Managing Hedge Fund Risk and Financing E-Book

David P. Belmont

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 666

Veröffentlichungsjahr: 2011

Beschreibung

The ultimate guide to dealing with hedge fund risk in a post-Great Recession world Hedge funds have been faced with a variety of new challenges as a result of the ongoing financial crisis. The simultaneous collapse of major financial institutions that were their trading counterparties and service providers, fundamental and systemic increases in market volatility and illiquidity, and unrelenting demands from investors to redeem their hedge fund investments have conspired to make the climate for hedge funds extremely uncomfortable. As a result, many funds have failed or been forced to close due to poor performance. Managing Hedge Fund Risk and Financing: Adapting to a New Era brings together the many lessons learned from the recent crisis. Advising hedge fund managers and CFOs on how to manage the risk of their investment strategies and structure relationships to best insulate their firms and investors from the failures of financial counterparties, the book looks in detail at the various methodologies for managing hedge fund market, credit, and operational risks depending on the hedge fund's investment strategy. Also covering best practice ISDA, Prime Brokerage, Fee and Margin Lock Up, and including tips for Committed Facility lending contracts, the book includes everything you need to know to learn from the events of the past to inform your future hedge fund dealings. * Shows how to manage hedge fund risk through the application of financial risk modelling and measurement techniques as well as the structuring of financial relationships with investors, regulators, creditors, and trading counterparties * Written by a global finance expert, David Belmont, who worked closely with hedge fund clients during the crisis and experienced first hand what works * Explains how to profit from the financial crisis In the wake of the Financial Crisis there have been calls for more stringent management of hedge fund risk, and this timely book offers comprehensive guidelines for CFOs looking to ensure world-class levels of corporate governance.

Leseprobe

Contents

Cover

Title Page

Copyright

Dedication

Acknowledgments

Introduction: Managing Complexity and Uncertainty

Chapter 1: The Quick and the Dead: Lessons Learned

The Global Credit Crisis: 2008–2010

The Quick and the Dead

Stakeholders' Rights

Conclusion

Chapter 2: An Integrated Approach to Hedge Fund Risk Management

Minimum Integrated Risk management Capabilities

Minimum Risk management Capabilities by Risk Type

The Importance of Integrated Risk Management: Lehman Brothers International (LBIE)

Conclusion

Chapter 3: A Survey of Hedge Fund Strategies and Risks

Hedge fund Strategies

Hedge fund Investment Risks

Business risk Management Strategies

Conclusion

Chapter 4: Analysis of the Risk/Return Profile of Hedge Fund Strategies

Opportunistic Strategies

Event driven Strategies

Relative value Strategies

Capital structure Arbitrage Strategies

Chapter 5: Managing Funding Risk

Constitutional Documents

Funding liquidity Risk management Strategies: Managing Investor Redemptions

Funding liquidity Risk management Strategies: Prime Brokers

Conclusion

Chapter 6: Managing Counterparty Risk

Hedge fund Exposures to Prime Brokers

Counterparty Risk Mitigation Strategies

Conclusion

Chapter 7: Risk Management for Hedge Fund Investors

Determining the Asset Allocation to Hedge Funds

Investment Approach

Selecting Strategies and Screening Funds

Detecting Abnormal Return Patterns

Hedge fund Monitoring

Conclusion

Chapter 8: Conclusion

The Importance of Change

Appendix 1: Topics for Due Diligence

Appendix 2: Hedge Fund Failures

Amaranth Advisors LLC (2006)

LTCM (1998)

Appendix 3: Cash Management and the Probability of Failure

Return Profiles

Structural default Model

Funding-based Failure Model

Index

Copyright©2011 John Wiley&Sons (Asia) Pte. Ltd.

Published in 2011 by John Wiley&Sons (Asia) Pte. Ltd.

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Library of Congress Cataloging-in-Publication Data

ISBN 978–0–470–82726–0 (Hardback)

ISBN 978–0–470–82728–4 (ePDF)

ISBN 978–0–470–82727–7 (Mobi)

ISBN 978–0–470–82729–1 (ePub)

Introduction: Managing Complexity and Uncertainty

Hedge funds and hedge fund investing is complex. Managing the risk of a hedge fund is similarly complex. At its core a hedge fund is a portfolio of securities whose future value is uncertain because of investment risk. However, the use of leverage, the operational realities of derivatives trading, the pledging of securities as collateral, and the asymmetric rights granted to investors, prime brokers, and hedge fund managers introduce funding, counterparty, and operational risk. Together these dramatically increase the complexity of the total risk management challenge for the hedge fund and the investment risks faced by investors.

Every hedge fund is unique in terms of its strategies, capabilities, investors, risk appetite, funding profile and legal structure. Collectively, however, hedge funds represent a fragile business model where investors' equity and prime broker funding should be balanced against investment risks and leverage if sustainable alpha is to be generated.

The risk profile of a given hedge fund can appear unique but thoughtful inspection reveals that hedge funds are not in fact a distinct risk species but, rather, share a common risk genus. Aspects of the risk management challenge and priorities for a given fund may be distinct but, fundamentally, hedge fund risks are more similar than they are different. Hedge funds share common vulnerabilities to investment, funding, counterparty and operational risks.

Hedge fund performance in the infamous market environment of 2008 showed that these vulnerabilities were underappreciated. Statistical risk modeling and measurement techniques which focused only on the potential returns of hedge fund investment portfolios grossly underestimated funding risk and the potential losses. Realized losses exceeded worst-case expectations of investors as a result of the impact of risks external to the investment portfolio; namely, counterparty, funding, and operational risks. In particular, assumptions about funding stability proved false when investors, prime brokers, and hedge fund managers acted to protect their interests. These hedge fund stakeholders exercised rights and forced actions which were optimal for individual investors, senior creditors and hedge-fund principals but sub-optimal for investors as a whole. To manage this risk going forward, an integrated risk management approach that combines stress and scenario testing of investment performance with worst-case investor-redemption behavior, a contraction in margin financing, and the proactive structuring of financial relationships with investors, creditors and trading counterparties should be considered.

This book presents in detail a new perspective on the risk which hedge fund investors and managers face. It proposes an integrated strategy by which hedge fund managers can structure financing and manage investment, counterparty, funding, and operational risks. These strategies can be customized to a specific hedge fund's investment strategy. The book details the construction, risk profile, and performance of all major hedge fund strategies over the past decade and specifically through the 2008 credit crisis. It summarizes the risk management lessons learned and details the minimum risk management capabilities a hedge fund should demonstrate across investment, funding, counterparty and operational risks to be prepared for the next crisis. Lastly, it recommends risk management strategies for each risk type and details ISDA, prime brokerage, fee and margin lock-up, and committed-facility lending terms that can be negotiated to manage counterparty and funding liquidity risk.

I am grateful to Tilly, Will and Emmafor the time to write this book.

You have done withoutmy attention for too long.

Acknowledgments

The recent credit crisis and its aftermath provided the content for this book. My various mentors gave me the framework for organizing that experience and distilling its lessons. My colleagues gave me a forum in which to debate and refine my ideas before writing. My wife and family gave me the time to write it.

The opportunity to publish came from Nick Wallwork at John Wiley & Sons, who plucked me from a podium in Singapore and asked me if I could convert my ideas about how risk management can be used to create shareholder value into a book. That moment led to my first book and started my publishing career.

The quality of this book has also been much improved by my editor, John Owen, who brought to it much-needed cogency and organization.

There are many more people I could thank, but time, space, and their modesty compel me to stop here.

Chapter 1

The Quick and the Dead: Lessons Learned

The Global Credit Crisis: 2008–2010

The global economy and capital markets have gone through a number of cycles in the 80 years since the Great Depression but none of the downturns has been as dramatic and severe as the credit crisis of 2008–2010. In the span of just eight weeks beginning in September 2008, a “tsunami” swept through the financial markets. The first ripple began on September 7, 2008, when the U.S. government stepped in to prevent the collapse of two cornerstones of the U.S. economy and took control of Fannie Mae and Freddie Mac in an extraordinary Federal intervention in private enterprise.

A week later, the ripples became waves and on September 14, Lehman Brothers, a 150-year-old institution that had survived the Great Depression, capsized and became the largest company to enter bankruptcy in U.S. history. On the same day, Merrill Lynch agreed to merge with Bank of America in order to avert its own demise. Two days later, AIG, the world's largest insurer, received an US$85-billion bailout package from the U.S. Federal Reserve in order to stave off collapse.

On September 21, with the crisis deepening and just five days after the AIG bailout, Morgan Stanley and Goldman Sachs, the two leading providers of financing to the hedge fund industry, sought shelter in safe harbors and received Federal approval to become bank holding companies. This enabled both firms to gain much-needed access to the Federal Reserve's emergency-lending facilities to ensure their liquidity. The move effectively ended the era of investment banking that arose out of the Glass–Steagal Act of 1933, which separated investment banks and commercial banks following the Stock Market Crash of 1929.

Pressures in the financial markets continued to mount and on September 26, Washington Mutual became the largest bank failure in U.S. history when it was seized by Federal regulators. With confidence in the financial markets under intense pressure, the White House and Congress drafted a historic US$700-billion bank rescue plan for the financial sector on September 29. This rescue plan would eventually become known as the Troubled Assets Relief Program (TARP).

Hedge funds continued to sail in this tempest and navigate a trifecta of forces that threatened their extinction. Some of these privateers understood the limitations of their fragile craft and sought shelter, while others risked their fortunes and sought to profit from opportunities created by the distress. During this turbulent period, concern regarding the health of the hedge fund industry was widespread, as catastrophic investment performance put the entire industry under unprecedented pressure. A record 1,471 individual hedge funds either failed or closed their doors during the credit crisis of 2008. A further 668 closed or failed in the first half of 2009. The difference between those that survived and those that failed is that the latter had great conviction about the future return of their investments while the former knew they could not predict the future, had prepared for uncertainty by investing in their firm's risk management, and followed their risk management discipline to get to a safe harbor until the financial tsunami passed.

Figure 1.1 shows that the rate of hedge fund failures more than doubled, from less than 7 percent in 2007 to more than 16 percent in 2008.

Figure 1.1 Hedge fund failures (1996–2009)

Figure 1.2 shows the massive contraction in assets under management of the hedge fund industry in 2008, as fund performance fell, funds failed, and investors exited hedge fund investments.

Figure 1.2 Estimated growth of hedge fund net assets (1990–2009)

Source: Hedge Fund Research, Inc. as of January 2010

Increased Systematic Risk

The first of the three forces threatening the performance and survival of hedge funds was systematic risk. The systematic disruption in the capital markets directly increased the volatility and risk in the markets in which most hedge funds traded. Fundamental systematic risk manifested itself in the form of market volatility and illiquidity, leading to mark-to-market losses for many hedge funds and increased demands for margin from their creditors.

As evident in Figure 1.3, the market volatility during 2008 was unprecedented, with both the frequency and size of large market price movements increasing well beyond historical norms.

Figure 1.3 Day-to-day price moves greater than 5 percent (S&P Index)

Source: Bloomberg

The bear market that began after the market peaked in October 2007 was one of the worst bear markets since the 1920s, and second only to the Stock Market Crash of 1929. From the peak of the bull market on October 9, 2007 the broader equity market, as measured by the U.S. S&P 500 index fell more than 58 percent. Over 25 percent of that decline occurred in the 13 days prior to October 16, 2008. Indeed, while all of 2008 was a lethal year for hedge funds, September and October were particularly deadly. As shown in Table 1.1, five of the largest one-day declines ever in the S&P 500 occurred in 2008, and three of those days were in September and October.

Table 1.1 Largest one-day market declines in S&P 500.

Source: Bloomberg

DateDecline (%)October 19, 198720.47October 15, 20089.03December 1, 20088.93September 29, 20088.79October 26, 19878.28October 9, 20087.62November 13, 20086.92October 27, 19976.87August 31, 19986.80January 8, 19886.77

Amid one of the worst bear markets in history, volatility rose to unprecedented levels, surpassing the volatility experienced even on “Black Monday”—October 19, 1987. shows the rolling 60-day volatility of the Standard & Poor's 500 Index and allows comparison of volatility levels in prior crises. The levels of volatility realized during the Credit Crisis of 2008–09 surpassed those of the “Black Monday” crisis and all prior crises by more than 15 percent.