Measuring Hedge Fund Risk Bernard Minsky, Margin Risk Manager Graham Jung, Prime Brokerage Sales

1. Measuring Hedge Fund Risk Bernard Minsky, Margin Risk ManagerGraham Jung, Prime Brokerage Sales 20 February 2003

2. Topics For Discussion • How are hedge funds different? • Common myths • Who are the interested parties? • The Prime Broker’s view of risk

3. Long only Benchmark awareness Diversified portfolios Performance measured over quarters and years Little or no leverage Derivative use not widespread Prop Desks Separate risk function Sophisticated ‘client base’ Long and short positions Absolute return focus Concentrated portfolios Performance measured over days, weeks and months Ability to use leverage Significant derivative use Limited risk resources Wide range of investors Traditional Funds Hedge Funds

4. ‘Hedge funds are highly leveraged vehicles’ ‘Hedge funds make extensive use of derivative products’ ‘Hedge fund assets are illiquid and prices are stale, smoothing the returns’ ‘Hedge fund managers are highly secretive’ The vast majority of funds, by number and assets, operate with minimal leverage, especially in the current environment. It depends on the strategy, many funds trade stock options and index futures at the most. Even strategies that use more derivatives tend to stick to listed, liquid instruments Again, it depends on the strategy, most funds have good liquidity and clean prices. It depends on the manager. Many new managers are prepared to disclose positions if they are assured of confidentiality. Common Myths

5. Who Are The Interested Parties? Regulators Prime Broker Investors Hedge Fund Manager Other Brokers HEDGE FUND Competitors Administrator / Custodian Press / Public opinion Suppliers SERVICES

6. The Hedge Fund Manager – Outsourcing the Risk Infrastructure Use the Prime Broker: • All serious Prime Brokers offer risk analysis tools • Most will be only work on assets held on the Prime Broker’s custody accounts Develop an in-house system: • Certainly possible for the less-complex strategies • Usually as part of an integrated analysis and position management system Adopt a vendor solution:: • The usual out-sourcing pros and cons • Large and complex systems can overwhelm a hedge fund’s resources • Pricing policy is crucial – these are small, fast growing businesses

7. Non Market Risk – A Matter Of Perspective From the Investor’s Point of View: • Poor performance • Operational risk • Fraud • Illiquidity • Style drift From the Manager’s Point of View: • Poor economics, either through poor performance or low asset size • Operational risk From the Prime Broker’s Point of View: • Counterparty risk • Fraud

8. Who Are the Interested Parties? Regulators Prime Broker Investors Hedge Fund Manager Brokers HEDGE FUND Competitors Administrator / Custodian Press / Public opinion Suppliers SERVICES

9. The Prime Broker’s View of Risk

10. Prime Broker As Finance Provider • The Prime Broker provides leverage • By lending the hedge fund cash to purchase securities; and • By lending the hedge fund securities to sell short • Converting Credit Risk to Market and Liquidity Risk • All Prime Brokers’ loans are collateralised - margin loans • Accept many types of collateral – cash, equities, bonds • Determining the margin • Too much and the hedge fund returns are too low • Too little and the Prime Broker takes credit risk • The Prime Broker only makes a loss • if the value of the collateral in liquidation is less than the loans advanced • not necessarily as soon the hedge fund makes losses

11. How Much Risk?

12. Margin Policy • Collateral and funding • Perfecting a security interest • Collateral is only as good as the security interest obtained • Depends on where the collateral is issued or clears • Depends on where the hedge fund is domiciled • Depends on the the contract law of the agreement • Title Transfer • Title transfer allows re-hypothecation and funding • May be against local regulations – segregation of assets • May be a taxable event – UK stamp duty • Charge over Assets • Avoids taxable events • Does not necessarily allow re-hypothecation

13. Margin Rate Setting • Discretionary or Regulated • US margin rules set in Reg T and NYSE rules • One size fits all • Not risk-based • UK margin rules are discretionary • Depends on collateral and trading portfolio • Can recognise the risk reducing effect of hedges • Can use risk models to determine collateral requirements – VaR, Stress Tests • Can be customised for specific funds, such as • Long/Short Equity • Convertible Arbitrage • Statistical Arbitrage • Risk Arbitrage

14. Monitoring The Risk

15. Risk Monitoring • What are the risks we really worry about? • Directionality • Exposure to market jump risk – crashes • Metric – Net Assets/Net Market Value • Concentration • History teaches us – never bet the house • Metrics – MV as % of Total MV, Margin as % of Total Margin • Liquidity • Mark-to-market assumes the position is liquid • Metrics – Position as # Days Trading, Bid/Offer Spread • Portfolio changes • Trading strategy, funding • Portfolio P&L

16. Risk Management Tools

17. Risk Management Tools • Operational Reports • Daily Margin Reports • Daily Collateral Call Summary • Risk Analytics • Directionality report – 30% stress • Liquidity report – weighted average liquidity greater than 1 day • Concentration report • One position market value greater than net assets • One position margin greater than 20% of total margin • Portfolio changes report • From trading • From market moves • From cash movements (redemptions, investments, etc)

18. Risk Management Tools • Risk Testing • Value at Risk • Linear Portfolios using Covariance Matrix • Backtesting against P&L attributed to market moves • Scenario Analysis • Non-linear portfolios such as Convertibles • Worst case loss across a small number of disaster scenarios • Portfolio statistics • Event Risk • Merger Risk stress • Bond maturity risk – weighted average time to maturity/next put

19. The Prime Broker’s Perspective

20. In Summary • Prime Broker Objective • To lend cash and securities against excess good collateral • To avoid exposure to credit and reputational risk • To manage resultant market and liquidity exposure • Risk Manager Responsibility • To set reasonable collateral requirements • To identify potential exposures before they become critical • To ensure risks are commensurate with returns • To protect our capital and our reputation • Prime Broker view vs Hedge Fund view • Prime Broker’s payoff is asymmetric – earn spreads, lose capital • Hedge Fund’s payoff depends on returns and overrides • Prime Broker allies to Hedge Fund goals, but does not adopt them

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