Lecture 4 Flashcards
List the major risks faced by hedge funds.
- Market Risk
- Currency Risk
- Geopolitical Risk
- Operational Risk (including Fraud and Internal Misconduct Risk)
- Technological and Organizational Risk
- Counterparty Risk
- Model Risk
- Concentration Risk
- Leverage Risk
- Liquidity Risk
- Inflation and Interest Rate Risk
- Credit Risk
- Redemption Risk
- Tail Risk
What is Market Risk in hedge funds?
- Definition: The potential for financial loss due to adverse price movements in the market.
- Example: A hedge fund investing heavily in tech stocks faces significant losses if the tech sector experiences a downturn.
What is Currency Risk in hedge funds?
- Definition: Risk due to fluctuations in currency exchange rates affecting foreign investments.
- Example: A hedge fund holding European equities might use Euro call options to hedge against a depreciation of the Euro.
What is Geopolitical Risk in hedge funds?
- Definition: Risks from political instability, regulatory changes, or sanctions affecting investments.
- Example: A hedge fund invested in emerging markets might face losses due to political unrest.
What is Operational Risk in hedge funds?
- Definition: Risks arising from internal processes, people, or systems, including fraud or poor governance.
- Example: Insider trading scandals can damage a hedge fund’s reputation and lead to legal issues.
What is Technological and Organizational Risk in hedge funds?
- Definition: Risks from technology failures or weak organizational structures disrupting operations.
- Example: Cybersecurity breaches in algorithmic trading systems can lead to substantial losses.
What is Counterparty Risk in hedge funds?
- Definition: The risk of financial loss due to a counterparty defaulting on obligations.
- Example: If a counterparty in a swap agreement defaults, the hedge fund may suffer losses.
What is Model Risk in hedge funds?
- Definition: Risks from inaccurate financial models used for decision-making or valuations.
- Example: A quantitative model failing to predict sudden market shifts can lead to significant losses.
What is Concentration Risk in hedge funds?
- Definition: Risks from overexposure to a single investment or sector.
- Example: A hedge fund heavily invested in energy may face severe losses if oil prices collapse.
What is Leverage Risk in hedge funds?
- Definition: Risks from using borrowed capital to amplify investments, leading to magnified losses.
- Example: A fund doubling its investment with leverage can lose more than its initial investment in a downturn.
What is Liquidity Risk in hedge funds?
- Definition: Risks from an inability to quickly sell assets, potentially leading to financial distress.
- Example: A hedge fund holding illiquid assets struggles to raise cash during market downturns.
What is Inflation and Interest Rate Risk in hedge funds?
- Definition: Risks from changing economic conditions affecting fixed-income investments.
- Example: Rising interest rates can erode returns on bonds.
What is Credit Risk in hedge funds?
- Definition: Risks from a borrower’s failure to meet contractual obligations.
- Example: A hedge fund faces losses if a counterparty defaults on a loan or derivative agreement.
What is Redemption Risk in hedge funds?
- Definition: Risks from large-scale investor withdrawals forcing asset liquidation at unfavorable prices.
- Example: Sudden redemptions during market volatility can lead to steep losses.
What is Tail Risk in hedge funds?
- Definition: Risks from extreme market movements leading to substantial losses.
- Example: A “black swan” event, such as a financial crisis, can drastically affect hedge fund performance.
What is the correlation and implication between market risk and valuation risk in hedge funds?
- Correlation: High. Adverse market movements can lead to misvalued assets.
- Implication: Long-short strategies can hedge against market risk but require accurate valuation models. Incorrect valuations can lead to unprofitable long or short positions.
How do currency risk and geopolitical risk interact, and what is the implication for hedge funds?
- Correlation: Moderate. Currency fluctuations often correlate with geopolitical instability.
- Implication: In FX hedging strategies, geopolitical risk assessment becomes essential. Signal-driven strategies may need to incorporate geopolitical indicators into their models.
What is the correlation and implication between operational risk and reputational risk?
- Correlation: High. Operational failures can directly impact a fund’s reputation.
- Implication: Hedge funds must implement stringent operational controls to mitigate reputational damage.
How do concentration risk and leverage risk interact, and what is their implication for hedge funds?
- Correlation: High. High leverage often leads to concentration in specific investments, increasing significant losses.
- Implication: Hedge funds using high leverage should diversify their positions to mitigate concentration risk.
What is the correlation and implication between credit risk and counterparty risk?
- Correlation: High. Derivatives trading exposes funds to both credit and counterparty risks.
- Implication: Signal-driven strategies relying on derivatives must assess counterparties’ creditworthiness carefully.
How do liquidity risk and redemption risk correlate, and what is the implication?
- Correlation: High. Low liquidity can lead to redemption risk during market downturns, forcing asset sales at unfavorable prices.
- Implication: Hedge funds need sufficient liquidity reserves to meet redemption demands during high volatility.
What is the correlation and implication of behavioral risk on market risk?
- Correlation: Moderate. Behavioral biases may lead to market inefficiencies, affecting market risk.
- Implication: Hedge funds using signal-driven strategies must account for behavioral biases that could distort their models.
How do cybersecurity risk and operational risk correlate, and what is the implication?
- Correlation: High. Cyber breaches can disrupt operations, leading to operational risk.
- Implication: Hedge funds must implement robust cybersecurity measures to protect data and ensure operational continuity.
What is the correlation and implication between inflation, interest rate risk, and reinvestment risk?
- Correlation: Moderate. Rising inflation affects interest rates, influencing reinvestment opportunities.
- Implication: Hedge funds must consider macroeconomic indicators when making reinvestment decisions.
What was LTCM?
Long-Term Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether, employing Nobel Prize-winning economists and advanced quantitative models for fixed-income arbitrage and convergence trades.
What led to LTCM’s collapse in the late 1990s?
Key factors:
- Excessive leverage amplifying returns and risks.
- Russian financial crisis in August 1998 causing bond price declines and market volatility.
- Models failed to anticipate extreme market conditions.
- Liquidity crisis as positions became illiquid.
- Counterparty risk due to diminished support from trading partners.
What was the financial impact of LTCM’s collapse?
LTCM accumulated $4.6 billion in losses and required a $3.6 billion bailout orchestrated by the Federal Reserve to prevent a broader financial crisis.
What risk management failures contributed to LTCM’s downfall?
- Overreliance on models assuming normal market conditions.
- Lack of stress testing for sudden shocks.
- Excessive leverage amplifying risks.
- Poor liquidity management during market downturns.
What lessons can hedge funds learn from LTCM?
What lessons can hedge funds learn from LTCM?
Back: Hedge funds must implement comprehensive risk assessments, perform rigorous stress testing, and adopt prudent leverage practices to avoid catastrophic losses.
What is Bridgewater Associates known for?
Known for its “Pure Alpha” strategy employing global macro approaches and quantitative analysis to manage risks across equities, fixed income, commodities, and currencies.
What is the strategy of Alyeska Investment Group?
Employs a global long/short equity strategy with macro overlays, utilizing quantitative methods to identify mispriced stocks globally.
What makes Man Group’s AHL strategy unique?
Focuses on systematic trading, combining equities, futures, and FX instruments with algorithms to manage risks and capture market trends.
How do the performances of Bridgewater, Alyeska, and Man Group compare?
- Bridgewater: 5-year return of 8-10%, mixed trends.
- Alyeska: 5-year return of 7-9%, steady performance.
- Man Group: 5-year return of 10-12%, strong in volatile markets.
What is the primary strategy of Quantum Hedge Fund?
Quantum Hedge Fund employs a global quantum strategy that uses quantitative models to invest in diversified portfolios of global equities, fixed income, and derivatives, including FX overlays to manage currency risks.
What is the Quantum Hedge Fund’s Asset Under Management (AUM) and investment focus?
AUM: $3 billion.
Investment Focus:
- 60% in global equities.
- 30% in fixed income.
- 10% in derivatives.
Which geographic and currency exposures are associated with Quantum Hedge Fund?
- Geographic Exposure: Investments spread across North America, Europe, and Asia.
- Currency Exposure: Significant holdings in Euros, British Pounds, and Japanese Yen.
What challenges has Quantum Hedge Fund faced recently?
- Decline in Euro value due to geopolitical tensions in Europe.
- Increased global equity market volatility, leading to tech and financial sector losses.
- Unexpected U.S. interest rate rise impacting bond valuations.
What is the primary objective of the case study on Quantum Hedge Fund?
Students analyze the risks faced by Quantum Hedge Fund and develop a risk matrix based on identified risks.
What are the highest-rated risks in Quantum Hedge Fund’s risk matrix?
- Market Risk (Likelihood 4, Impact 5, Risk Rating 20).
- Currency Risk (Likelihood 4, Impact 4, Risk Rating 16).
List a few key risk mitigation strategies for Quantum Hedge Fund.
- Diversification.
- Dynamic FX Hedging.
- Liquidity Management.
- Model Validation and Stress Testing.
- Counterparty Risk Assessment.
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