Saturday, May 17, 2014

Considerations in quantifying hedge fund portfolio risks

 "And now for something completely different ..."
                                                                      John Cleese

We've been asked about quantification and monitoring of risk for hedge fund managers. It's a process that tends to be dramatically different from what banks or insurance firms undergo. Hedge funds develop risk measures that are both highly dynamic and practical in nature. Here is a generic list of considerations (sent by a Sober Look reader)- a more comprehensive list would of course vary by strategy.

                Measuring portfolio leverage and directionality
o   Gross vs. net leverage measures
o   Beta adjusted vs. net notional exposure (are you long or short?)
o   Combining credit and equity risks into a single exposure
o   The use/limitations of basic spread and rate risk measures (portfolio duration, CS01, etc.)

        Working with beta measures
o   Asymmetry
o   Stability
o   Can beta methodology be effectively applied to credit?
o   Managing basis risks
o   Choosing a benchmark index for the portfolio

·           Working with highly nonlinear portfolios
o   Developing practical portfolio scenarios,  including historical simulations
o   Practical uses of portfolio option greeks.
o   Tracking portfolio duration under various conditions :
§  prepayment speeds,
§  spread shocks,
§  yield curve slope, etc.

·           Measuring “tail risks”
o   Conditional (“tail”) value-at-risk
o   Spectral risk measures (overweighing certain adverse outcomes)
o   Managing macroeconomic stress tests – what’s considered “extreme but realistic”?

·          Exploring hedging techniques
o   Treasuries or currencies as macro hedges
o   Credit CDS indices (CDX) and credit swaptions
o   Equity options, binary options,  and other overpriced products etc.
o   Other

 Assessing and managing liquidity risk
o   Stress testing margin requirements and leverage sustainability
o   Assessing investor redemption risks
o   Determining liquidation periods for portfolio components
o   Assessing cash balance requirements

Tracking countrparty risk
o   Measuring the health of swap counterparties and prime brokers
o   Cash and fully-paid-for securities segregation and monitoring

Note: risk adjusted performance measures and performance attribution will be discussed at a later stage.

We would like to hear from Sober Look readers. What's missing? What should be expanded?
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