Introduction

The President's Working Group (“PWG”) report on financial markets was produced in 1999 in response to the collapse of the Long Term Capital Markets hedge fund. The PWG report called for a group of hedge funds to draft and publish sound practices for their risk management and internal controls.

In response to this call, a group of five hedge funds including Soros Fund Management LLC published the 'Sound practices for hedge fund managers' report in February 2000. In this article we examine the risk management measures proposed in the sound practices document and look at how a fund might make full use of advanced software to achieve their risk management objectives.

Risk inter-relationships

Classically, risk has been defined in terms of market risk, credit risk, liquidity risk and less quantifiably, operational risk. Market risk relates to the losses that could be incurred due to changes in market factors (ie, prices, volatility and correlations). Credit risk relates to losses that could be incurred due to declines in the creditworthiness of entities that the fund invests or with which that fund deals as a counterparty. Liquidity risk relates to losses that could be incurred when declines in liquidity in the market reduce the value of investments or reduce the ability of the fund to fund its investments. Operational risk is the risk of process or system failure — be it malicious (eg, fraud) or accidental (eg, data loss). While much has been written about the integration of market and credit risk, current market practice is still to treat these risks separately. The report emphasises that it is crucial for hedge fund managers to recognise the overlap that exists between and among market, credit and liquidity risk.

The report argues that the risk management function should monitor, in combination, the three interrelated risks of market, liquidity and credit, with specific attention to

• Market risk, including asset liquidity and credit risk associated with investment
• Funding liquidity risk
• Counterparty credit risk

Market risk

Hedge fund managers are urged to evaluate market risk, not just for each hedge fund in aggregate, but also for the components of the portfolio where relevant. For example, this might be by strategy, asset class, type of instrument used, geographic region or industry sector, as appropriate. It should also be possible to identify the market risk assumed by each fund manager. The report argues that hedge fund managers should employ the value at risk (VAR) model or other consistent framework for measuring the risk of loss for a portfolio, and its components. The normal factors that are incorporated into a market risk model include

• Level and shape of the interest rate term structure in relevant currencies
• Foreign exchange rates
• Equity prices and/or equity indices
• Commodity prices
• Credit spreads
• Nonlinearities
• Volatilities
• Correlation

It is worth noting that not all funds are influenced by all of these factors. Clearly, a fund with a mandate to invest only in long short equity will not be overly concerned with Zinc prices, unless style drift is particularly strong!

The sound practices proposed suggest that hedge fund managers should consider incorporating additional measures to capture asset liquidity. That is to say, the change in the value of an asset due to changes in liquidity of the market in which the asset is traded. Suggested measures of asset liquidity that might be captured include

• the number of days that would be required to liquidate and/or neutralise the position in question
• the value that would be lost if the asset in question were to be liquidated and/or neutralised completely within the holding.

A common standard to adopt is to look at the first of these measures and rarely venture into positions that would take more than two days to liquidate.

The final, important observation made by the recommendations with regard to market risk, is that any positions managed externally to the fund should be incorporated into the routine risk measurement.

This object is not as readily achievable as might at first be assumed. With more and more funds adopting a multiple prime broker approach it is imperative that there is a single integrated software solution that can bring all the trades in a single repository. Furthermore, the value of a single point of trade capture and automated processing of the deal through its lifecycle should not be under estimated. Associating each and every trade with a particular account or strategy will make tracking performance and performing detailed risk management at the strategy level easier.

Many funds have a mandate to trade a broad range of instruments and so it is important for fund managers to find a trading system that would be able to cope with whatever instruments the fund decides to trade, either now or in the future.

Stress testing

The report states that hedge fund managers should perform stress tests in order to determine how potential changes in market conditions could impact the market risk of their portfolio. It goes on to explain which market parameters it might be appropriate to stress for linear and non-linear instruments.

For linear instruments it is typical to stress market parameters such as

• Prices
• The shape of term structures
• The correlation between prices

For portfolios containing non-linear instruments, the report suggests stressing

• Volatilities
• Nonlinearities (also referred to as convexity or gamma)

Scenario analysis is also proposed to benchmark the risk of the fund's current portfolio against various scenarios that the fund may have to weather. These could include the 1987 stock market crash, the Asian financial crisis of 1998, the Russian crisis or particular events relevant to the fund in question.

This is particularly interesting where a fund manager uses derivatives as part of his strategy. Due to the derivatives in the portfolio the risk measures tend to be expressed in terms of the underlying of the derivative. By expressing risk measures such as the delta of the portfolio in terms of the index, sweeping what–if questions can be asked. These typically include analysise such as “tell me my delta risk if the index moves down one percent and what the impact of that on the P&L would be”. Indeed, these questions are asked at least once a day of most funds as a whole and at a strategy and security level.

Managing the fund's risk at a more sophisticated level could be achieved by examining the sensitivity of the portfolio to the interaction of several of these market risk factors by tweaking the values in concert. For example, one might look at moving the equity prices from down 20 percent to up 20 percent in steps of five percent, while at the same time moving the volatility up and down a few percentage points.

The risk management infrastructure that facilitates all this in several hedge funds around the globe are tools built in Excel and VBA. Once a sheet has been created to handle a specific instrument, such as a certain convertible bond, the following is brought together

• instrument definition
• The required market data
• The pricing model required to price the instrument.

The report also stresses the usefulness of back testing for validating any market risk models that are used and most fund managers would agree (at least privately) that back testing results has been a useful technique for them in fine tuning, or completely reassessing the validity of their analysis.

Funding liquidity risk

Funding liquidity is identified by the report as being critical to the hedge fund manager's ability to continue trading during stress. Adequate funding liquidity gives a hedge fund manager the ability to continue the trading strategy without being forced to liquidate assets or close out positions when losses arise.

The report advises that cash ought to be actively managed. Fund managers should know where cash is deployed in the fund. Cash management should be centralised and managers should consider the costs and benefits of leaving excess cash in trading accounts.

Ongoing levels of liquidity should be measured and assessed relative to the size in riskiness of the fund. Possible liquidity measures include

• cash/equity
• VAR/(cash plus borrowing capacity)
• worst historical drawdown/(cash plus borrowing capacity)

Of these suggestions, fund managers will keep track of the liquidity risk by examining the gross fund/equity and net fund/equity. Not surprisingly, the historical drawdown is also looked at closely for the fund and this kind of data is quickly available by use of the high-performance database technology for time-series data.

Counterparty credit risk

Hedge fund managers should establish policies and procedures to track and manage the fund's exposure to concentrations of credit risk with particular counterparties according to the report. It may also be appropriate to be aware of concentrations of credit risk in a particular economic or geographic region. Management of credit risk includes identifying counterparties as acceptable based on analysis of their creditworthiness and continuous monitoring of their creditworthiness.

Assessment of exposure to a particular counterparty should include analysis of

• Current replacement cost
• Potential exposure
• The probability of loss
• Risk mitigation and documentation

Current replacement cost is the amount the fund would lose if the counterparty were to become insolvent immediately and the fund manager had to go to the market to replace the contract.

Potential exposure is a probabilistic assessment of the additional exposure that could result if the counterparty defaults, not immediately, but at some time in the future. This is particularly applicable to derivatives, where exposure is reciprocal and likely to change substantially before the contract expires.

Probability of loss is the likelihood of a counterparty defaulting over a given time horizon. Factors including the counterparty's current credit quality, the time to expiry of the contract and even the nature of the contract determine the probability of loss.

Mitigation of credit risk can be achieved to some extent by use of collateral provisions, bi-lateral netting agreements and/or credit enhancement. A documentation management process is encouraged that should expedite the timely and consistent application of documentation of the appropriate provisions.

As the prime broker guarantees settlement for a fund's transactions, much of the credit risk described in the report is more from a seller's perspective. However, this should not preclude the astute fund manager from monitoring concentrations of trades by counterparty and brokers. For example, it could be appropriate to perform portfolio analysis by broker and by geographic location (such as Singapore) depending on the particular concentrations that the fund was facing at a particular time.

Leverage

Leverage measures can generally be classified as either

• Accounting based
• Risk based

Accounting based measures compare the nominal sizes of the fund's balance sheet to equity. Risk-based measures assess the relationship between the riskiness of a fund's portfolio and its capacity to absorb the impact of that risk.

Leverage is identified by the report as an important factor for hedge funds due to the influence it has on the rapidity with which changes in market, credit and liquidity risk change the value of the fund.

Accounting based measures are

• Gross balance sheet assets to equity
• Net balance sheet assets to equity
• Gross accounting leverage
• Net accounting leverage

Risk based measures are

• (Volatility in value of portfolio)/Equity
• VAR/Equity
• (Scenario derived market risk measure)/Equity

Many funds maintain leverage at a level of no more than a given multiple of the equity in fund and use a variety of accounting and risk based measures to keep track of leverage.

Conclusion

The 'Sound practices for hedge fund managers' report published by a group of hedge funds in response to the President's Working Group, presents many challenges to risk managers in hedge funds. Market risk, credit risk, funding liquidity and leverage are identified as presenting a distinct, and potentially toxic, cocktail of challenges for risk managers in hedge funds. These risk managers are often are not afforded the budget or IT resources available to their investment bank counterparts. This can also be compounded by the fund's ability to trade a diverse range of asset classes. Equity fund may be mandated to trade not just Equities, but Futures, ADRs, ELNs, CBs, Options, Warrants, Exotics, Equity Swaps, etc. However, even for funds with such complex and diverse portfolios the risk management challenges set out in the report can be met by using software solutions.