"And now for something completely different ..."
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 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.
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?