Theory and Practice of Risk
Management in Hedge Funds
Barry Schachter
Overview & Summary
What goes
on in hedge funds
Landscape of risks
Risk Measurement
Risk Management
2005.12.05
Copyright 2005 Barry Schachter
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Tradewinds International

Charles L. Harris
Raised from 30 investors $10MM between 1995/2001 and 2004
Made false statements (K-1) about NAV ($30MM vs $1.1MM in 2003)
Used investor funds ($2.4MM) for
 Personal expenses
 To repay investors at inflated NAVs
Losses: Commodity futures/options 2003-2004
SEC/CFTC civil actions 2004/09/02
DoJ criminal suit 2004/09/09
Sentenced to 168 months/$13.9MM 2005/10/06
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Pirate? 1723/07/19
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2005.12.05
Copyright 2005 Barry Schachter
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Operational Risk
Defn: Loss from
failure of ordinary business
processes (getting business done)
Causes: poor process, poor training, poor
alignment of incentives, serendipity
2005.12.05
Copyright 2005 Barry Schachter
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Op Risk Remedies
 Internal
Solutions
 Prudent
actions
 Investor-Manager contract
 Industry Guidance (CRMPGII, IAFE Op Risk)
 External
Solution – Regulation
 Prime
Directive – ‘Break glass’ only if internal solution isn’t
socially optimal and incremental costs do not exceed benefits
 Perception that HFs are ‘lightly regulated’
 Relative
to what?
 Light is equated with poor in perception
2005.12.05
Copyright 2005 Barry Schachter
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US HF Regulation Overview
 SEC
 Registration
required (Feb 2006) (2Yr lock-up exception) Form
ADV
 Fraud/Fiduciary
 Reg. Filings – Form 13D
 Indirect – Prudential Supervision of PB (‘CSE’)
 CFTC
 Registration
required (CTA/CPO)
 Fraud/Fiduciary
 Reg. Filings - Speculative position limits
2005.12.05
Copyright 2005 Barry Schachter
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HF Risk Management – Big
Picture
Op Risk
is not the first concern
Market
Risk
Credit Risk
Liquidity, Concentration, Reputation
No
regulation demands
No standard risk management model
Limited independence
2005.12.05
Copyright 2005 Barry Schachter
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Brief Aside on Risk Measurement
Quantification Helps
Some
Risk Control
Measures
Value
at Risk (VaR)
Stress Testing
Sensitivities (e.g., bpv, options)
Notionals (e.g., GMV, NMV)
P/L volatility
Drawdown
2005.12.05
Copyright 2005 Barry Schachter
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Market Risk
The risk
of monetary loss arising from an adverse
move in market prices or rates (includes traded
credit risk)
2005.12.05
Copyright 2005 Barry Schachter
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Market Risk Management – On
the Desk
Trading limits
Risk-based
(VaR, Stress)
Nominal (Gross/Net positions, Concentration,
Liquidity
P/L related (portfolio stop and drawdown)
Dialogue
2005.12.05
– more important than limits
Copyright 2005 Barry Schachter
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On the Desk (cont’d) - Dialogue
 Asking
Good Questions
 Is
that really correlated?
 Does that data change your thesis?
 Is it in the price already?
 Reducing Trader
Errors
 Drunk
with success
 Doubling down
 Fear of failure
 Deer in the headlights (stops)
 Options trading problems
2005.12.05
Copyright 2005 Barry Schachter
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On the Desk (cont’d) – Options
Trading Mistakes
 The
short vol game (Caxton ED)
 Implied leverage near expiry (BAM biotech)
 Exercise to exit (SAC healthcare)
 The lottery ticket
 Buy
OTM near expiry (BAM equity)
 Ignore MV vs Intrinsic (Caxton EUR)
 Fair
value vs. Quote (Caxton exotic)
 Buy/Write to protect profit (BAM retail)
2005.12.05
Copyright 2005 Barry Schachter
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Getting Inside a Trader’s Head
Entry (timing, catalyst, technicals)
Sizing (look
for confirmation, scaling in)
Position management
Exit (stops vs. price targets)
2005.12.05
Copyright 2005 Barry Schachter
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What Worries Me - Traders
 Hubris
 “I
have never lost money before”
 “There are a million reasons for this to work”
 Style
drift
 Market
view takes over (becoming a macro trader)
 Losers become long-term trade ideas
 Focus
 “I
will just allocate 1% of capital”
 “I don’t want to hedge the FX exposure”
 Wanting the last quarter point of a trade
 “Another PM got me into it”
2005.12.05
Copyright 2005 Barry Schachter
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Portfolio Risk Management
 Measurement
Problems are Everywhere
 Flat
at the close
 Arbitrage/convergence (OTR vs off-the-run; liquidity bet)
 Merger arbitrage
 Liquidity risk for “chunky” positions
 Collateral-at-risk
 Valuation
Problems
 Operational Risks
2005.12.05
Copyright 2005 Barry Schachter
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Operational Risk Example –
Bayou (2005)
Raised
$400MM, ‘lost’ $300MM
High risk trades to try to make up losses
CFO owned ‘independent’ auditor
Affiliated broker made $50MM commissions from
Bayou
Misreported NAVs, commission exp.
Principal, Samuel Israel III, lied about background
in marketing
2005.12.05
Copyright 2005 Barry Schachter
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Operational Risk Example – Wood
River (2005)
No
auditor/audits (contrary to marketing
materials)
PPM stated max position 10% capital
Placed 65% of capital in one small cap (not
disclosed to investors)
2005.12.05
Copyright 2005 Barry Schachter
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Operational Risk Example –
Lipper Convertibles (2002)
Convertible arb
fund
Assets plunged 40%, not up “a few” percent
Revised managers’ valuations after they left
Delta hedges not adequate
2005.12.05
Copyright 2005 Barry Schachter
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Operational Risk Example
Phoenix Research and Trading
$125MM
losses – January 2002
Trading US Treasuries
2005.12.05
Copyright 2005 Barry Schachter
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Operational Risk Example (Sellside Lessons)
Allfirst Financial
– John Rusnak
$690MM
losses – February 2002
Trading major currencies
National Australia Bank
Almost
2005.12.05
– Jan ‘04
identical story
Copyright 2005 Barry Schachter
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Fundamentals of (Independent) Risk
Management
Be
proactive not reactive
Create risk management culture
Align interests (the “free put”)
Have independence and authority
Establish credibility and trust
2005.12.05
Copyright 2005 Barry Schachter
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Fundamentals of (Independent) Risk
Management cont’d
Understand range
Hidden
Know
and magnitude of risks
risks (e.g. equity factors)
what you don’t know
Vol
swap
Economic derivatives
Communicate issues clearly
How
to say “no”
Speaking the language
2005.12.05
Copyright 2005 Barry Schachter
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What Worries Me - Options
Unmeasured
risks (pin, knockout, corr.)
No marks (price/vol)
Dealer/trader supplied marks
Liquidity
2005.12.05
Copyright 2005 Barry Schachter
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What Worries Me - Liquidity
Volume
Firm
position
Market players
Short interest
Technical stops and the rush to exit
When the market stops trading
2005.12.05
Copyright 2005 Barry Schachter
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Managing Up
Communication
Keep
message simple
Be clear (accuracy less important)
Overview
Monitor
risk appetite
Evaluate performance
2005.12.05
Copyright 2005 Barry Schachter
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Managing Out - Investor Risk
Disclosures
Requirements/Practice
Issues with
disclosure
Disclosure
dissipates private information
Only position level disclosure makes aggregation
possible
“Snapshots” of risk are misleading
Fund risks have option characteristics
2005.12.05
Copyright 2005 Barry Schachter
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Conclusion
Successful risk management is
in the details
Subjective component of risk management looms
large
The only constant is change
2005.12.05
Copyright 2005 Barry Schachter
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