8. Risk Management & Portfolio Management Flashcards
Amaranth Advisors, LLC.
Muti-strategy fund started in 2000 by convertible arbitrage trader. In 2004, hired Brian Hunter, Canadian gas trader. Made directional bets, long winter futures contracts, short summer futures contracts.
Lessons Learned from Amaranth
- Prime Brokers have significant impact on viability of fund.
- Multistrategy funds should be diversified
- Regardless of profits, managers need to monitor
- Operated in largely unregulated areas
- Improper Risk Management led to significant leverage
- Funds positions were so significant that they were driving the market.
Peloton Partners Hedge Fund
Established in 2005, trading strategy- capital structure arbitrage through mortgage backed securities. Specifically, long AAA, short BBB, with significant leverage. In 2008, value of AAA bonds fell sharply, couldn’t make collateral calls, forced to liquidate.
Lessons Learned from Peloton
- Use of low risk securities does not guarantee a low risk strategy.
- During extreme events, creditors reluctant to extend credit.
- Leverage magnifies losses
Carlyle Capital Corporation Hedge Fund
Established 2007 by Carlyle Capital Corporation. Investment strategy: borrow capital at short term rate and purchase long term AAA- rated mortgage bonds.
Purchased from Freddie, Frannie with expectation of low risk due to government entities.
32X leverage
2008, AAA-bonds fell in value, funds collateral seized, fund became insolvent.
Lessons Learned from CCC
- Mortgage bonds backed by government, not free of risk.
- Periods of distress, can’t expect prime broker to modify terms.
- High leverage on any level of risk instrument can still be disastrous.
Marin Capital Hedge Fund
Established in 1999.
Strategy: convertible arbitrage, whereby took long position in convertible corporate bond, and short the stock of the same company.
Failed in 2005 due to downgrade of bonds for GM & F to below investment grade= signif losses on long side. Additionally, losses on short side when takeover bid for GM cause rise in prices of all auto stocks.
Voluntarily wound down due to losses from both side, and returned remaining capital.
Lessons Learned from Marin Capital
- History of success is no indicator of future profits.
ROE Calculation
ROE = (ROA x L) - [r x (L-1)]
r= interest rate paid on leverage
Behavioral Biases
Cognitive or emotional biases that cause people to act in an irrational manner.
Confirmation Bias
Individuals more heavily weigh information that agrees with their beliefs while discounting information that disagrees.
Anchoring
Individuals seems to be anchored to a value or belief as if it has a gravitational pull.
Bayou Hedge Fund
Started in 1996 as legitimate fund. Quickly had losses, and fabricated statements to cover up. Then established broker to rebate commissions. Finally, created accounting firm by name Richard- Fairfield Associates.
2003- liquidated fund, and started 4 new ones.
2004- ceased all trading and transferred to Israel
2005- Arizona officials uncovered fraud in unrelated investigation, $100 mil recovered, fake suicide attempts.
Lessons Learned from Bayou
- Investors should conduct background checks
- Demand independent auditor
- Regulations are not a suitable substitute for due diligence.
Bernie Madoff Ponzi Scheme
Strategy: option collar
Promised 8-12% return with virtually no volatility.
Posted Performance: ave. annual returns of 11.2%, volatility of 2.5%, no down years, almost no down months.
Harry Markopolos: raised reg flag many times. Created simulated results of the strategy and gave to SEC in 2000 and 2001.
2005: again went to SEC, claimed Ponzi scheme
2006, 2007: again, SEC found nothing in invest
Dec. 2008- sons turn him in
Fraud estimated at $50 billion
Lessons Learned from Bernie Madoff
- Beware of affinity fraud
- Need for proper due diligence
- Beware of potential responsibilities in event of fraud, such as returning fund distributions
Option Collar Strategy
Alleged to be used by Bernie Madoff
- constructed by purchasing an equity position, selling a call, and buying a put with strike price less than that of the call.
- effectively puts a band around possible returns. downside limited by long put, upside limited by short call.
Affinity Fraud
Relies on similarities between the person in charge of the fraud and the target of the fraud.
Ex: Religious and Ethnic bonds to potential investors
Lancer Group
Equity based HF run by Michael Lauer
Investment strategy- use of both private and public small cap equity securities.
Lessons Learned from Lancer Group
- No transparency can be very dangerous
- Be suspicious of internal valuations
- Beware of window dressing
- Ensure adequate audit and regulatory safeguards
Window Dressing
Portfolio transactions or valuations made just before the end of a reporting period to improve the valuations and/or appearance of a portfolio.
Investment Strategy
A fund determines the objectives, methods, practices, and procedure that are used to create and alter the portfolio.
Actual Investment Strategy
Strategy implemented at a particular point in time
Permitted Investment Strategies
Define the range of actions a manager may take
Style Drift
Divergence from a funds stated investment style or objective. No temporary divergence, but change over time resulting from manager’s decisions.
Market Risk
Dispersion of economic outcomes that results from changes in market factors such as prices or interest rates.
More narrowly, it is systematic risk, the portion of the asset’s total risk that is attributed to changes in the value of the market portfolio.
***Cannot be diversified away
Investment Mandate
Provides a statement of the objectives and risks of the strategy as well as what investment actions are permitted within the confines of that stated strategy.
Risks of Actual Investment Strategy
- Hedges may be imperfect
- Leverage used to a greater degree than specified
- Implements strategy that is different from mandate
- Multiple managers may follow same strategy, causing herding
Operational Risk
Any deviation of the actual return from the expected return of the stated strategy resulting from operational failures with the fund.
Primary Sources of Operational Risk
- Operational Errors
- Agency Conflicts - employees act to benefit self
- Operational Fraud
Investment Process Risk
Stems from the difference between the proper implementation of a strategy to achieve fund goals and the actual implementation of the strategy.
Position Limits
Restrict the size of the holdings of a particular security or collection of securities.
***Position limits easy to enforce, risk limits are not.
Potential Issues to Valuation Procedure
- Obscure fund losses to avoid reporting poor performance
- Smooth returns so that volatility appears lower, and risk adjusted returns are appear higher
- Vary Risks
Aggregating of Risks
Total risk of fund activities: Investment, Operational, Business
Kundro and Feffer Study
- Operational risk contributed at least in part to 54% of hedge fund failure, of which:
41% fraud, 30% theft, 14% style drift, 6% inadequate resources. - Operational risk did not contribute to 38%, those funds had only market risk.
- Business and other risks contributed to final 8%
Synergistic Risk Effect
Between market risk and other risks. Combination or relationship of two or more may increase total risk of the fund beyond mandate.
Optimal Operational Risk Level
Not zero, because cost prohibitive.
Put-Call Parity & Riskless Hedges
put - call + stock = riskless bond
Long in a put, short in a call, and a long position in the underlying stock.
Assumptions: no dividends, options only exercised at expiration (Euro), expiration date and strike must be the same for the put and call
Risk Exposure Measurement_Delta
Measures the sensitivity of the option’s theoretical value to a change in the price of the underlying asset
Risk Exposure Measurement_Gamma
Measures the rate of change in the delta for each one point increase in the price of the underlying asset
Risk Exposure Measurement_Vega
Measures the sensitivity of the price of the option to changes in volatility
Options as Volatility Bets
Long Position - to place directional bets on underlying assets
Short Positions - when they perceive that volatility is mispriced
