CAIA L2 - 5.1 - Cases in Tail Risk Flashcards
Identify
Reasons why
Amaranth Advisors, LLC
collapsed (2006)
5.1 - Cases in Tail Risk
- Multistrategy hedge fund
- Main strategy = Calendar spread strategy on natural gas prices (long winter futures / short nonwinter futures
Lessons learned:
- Prime brokers can have a significant impact on the viability of a hedge fund.
- Multistrategy funds should be diversified, and investors should confront managers if style drift becomes severe.
- Fund managers should carefully monitor all of the fund’s traders, regardless of the size of their profits or past track record.
- Large risk of unregulated arenas (like the ones Amaranth operated in).
- Proper risk management is crucial. Stop-loss or concentration limits may help protect against extreme events.
- Small futures markets for some commodities - enough that one fund can consume most contracts.
5.1 - Cases in Tail Risk
Identify
Reasons why
Long-Term Capital Management (LTCM)
collapsed (1998)
5.1 - Cases in Tail Risk
- Hedge fund
- Main strategy = fixed-income arbitrage + large amounts of leverage
- Trigger = Russian default
Lessons learned:
- Extreme leverage can turn a relatively low-risk strategy into a high-risk strategy.
- Market participants should be aware of the amount of leverage that counterparties have taken on.
- During extreme market events, liquidity will dry up, and creditors will be reluctant to extend further credit.
5.1 - Cases in Tail Risk
Identify
Reasons why
Carlyle Capital Corporation (CCC)
collapsed (2008)
5.1 - Cases in Tail Risk
- Exchange-listed Hedge fund
- Main strategy = borrowed huge amounts of capital at short-term rates and purchased long-term AAA-rated mortgage bonds (Fannie Mae/Freddie Mac) + leverage of about 99 times
- Trigger = US mortgage crisis
Lessons learned:
- Mortgage securities are not free from the risks of credit and liquidity crises - even backed by the faith of the U.S. government (either implicitly or explicitly) .
- Hedge funds cannot rely on creditors to modify terms or prime brokers to extend liquidity during periods of distress.
- High levels of leverage, even if used with low-risk securities, can still have disastrous consequences.
5.1 - Cases in Tail Risk
Formula
provide the formula for ROE
f(ROA, L, r)
Understand the relationship between declining investment opportunities and leverage
5.1 - Cases in Tail Risk
ROE = (ROA × L) – [r × (L – 1)]
L= A/E (Leverage)
ROE = return on equity
ROA = return on assets
L = leverage
r= interest rate paid on leverage
When investment returns begin to shrink due to strategy degradation (lower ROA) => naive fund managers will maintain ROE by using more leverage
5.1 - Cases in Tail Risk
Describe
Link between
behavioral biases
and
risk taking
5.1 - Cases in Tail Risk
- Confirmation bias refers to instances where individuals more heavily weigh information that agrees with their beliefs, while discounting information that disagrees with their beliefs. Opportunities may be seen as falsely profitable even if they are identified in error.
- Anchoring refers to the fact that individuals seem to be too anchored to a value or belief. Anchoring can cause fund managers to be overly confident that markets or strategies that have earned them profits in the past will continue to earn profits in the future. Of course, these managers may be failing to account for the fact that the investment environment has likely changed.
5.1 - Cases in Tail Risk
Describe
unwind hypothesis and
crowded trades
explain the Quant Meltdown of August 2007
5.1 - Cases in Tail Risk
crowded trade - similar strategies leading to similar positions
unwind hypothesis - losses lead to stop losses, causing prices to move further, leading to a trigger of other funds stop losses
Both explains the Quant Meltdown of August 2007, as U.S. subprime mortgage crisis began to take hold in early-to-mid 2007, many quantitative long/short (market-neutral) equity hedge funds began to experience significant losses
5.1 - Cases in Tail Risk
Describe
Flash Crash
of May 6, 2010
and relationship with circuit breakers
5.1 - Cases in Tail Risk
2010 US equity Markets -3%
=> then <-9% in 5 min
=> then -3% in other 20 min
Cause:
British trader - using spoofing algorithms (entering large orders with no expectation of executing the orders). Other traders joined to sell futures contracts and arbitrageurs began selling equities in the spot market pushing the spot market down.
circuit breakers = to mitigate this kind of sudden crash - act by restricting trading in the event of significant market fluctuation under the premise that the pause will allow market participants time to gather information and make informed trading decisions.
5.1 - Cases in Tail Risk
Describe
Defective piece of software of
Knight Capital Group
(August 1, 2012)
5.1 - Cases in Tail Risk
trading systems entered millions of erroneous orders
Losses had totaled $460 million. small trading error is magnified by the speed of transactions.
5.1.2 - Cases in Tail Risk
Identify
Reasons why
Bayou Management
failed (fraud - 2008)
5.1 - Cases in Tail Risk
- Hedge fund
- Samuel Israel III and Daniel Marino
- Fraud = fabricating its financial statements to hide its losses and high volatility + broker creation + fired their independent auditors + created own audit (Richmond-Fairfield Associates) + transferred assets to Israel
- Trigger = US mortgage crisis
Lessons learned:
- Investors should conduct background checks on the principals of a fund.
- Investors should demand hedge funds use a well-known, independent auditor.
- Investors should realize that regulations are not a suitable substitute for due diligence.
5.1.3 - Cases in Tail Risk
Identify
Reasons why
Bernie Madoff (Ponzi Scheme)
failed (fraud - 2008)
5.1 - Cases in Tail Risk
- Hedge fund
- Bernie Madoff
- Fraud = claimed to have used an option collar to generate returns; Markopolos approached SEC several times; cost $ 50b
- Trigger = Son turned him
Lessons learned:
- Investors should be aware of affinity fraud - fraud that relies on the similarities between the person in charge of the fraud and the target of the fraud. Bernie Madoff relied on his religious and ethnic bonds to potential investors. These common bonds often cause potential investors to be less diligent than they ordinarily would be.
- Proper due diligence may have uncovered early warning signs. Madoff’s firm administered, executed, and cleared trades in house, and the investment return profile was inconsistent with the stated investment strategy.
- When investors unknowingly profit from a fraud, such as a Ponzi scheme, they can be legally obligated to return any fund distributions (i.e., pay restitution).
5.1 - Cases in Tail Risk
Identify
Reasons why
Lancer Group
failed (fraud)
5.1 - Cases in Tail Risk
- Equity-based Hedge fund
- Michael Lauer
- Traded private and public small-cap equity securities (AUM 1.2b to $70m)
- Fraud = ?
- Trigger = ?
Lessons learned:
- Funds with no transparency can be dangerous. Lancer’s portfolio was illiquid. Lauer chose to keep all positions held by the fund private to prevent other traders from taking advantage of this information and harming the hedge fund. The lack of transparency prevented investors from examining the risks of their investment and from hedging these risks. I
- Be suspicious of internal valuations. Lauer performed these valuations himself. This lack of objective appraisal is a clear conflict of interest, as the higher the value Lauer attached to the securities, the higher the fees Lauer earned.
- Beware of window dressing. While window dressing can be legal when done correctly, Lancer’s attempts at window dressing were illegal. Window dressing involves portfolio transactions or valuations made just before the end of a reporting period to improve the valuation and/or appearance of a portfolio. Lauer allegedly engaged in painting the tape, which involves manipulating the market prices of securities in the portfolio to record low or high prices on the public transaction record. This illegal practice is often performed just before the close of the reporting period so that the portfolio is valued higher.
- Ensure adequate audit and regulatory safeguards. The audits failed to clearly identify the conflict of interest issues associated with some of Lancer’s investment valuations. In addition, Lancer violated the SEC’s regulation requirements by not filing Form 13D for 15 holdings in which it held a 5% or greater ownership stake. If these reports had been filed and thoroughly examined (or if investors had been informed of these violations), Lancer’s investors may have had a better understanding of its risks.
5.1 - Cases in Tail Risk
Describe the XIV and key takeaways from XIV collapse
LO 5.1.1
XIV is a volatility derivative traded as an exchange-traded note. A long position benefits from anticipated steady or decreasing S&P 500 volatility.
Long positions have short volatility exposure (expect volatility exposure to decline).
Short positions have long volatility exposure (expect volatility to increase)
2016 - large spike of anticipated volatility causing XIV to decline. Led to unwinding of short futures positins, flooding the market with buy orders with relatively low available liquidity. Demand drove prices higher causing more declines in XIV and XIV was finished shortly thereafter
Takeaways:
Volatility products are capable of generating futures transactions that could overwhelm the liquidity of futures markets and lead to their own demise.
These products are complex and must be thoroughly understood by the investment community.
A history of large profits leads to significant risk when the market becomes heavily crowded.
XIV was considered an insurance-writing strategy, and these carry negative skewness.
List the key lessons from the Theranos Fraud
LO 5.1.3
Investors should have more experience with the underlying business to which they are investing. Most of Theranos’s directors and investors had little experience in blood testing and medical equipment development.
Corporate partners, investors, and directors did not require product demonstrations, even as the primary product did not deliver on its claimed capabilities.
Fraud detection in public firms is enhanced through regulatory oversight and short selling. Theranos was a private firm, and its stock could not be sold short; thus, there was no financial incentive to perform or publish research to help identify any fraud.
Tail risk of venture capital investments is significant, and due diligence is needed from specialists with experience in the underlying technology.
