Leverage – Ratio of exposure to NAV should not exceed

2 times of the NAV

NAV is the total market value of all securities

Funds to inform regulators if breach occurs, action by regulators

If the leverage limit is breached, report to clients (before 10 am) and Custodian.


44

DISCLOSURE

Alternative Investment Fund shall provide at least on an annual basis, within 180 day from the year end, reports to investors including the following information, as may be applicable to the Alternative Investment Fund:

► Financial information of investee companies.► Material risks and how they are managed which may include:

(i) concentration risk at fund level(ii) foreign exchange risk at fund level(iii)leverage risk at fund and investee company levels(iv)realization risk at fund and investee company levels(v) strategy risk at investee company level(vi)reputation risk at investee company level(vii) extra-financial risks, including environmental, social and corporate governance risks, at fund and investee company level.


45

SEBI REVISED GUIDELINES FOR ALTERNATIVE INVESTMENT FUNDS

Disciplinary history

Reporting leverage

Requirement of maintaining minimum corpus


46

FIRST AIF CATEGORY III-HEDGE FUND

Karvy capital-systematic edge fund

This fund is an open-ended category-III AIF (alternate investment fund), under the

AIF guidelines issued by SEBI.

Collected 100 crores from HNIs and select institutions

Karvy invested in futures and options of equity stocks and indices.


47

Hedge Funds & P-Notes

DIFFERENCE BETWEEN HEDGE FUNDS & MUTUAL FUNDS

Mutual funds Hedge Funds

-Subject to rigorous regulation -Are virtually unregulated.

-Designed to serve a large number of small investors

-Small firms dominated by one or two key investment people-Designed to serve a small number of large investors.

-Relative return as compared to benchmark indices

-Absolute return as compared to relative return.

9/20/2015

48

Hedge Funds & P-Notes Mutual funds Hedge Funds

-Manager is only an agent of client -MF manager may have no personal assets at all invested in the funds

-Client doesn’t merely hire the manager. Instead client & manger become partners, co-investing in situations.

-Limitations on strategies -Wide investment techniques like short selling, leverage, diversification etc

-Return determined by :Performance of the market in which manager investsStrategies adopted as per the skills of manager

-Return determined by :Strategies adopted as per the skills of manager

9/20/2015

49

Hedge Funds & P-Notes Mutual funds Hedge Funds

-Larger -Hedge Fund firms tend to be smaller

-Daily liquidity -Limitations on investment and redemption (lock-in-period)

-Fees is asset based -Fees is asset based and performance based

-Broad access -Limitations to marketing & selling

-Investment objectives and strategies are set out in Prospectus=Narrowly defined

-Information memorandum=mission broadly defined

9/20/2015

50

STRATEGIES EMPLOYED BY HEDGE FUNDS

Arbitrage

Relative Value

Convertible Arbitrage


51

ARBITRAGE


52

RELATIVE VALUE

Also called ‘Pairs Trading’

Designed to take advantage of mis-pricing

Used in sideways market (within a specific range)

When the prices diverge – arbitrage arises


53

CONVERTIBLE ARBITRAGE

Relationship between company’s convertible bonds and stock Buy convertible bonds Sell stock If stock price rises If stock price falls Effect of interest rate


54

Bond @ $1000 Stock @ $50 Bond convertible for 20 shares If stock price is 55 – convert the bond and short stock If stock price is 45 – hold the bond


55

EQUITY HEDGE STRATEGIES


56

SHORT SELLING

Seeks to profit from declines in the value of stocks Eg. sell one month Futures @ rs.5000 Margin = Rs.1000 (assuming 20% margin) Interest = Rs.8 (assuming 10% interest) Buy back the stock at lower price say 4800 Total gain=(5000-4800) + 8 = Rs. 208 Loss if the stock prices rise


57

DELTA HEDGING


58

MARKET NEUTRAL STRATEGY

Overall delta value of the position is near to zero so that changes in the underlying stock price do not affect the overall value of the position.

The portfolio delta can be made to sum to zero, and the portfolio is then delta neutral


59

Eg. buying an at the money call and buying an At-The-Money put option

Assume Δ=0.5


60

Futures Call 6000 @Rs.100

Put 6000 @Rs.100

6080 (20) (100) 6120 20 (100)6000 (100) (100)6100 0 (100)

COVERED CALL

Employed when manager is neutral about the market or is moderately bullish

Buy stock and sell OTM call option Eg. Buy stock @ rs.300 Sell call of rs.330 on the same stock for rs.20

05/01/2023


61

Market Stocks underlying price

Option P&L

320 320-300 20 40350 350-300 330-

350+2050

250 250-300 20 -30

EVENT DRIVEN


62

A position is taken to take advantage of price moves arising from new market information release or events occurring.

Merger Arbitrage

Distressed Restructuring

Activist shareholder

05/01/2023


63

Merger Arbitrage

After merger Company A remains. 1:1 scheme of m&a is assumed. i.e for every 1 share of Co B you will get 1 share of Co A


64

Merger Arbitrage 05/01/2023 Hedge Funds & P-Notes

65

Distressed Restructuring

Buy Undervalue Securities of the firm in financial distress when analysis shows that the value will increase by restructuring

The hedge funds may invest in debt or equity of such companies

05/01/2023


66

Activist shareholder

Buying sufficient quantity of equity to influence companies policies

Goal is to increase the company’s value

05/01/2023


67

GLOBAL MACRO STRATEGY

Focuses on investing in instruments whose prices fluctuate based on the changes in economic policies, along with the flow of capital around the globe.

May invest in equities, fixed income, currency or commodities.

For example, if a manager believes that the U.S. is headed into recession, then he or she might short sell stocks and futures contracts on major U.S. indexes or the U.S. dollar. Or, a manager seeing big opportunity for growth in Singapore might take long positions in Singapore's assets.

05/01/2023


68

Effects of the subprime crisis on hedge funds

05/01/2023


69

Purchased Collateralized Debt Obligations (CDO’s)

Used more Leverage

Purchased Credit Default Swaps

Positive Carry

05/01/2023


70

Subprime Mortgage Backed Securities behaved well outside what was expected by the Hedge Fund Managers

Default from Home-owners

They had insufficient credit insurance to protect these losses

Financers started asking for more money or collateral because of the drop in the value of the bond

05/01/2023


71

These Funds had no cash on the sideline

Bear Stern was the first one in trouble

Cascading effect

Hedge Funds collapsed

05/01/2023


72

Bear Stearns Hedge funds collapsed


73

Defaults from home owners in early 2007

Their High Grade Structured Credit fund received $1.6 Billion

High Grade structure credit fund and high grade structure credit leveraged funds lost almost their entire value

31st July 2007, both these funds filed for bankruptcy

05/01/2023


74

Bear Stearns Stock Price 2005-2008

05/01/2023


75

Participatory Notes

05/01/2023 Participatory Notes commonly known as P-Notes or PNs

PNs are instruments issued by registered foreign institutional investors (FII) to overseas investors, who wish to invest in the Indian stock markets without registering themselves with the market regulator, the Securities and Exchange Board of India

Any dividends or capital gains collected from the underlying securities go back to the investors

Investing through P-Notes is very simple and hence very popular amongst foreign institutional investors


77

05/01/2023

TOP 5 FIIS ISSUING PN’sHedge Funds & P-Notes

78

05/01/2023

PN’s CRISIS OF 2007

Oct 16th - SEBI proposed to curb PNs

Oct 17th

Sensex crashed by 1744 points Announcement by P.Chidambaram

Oct 18th

Sensex tumbled 717 points

Oct 22nd Announcement by Mr.Damodaran


79


80


81

FII RULES05/01/2023 Hedge Funds & P-Notes

82

SEBI new classification of Foreign investors


83

05/01/2023

ADVANTAGES OF INVESTING IN PN Easily transferable by endorsement & delivery

No Tax

Anonymity of investor is maintained


84

05/01/2023

WHY BAN PN’SHedge Funds & P-Notes

85

05/01/2023

P-NOTES AND CGT EVASIONWith P-Notes Without P-notes

Tom can buy Indian shares via FII via p-notes.

Tom have to get PAN+DEMAT. Only then, they can buy/sell Indian shares.

Tom sells this P-note to X @profit. X doesn’t need to pay CGT to Indian

Government, because we cannot trace what Tom did with that piece of paper in USA!

Even if P-note is sold 10 times to 10 different people, we cannot get CGT.

We’ll get CGT only once, when the said p-note owner instructs the FII to sell the shares from its Indian DEMAT account/ portfolio.

If Tom sells his shares to X (and makes profit), then That X will have to pay Capital gains tax to India.

Because Income tax official can trace it by monitoring the DEMAT activity of both accounts.


86

LONG TERM CAPITAL

MANAGEMENT

05/01/2023

SUMMARY OF EVENTS

In 1994, John Meriwether, the famed Salomon Brothers bond trader, founded a hedge fund called Long-Term Capital Management

Meriwether assembled an all-star team of traders and academics in an attempt to create a fund that would profit from the combination of the academics' quantitative models and the traders' market judgement and execution capabilities

Sophisticated investors, including many large investment banks, flocked to the fund, investing $1.3 billion at inception

But four years later, at the end of September 1998, the fund had lost substantial amounts of the investors' equity capital and was teetering on the brink of default


88


89

05/01/2023 To avoid the threat of a systemic crisis in the world financial

system, the Federal Reserve orchestrated a $3.5 billion rescue package from leading U.S. investment and commercial banks

In exchange the participants received 90% of LTCM's equity


90

05/01/2023

LTCM’S STRATEGY

The basic principle of LTCM’s strategy was that in the long term, the price of a security would converge to its fair market value even though there may be mispricing in the short term

LTCM utilized computer models to find arbitrage opportunities between markets

LTCM's central strategy was convergence trades where securities were incorrectly priced relative to one another

LTCM would take long positions on the under priced security and short positions on the overpriced security


91

05/01/2023 The strategy depended on exploiting deviations in market value from

fair value. And it depended on "patient capital" -- shareholders and lenders who believed that what mattered was fair value and not market value. That is, because the fair values were hedged, it didn't matter what happened to market values in the short run — they would converge to fair value over time. That was the reason for the "Long Term" part of LTCM's name.


92

05/01/2023 A convergence trading strategy in the stock markets, is a trade idea

based on the principle that when the price of a stock (or stock portfolio) significantly deviates from its long-term trend, it will sooner or later converge (move back) back to its original trend. For example, a trading strategy that generates a buy signal at every dip of the stock price in a general up trend is a convergence trading strategy.


93

05/01/2023

CONVERGENCE TRADES LTCM's main strategy was to make convergence trades. These trades

involved finding securities that were mispriced relative to one another, taking long positions in the cheap ones and short positions in the rich ones

When an arbitrage opportunity was identified by the computers then LTCM would immediately trade and take on the position, and when the price difference converged back to mean normal course, the computer would identify this and LTCM would immediately close off their position.


94

05/01/2023

TYPES OF TRADES

Convergence among U.S., Japan, and European sovereign bonds

Convergence among European sovereign bonds

Convergence between on-the-run and off-the-run U.S. government bonds

Long positions in emerging markets sovereigns, hedged back to dollars


95

05/01/2023 Because these differences in values were tiny, the fund needed to

take large and highly-leveraged positions in order to make a significant profit

At the beginning of 1998, the fund had equity of $5 billion and had borrowed over $125 billion — a leverage factor of 25:01


96

05/01/2023

LTCM's partners believed, on the basis of their complex computer models, that the long and short positions were highly correlated and so the net risk was small


97

05/01/2023 On-the-run treasuries

The most recently issued U.S. Treasury bond or note of a particular maturity. These are the opposite of "off-the-run treasuries".

Sovereign Bond A debt security issued by a national government within a given

country and denominated in a foreign currency.


98

05/01/2023

LTCM’S POSITIONS

LTCM had fixed income and equity positions. The equity positions were a mix of:

1) Index spread trades

2) Total return swaps

3) Takeover positions.

Index Spread TradesA spread is defined as the sale of one or more futures contracts and the purchase of one or more offsetting futures contracts. A spread tracks the difference between the price of whatever it is you are long and whatever it is you are short


99

05/01/2023

TOTAL RETURN SWAP

In a total return swap, the party receiving the total return will receive any income generated by the asset as well as benefit if the price of the asset appreciates over the life of the swap

In return, the total return receiver must pay the owner of the asset the set rate over the life of the swap

If the price of the assets falls over the swap's life, the total return receiver will be required to pay the asset owner the amount by which the asset has fallen in price


100

For example, two parties may enter into a one-year total return swap where Party A receives LIBOR + fixed margin (2%) and Party B receives the total return of the S&P 500 on a principal amount of $1 million. If LIBOR is 3.5% and the S&P 500 appreciates by 15%, Party A will pay Party B 15% and will receive 5.5%. The payment will be netted at the end of the swap with Party B receiving a payment of $95,000 ($1 million x 15% - 5.5%)


101

05/01/2023

THE ULTIMATE CAUSE OF THE DEBACLE


102

05/01/2023

FLIGHT TO LIQUIDITY The ultimate cause of the LTCM debacle was the "flight to liquidity"

across the global fixed income markets

As Russia's troubles became deeper and deeper, fixed-income portfolio

managers began to shift their assets to more liquid assets

What LTCM had failed to account for is that a substantial portion of its balance sheet was exposed to a general change in the "price" of liquidity. If liquidity became more valuable (as it did following the crisis) its short positions (rich assets) would increase in price relative to its long positions (cheap assets)

This was essentially a massive, unhedged exposure to a single risk factor


103

05/01/2023

As the case demonstrates, the lenders are the first to get nervous when an external shock hits

At that point, they begin to ask the fund manager for market valuations, not models-based fair valuations

This starts the fund along the downward spiral:

illiquid securities are marked-to-market

margin calls are made

the illiquid securities must be sold

more margin calls are made, and so on


104

05/01/2023

THE LESSONS TO BE LEARNED FROM THIS CRISIS ARE

Market values matter for leveraged portfolios

Liquidity itself is a risk factor

Models must be stress-tested and combined with judgement

LTCM fell victim to a flight to liquidity. This phenomenon is common enough in capital markets crises that it should be built into risk models, either by introducing a new risk factor — liquidity — or by including a flight to liquidity in the stress testing


105

05/01/2023 Another key lesson to be learnt from the LTCM debacle is that even (or

especially) the most sophisticated a financial models are subject to model risk and parameter risk, and should therefore be stress-tested and tempered with judgement

According to the complex mathematical models used by LTCM, the positions were low risk. Judgement tells us that the key assumption that the models depended on was the high correlation between the long and short positions.


106

05/01/2023 Certainly, recent history suggested that correlations between corporate

bonds of different credit quality would move together (a correlation of between 90-95% over a 2-year horizon)

During LTCM's crisis, however, this correlation dropped to 80%

Stress-testing against this lower correlation might have led LTCM to assume less leverage in taking this bet


107


108

Economy & Finance

hedge fund