Mila Getmansky Albany-MIT Fifth SD Colloquium October 4, 2002

1. Causes of Hedge Funds Collapses And Contagion To Other Financial Institutions: A System Dynamics Approach Mila Getmansky Albany-MIT Fifth SD Colloquium October 4, 2002

2. OBJECTIVE • Understand the conditions under which a hedge fund can fail • Determine when the collapse of a hedge fund can trigger a contagion effect that leads to the failure of another institution (bank)

3. HEDGE FUNDS – AN OVERVIEW • What are hedge funds? • Unregulated investment partnerships available to wealthy individuals and institutions (“sophisticated accredited investors”) • Seek above-average returns using aggressive, high-risk strategies unavailable to mutual funds and other traditional money managers

4. MORE ON HEDGE FUNDS • Investing strategies include, but are not limited, to: • Short selling • Leverage • Arbitrage • Derivatives • Compensation structure is as follows: • Percentage of assets under management (usually 1%) • Percentage of profits (usually 20%)

5. WHY ARE HEDGE FUNDS INTERESTING? • Due to their unregulated nature, hedge funds can take on huge positions, affect market dynamics and cause financial collapses: • LTCM in the 1997 Asian crisis and the 1998 Russian debt crisis ($3.6 billion bailout plan to rescue the fund) • Soros in the 1992 ERM crisis (funded a $10 billion short position in sterling, using collateral and margins) • Understanding the role of hedge funds in the global financial markets might help prevent future crises

6. SD VERSUS TRADITIONAL APPROACH • Not an equilibrium model (unless at steady-state); Focus is Dynamics • Objective: understand dynamics of underlying structure of a system such as hedge fund, contagion, etc.; model the impact of different scenarios and decisions versus finding an optimal point estimate

7. FUNCTIONAL DIAGRAM OF A HEDGE FUND

8. GENERAL ACCOUNTING FRAMEWORK

9. FLOWS: BANK LENDS TO A HEDGE FUND • Bank lends money to a hedge fund. It earns interest. • Hedge fund borrows money from a bank. It has to pay interest.

10. FLOWS: BANKS INVESTS IN A HEDGE FUND • Bank invests in a hedge fund. It earns return on investment. • Hedge fund receives cash invested by a bank, and usually invests right away.

11. REASONS FOR A HEDGE FUND FAILURE • Poor investment decisions • General market conditions are weak • Investors exiting • Banks or other lending institutions decide not to lend (make new deposits), especially in crises times when liquidity is very much needed • Presence of a rogue trader • Excess of leverage • Loss of Reputation • Broker – trader relationships

12. COST AND RISK OF LEVERAGE

13. RETURN POTENTIAL

14. REPUTATION

15. ROGUE TRADER • Losses • Bets • Probability of a rogue trader • Skill • Internal supervision

16. BEHAVIOR OF A ROGUE TRADER

17. BEHAVIOR OF A ROGUE TRADER

18. AGGRESSIVENESS OF A ROGUE TRADER

19. Not Rogue Trader Rogue Trader Probability of Staying a Rogue Trader Probability of Not Becoming a Rogue Trader ALTERNATIVE APPROACH

20. ROGUE TRADER MODEL

21. APPETITE TO HIDE LOSSES

22. PERCEIVED INTERNAL REPUTATION Test1: R=10%+RAMP(-0.5%,5) Test2: R=10%+STEP(-20%,5)+STEP(60%,50) Test3: R=10%+STEP(-30%,5)+STEP(80%,50)

23. SUPERVISION Test1: R=10%+RAMP(-0.5%,5) Test2: R=10%+STEP(-20%,5)+STEP(60%,50) Test3: R=10%+STEP(-30%,5)+STEP(80%,50)

24. TRADER AND BROKER INTERACTION

25. SUMMARY AND CONCLUSIONS • Dynamics Are Critical • Effects Are Highly Nonlinear • Implications for: • Credit • Liquidity • Volatility • Regulatory Environment