theory and practice of risk management in hedge funds barry schachter

Theory and Practice of Risk Management in

Hedge FundsBarry Schachter

2005.12.05 Copyright 2005 Barry Schachter 2

Overview & SummaryOverview & SummaryWhat goes on in hedge fundsLandscape of risksRisk MeasurementRisk Management


Tradewinds InternationalTradewinds 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 expensesTo repay investors at inflated NAVs

Losses: Commodity futures/options 2003-2004 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


Operational RiskOperational RiskDefn: Loss from failure of ordinary business

processes (getting business done)Causes: poor process, poor training, poor

alignment of incentives, serendipity


Op Risk RemediesOp Risk RemediesInternal Solutions

Prudent actionsInvestor-Manager contractIndustry Guidance (CRMPGII, IAFE Op Risk)

External Solution – RegulationPrime Directive – ‘Break glass’ only if internal solution isn’t

socially optimal and incremental costs do not exceed benefitsPerception that HFs are ‘lightly regulated’

Relative to what?Light is equated with poor in perception


US HF Regulation Overview

US HF Regulation Overview

SECRegistration required (Feb 2006) (2Yr lock-up exception) Form

ADVFraud/FiduciaryReg. Filings – Form 13DIndirect – Prudential Supervision of PB (‘CSE’)

CFTCRegistration required (CTA/CPO)Fraud/FiduciaryReg. Filings - Speculative position limits


HF Risk Management – Big Picture

HF Risk Management – Big Picture

Op Risk is not the first concernMarket RiskCredit RiskLiquidity, Concentration, Reputation

No regulation demandsNo standard risk management modelLimited independence


Brief Aside on Risk Measurement

Brief Aside on Risk Measurement

Quantification Helps Risk ControlSome Measures

Value at Risk (VaR)Stress TestingSensitivities (e.g., bpv, options)Notionals (e.g., GMV, NMV)P/L volatilityDrawdown


Market RiskMarket RiskThe risk of monetary loss arising from an

adverse move in market prices or rates (includes traded credit risk)


Market Risk Management – On the Desk

Market Risk Management – On the Desk

Trading limitsRisk-based (VaR, Stress)Nominal (Gross/Net positions, Concentration,

LiquidityP/L related (portfolio stop and drawdown)

Dialogue – more important than limits


On the Desk (cont’d) - Dialogue

On the Desk (cont’d) - Dialogue

Asking Good QuestionsIs that really correlated?Does that data change your thesis?Is it in the price already?

Reducing Trader ErrorsDrunk with successDoubling downFear of failureDeer in the headlights (stops)Options trading problems


On the Desk (cont’d) – Options Trading Mistakes

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)


Getting Inside a Trader’s Head

Getting Inside a Trader’s Head

Entry (timing, catalyst, technicals)Sizing (look for confirmation, scaling in)Position managementExit (stops vs. price targets)


What Worries Me - TradersWhat Worries Me - TradersHubris

“I have never lost money before”“There are a million reasons for this to work”

Style driftMarket 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”


Portfolio Risk ManagementPortfolio Risk ManagementMeasurement Problems are Everywhere

Flat at the closeArbitrage/convergence (OTR vs off-the-run; liquidity bet)Merger arbitrageLiquidity risk for “chunky” positionsCollateral-at-risk

Valuation ProblemsOperational Risks


Operational Risk Example – Bayou (2005)

Operational Risk Example – Bayou (2005)

Raised $400MM, ‘lost’ $300MMHigh risk trades to try to make up lossesCFO owned ‘independent’ auditorAffiliated broker made $50MM commissions from

BayouMisreported NAVs, commission exp.Principal, Samuel Israel III, lied about

background in marketing


Operational Risk Example – Wood River (2005)

Operational Risk Example – Wood River (2005)

No auditor/audits (contrary to marketing materials)

PPM stated max position 10% capitalPlaced 65% of capital in one small cap (not

disclosed to investors)


Operational Risk Example – Lipper Convertibles

(2002)

Operational Risk Example – Lipper Convertibles

(2002)

Convertible arb fundAssets plunged 40%, not up “a few” percentRevised managers’ valuations after they leftDelta hedges not adequate


Operational Risk ExampleOperational Risk ExamplePhoenix Research and Trading

$125MM losses – January 2002Trading US Treasuries


Operational Risk Example (Sell-side Lessons)

Operational Risk Example (Sell-side Lessons)

Allfirst Financial – John Rusnak$690MM losses – February 2002Trading major currencies

National Australia Bank – Jan ‘04Almost identical story


Fundamentals of (Independent) Risk Management

Fundamentals of (Independent) Risk Management

Be proactive not reactiveCreate risk management cultureAlign interests (the “free put”)Have independence and authorityEstablish credibility and trust


Fundamentals of (Independent) Risk Management cont’d

Fundamentals of (Independent) Risk Management cont’d

Understand range and magnitude of risksHidden risks (e.g. equity factors)

Know what you don’t know Vol swapEconomic derivatives

Communicate issues clearlyHow to say “no”Speaking the language


What Worries Me - OptionsWhat Worries Me - OptionsUnmeasured risks (pin, knockout, corr.)No marks (price/vol)Dealer/trader supplied marksLiquidity


What Worries Me - Liquidity

What Worries Me - Liquidity

VolumeFirm positionMarket playersShort interestTechnical stops and the rush to exitWhen the market stops trading


Managing UpManaging UpCommunication

Keep message simpleBe clear (accuracy less important)

OverviewMonitor risk appetiteEvaluate performance


Managing Out - Investor Risk Disclosures

Managing Out - Investor Risk Disclosures

Requirements/PracticeIssues with disclosure

Disclosure dissipates private informationOnly position level disclosure makes aggregation

possible“Snapshots” of risk are misleadingFund risks have option characteristics


ConclusionConclusionSuccessful risk management is in the detailsSubjective component of risk management

looms largeThe only constant is change

theory and practice of risk management in hedge funds barry schachter

Documents

barry schachter9 market

traded credit risk slide

practice of risk management

marketing slide

perception slide

serendipity slide

adequate slide

risk of monetary loss