Hedge Fund Risk Management

By Alan Laubsch, RiskMetrics Group

September 2009

Copyright 2009 by RiskMetrics Group. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission in writing from the publisher. Requests for permission to make copies of any part of this work should be sent to: RiskMetrics Group Marketing Department One Chase Manhattan Plaza, 44th Floor, New York, NY 10005 RiskMetrics Group is a trademark used herein under license.

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TABLE OF CONTENTS RISK MANAGEMENT CULTURE .............................................................................. 3 SEVEN ATTRIBUTES OF STRONG RISK MANAGEMENT .................................................. 4 THE RISK MANAGEMENT CYCLE ............................................................................ 5 MARKET RISK MEASUREMENT............................................................................... 5 MARKET EXPOSURES ......................................................................................... 6 SENSITIVITIES.................................................................................................. 6 VALUE-AT-RISK (VAR)........................................................................................ 6
Fat Tails................................................................................................................... 7 Outliers.................................................................................................................... 8 Responsiveness To Changing Market Conditions .................................................................... 8 Backtesting VaR.......................................................................................................... 8 Use of Correlations ...................................................................................................... 9

HOW TO CHOOSE AN APPROPRIATE VAR APPROACH .................................................. 9 HOW TO USE VAR............................................................................................ 11

Conditional VaR (CVaR)................................................................................................11 Monitoring Changes in Risk............................................................................................12

VAR LIMITS .................................................................................................... 12 STRESS TESTING ............................................................................................. 12 HISTORICAL SCENARIOS .................................................................................... 13 HYPOTHETICAL SCENARIOS................................................................................ 13 PORTFOLIO BASED REVERSE STRESS TESTS .........................................................13 CREDIT RISK................................................................................................... 14 LIQUIDITY RISK ............................................................................................... 16
Equities ..................................................................................................................16 Bonds .....................................................................................................................16

RISK REPORTING ............................................................................................. 17

Client Reporting ........................................................................................................18 Conclusions ..............................................................................................................18

Risk management is core to hedge funds. Since the beginning of the credit crisis in 2007, institutional investors have consistently ranked risk management as the single highest priority
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in making allocation decisions. The following is a brief overview of important hedge fund risk management practices.

RISK MANAGEMENT CULTURE

Risk management needs to start at the top. The funds leaders must encourage the development of a pervasive risk management culture across the organization, from front to back office. A common language for risk and regular communication are essential to developing a disciplined risk management culture.

Attributes of Strong Risk Management Culture Risk viewed as both danger and opportunity Enterprise & portfolio perspective, not just position level Continuously evolving process of seeking to identify, understand, monitor and manage risks throughout the organization Empowered risk management function Respect for different viewpoints and new ideas (and awareness of the dangers of Group Think) Regular discussions of risk between risk takers, risk management, senior management Tapping into network intelligence within and outside the organization Blend of art and science: subjective + objective

The organization of risk management responsibilities varies largely by size and type of fund. Large fund managers will typically have an independent risk management group, while risk management responsibilities may be given to the CFO, COO, or even portfolio managers at small funds. Ideally, a hedge fund would have an empowered risk management function, and to appoint risk managers with the appropriate expertise and experience to understand the types of risks relevant to the particular hedge fund strategy. Regular risk communication is core to risk management. Discussions should be organized at regular intervals (daily, weekly, monthly, quarterly) and meetings should be attended by the CEO, CFO, risk managers, portfolio managers, and traders. These meetings should include timely risk and P&L reports, and a commentary of the discussion should be included when reports are filed.

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Risk management is most effective when integrated into the investment process, as opposed being post-trade compliance. Some funds seat risk managers next to portfolio managers on the trading floor to encourage constant dialogue as trade ideas are shaped.

SEVEN ATTRIBUTES OF STRONG RISK MANAGEMENT

When Steve Thieke was asked by CEO Dennis Weatherstone to set up JPMorgans first independent enterprise risk management group in 1991, he formulated the following Seven Attributes of Strong Risk Management which still hold true today:

Effective policies and control - A risk culture must be developed within the institution, using a common language so that portfolio managers and risk managers and management can communicate effectively. Analytically rigorous measurement - Risks can be analyzed and all efforts should be made to develop a framework that can effectively quantify a funds appetite for risk taking. Diversification - taking multiple risks provides superior return on risk, and excessive concentration risks must be avoided. Transparency of risks - Risks that are not identified cannot be managed effectively. Risk transparency is important from a security level up to the diversified portfolio perspective. Timeliness and quality of information - Risk measurement needs high quality data on positions and on markets in a timely fashion to permit management to make informed decisions on potential changes in the risk profile of the fund.

This area is usually associated with the largest investments in terms of systems.

Disciplined judgment - Though the risk measurement process is governed by statistical processes, the risk management process cannot be dissociated from the use by managers of disciplined judgment. Independent oversight - While risk taking is the role of the funds portfolio managers, ideally an independent group reporting directly to Senior Management would provide independent risk monitoring and oversight.

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THE RISK MANAGEMENT CYCLE

Risk management is a continuous cycle of identifying, measuring, monitoring, and managing risk. A crucial step in the cycle to identify and understand hidden concentrations. This could include investment theme risk, common macro-economic factors, and other hidden linkages between multiple investments. This process should provide insight into strategic questions:

Where are the major risk exposures? Are portfolio managers taking risks that compound or offset each other? What are reasonable return targets given a level of risk? How should a funds capital be allocated to different risk taking businesses?

Major Risks Include

Market Risk: potential MTM losses due to price fluctuations. Credit Risk: potential loss due to counterparty or obligor default. Liquidity Risk: 2 perspectives: 1) the inability to liquidate thinly traded positions; 2) funding risk. Operational Risk: potential losses due to operational failures. Other major risks: Legal, Reputation, Regulatory.

In the next section we will focus on market and credit risk measurement, and briefly address liquidity risk.

MARKET RISK MEASUREMENT

A spectrum risk measures are available to help hedge funds better understand and quantify market risk, and to analyze risk concentrations. We will focus on the following four groups of risk measures below:

Market Exposures Exposure Sensitivities VaR and related measures Stress Tests
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MARKET EXPOSURES
When analyzing a portfolio, the natural starting point is to look at Market Exposures in multiple dimensions (e.g., Net Long / Short, Gross positions by country, industry, company, rating, instrument type, etc.). Credit and liquidity limits are generally set using notional exposures. However, exposures are not comprehensive measures as they give no indication of likely losses or portfolio effects. Exposures of different instruments are not comparable (for example, a $1mm exposure to an equity, government bond, and corporate bond represent very different risks), and more information is required to understand derivatives exposures.

SENSITIVITIES
Sensitivities help us understand how positions are affected by small movements in risk factors. Common sensitivity measures include Betas for equities and Duration & convexity for bonds. A full range of Greek sensitivities (Delta, Gamma, Vega, Theta, Rho) are used to better understand options exposures. As part of sensitivity analysis, its useful to apply a range of small to large shocks to a portfolio to and to see how sensitivities and P&Ls change. Derivatives traders, for example, use Top Sheets where Greeks and P&Ls are recalculated for a series of incremental up and down movements. Sensitivities only offer a partial perspective of risk, however. For options portfolios, Greeks can change dramatically with movements in the underlying. And Betas only measure statistical comovement with an index, and do not capture idiosyncratic risk. Durations can also be misleading, and can change dramatically with changes in interest rates (especially for ABS or MBS securities with prepayment or extension risk).

VALUE-AT-RISK (VAR)
VaR is essential to portfolio risk analysis and monitoring, but it must be used with an understanding of the underlying methodology and assumptions. Benefits of VaR include:

Measures risk, not notional exposure Comparable risk measure across all instrument types and asset classes Facilitates aggregation of risk, taking into account portfolio effects

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Ability to compare to daily P&Ls as a reality check Facilitates stress testing to help uncover hidden concentration Dynamically reflects evolving market dynamics and can provide early warning

In this section we will review different approaches to VaR and highlight advantages and limitations, while dispelling popular myths. In every crisis there are always calls to throw out the models, but critiques are only valid for certain implementations of VaR. While many popular VaR models indeed failed to respond appropriately during the recent credit crisis, responsive VaR models worked and even gave valuable early warning signals. A blanket dismissal of VaR is just as misguided as relying on VaR exclusively for risk management. You might think of quantitative risk models as a GPS navigation system. The GPS provides information on location, altitude, speed and direction, but you also need to look out the window and assess road, traffic, and weather conditionsand slow down if youre in an ice storm. In practice, its effective to use VaR alongside other risk measures, with a clear understanding of each measures strengths and limitations. Risk management is not about reductionism or finding one perfect silver bullet. Quite the contrary, robust risk management depends on being able to accommodate multiple perspectives, encompassing objective measures and subjective judgment. When Sir Dennis Weatherstones asked why he chose the 95% as JPMorgans VaR confidence level, he replied: I trust my models 95% of the way, and I pay my risk managers good salaries to look after the rest. VaR is a useful day-to-day volatility estimate, but more analysis is clearly required to understand extreme tail risk. In this section we address some common criticisms of VaR.

Fat Tails
The popular Gaussian / Normal distribution has been justly criticized as not being realistic because markets exhibit fat tails. And indeed, while the Normal distribution matches market behavior reasonably well up to 95% confidence, it progressively underestimates risk as we approach 99% confidence level and beyond. For greater accuracy, the RiskMetrics 2006 methodology uses a Student t-distribution instead of a Normal distribution. RM 2006 has been backtested against other popular forms of VaR and has shown consistent improvements in tail risk estimation in both normal and stressed market conditions. See Zumbachs Backtesting Risk Methodologies from One Day to One Year in RiskMetrics 2007 Winter Journal for more information.

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Outliers
However, even with a more realistic Student t-distribution, we still see occasional outliers. An outlier tells us an unusual event has occurred, which means we need to pay greater attention and be more vigilant with stress testing and managing risk. Outliers dont not invalidate VaR, but to the contrary sophisticated VaR models help us better detect when markets exhibit strange behavior. Indeed, risk managers with responsive VaR models detected a large volatility spike in the credit market in mid Dec 2006 and a major outlier on February 23 2007, and risk managers had many months to reduce positions and put on hedges before credit markets collapsed in July 2007 (See Did VaR Forecast the Subprime Crisis at www.riskmetrics.com/inthemarket/20080815).

Responsiveness To Changing Market Conditions

When the subprime markets collapsed in Q3 2007, most major banks experienced a rash of large excessions after going through long periods of no excessions. One of the hardest hit global banks had 16 excessions in that quarter, after no excessions for 9 years. Clearly, their VaR model was not responsive, but rather was based on relatively static assumptions that were deemed conservative. Unfortunately, their VaR model was anything but conservative, and in fact promoted a false sense of security. At 99% confidence level 1 day horizon, an institution should observe at around 2 to 3 excessions per year the fact that none were observed for 9 years should be very worrying (to be precise, 9 years without an excession is 100 times less likely than a fiscal quarter with nine or more). At the end of the day, their model was simply not realistic. The goal must be to have a realistic model for portfolio risk, as opposed to producing a seemingly high but unrealistic number. Twenty-five years of financial research have established two facts: first, risk changes, with market volatility greater in some periods than others; and second, these changes can be forecast. Methods that ignore these facts produce inferior forecasts. Models that recognize that risk changes even those applied generically to all asset classes continue to produce useful forecasts. -- Chris Finger, RiskMetrics Group

Backtesting VaR
VaR models are designed to predict a portfolios volatility over a specific time horizon, such as one day or one week. Forecasts over these horizons can be validated: we can objectively differentiate a good model from a bad one. When backtesting different implementations of VaR through the credit crisis, we found that unresponsive volatility estimators (such historical simulation or equally weighted moving average based volatilities) performed poorly. On the other hand, models which used responsive volatility estimators (such as EWMA, GARCH) performed reasonably and even gave a number of useful early warning signals on subprime deterioration as early as six and four months before the first major implosion. Since risk is
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dynamic, it makes sense that volatility estimates must be dynamic. And markets have a memory, which means that what happened yesterday should have a higher weighting than what happened a year ago. While VaR is not a crystal ball that can predict future events (such as a natural disaster), good models can help forecast repercussions. Imagine someone unexpectedly throwing a rock into a lake VaR cant predict someone throwing a rock, but it can help forecast the resulting waves once the rock hits the water.

Use of Correlations
Correlations are a statistical measure of co-movement, and for diversified portfolios, correlations are the most important driver of portfolio risk. As with volatilities, correlations are dynamic and should ideally be re-estimated on a daily basis with increased weighting of recent price movements. Its important to note that correlations often change dramatically, especially in crisis situations. In a flight to safety, we typically see correlations increase between risky assets (such as equities, commodities, corporate bonds, and carry currencies), while correlations between perceived risk-free and risky assets often reverse (for example, even though the average correlation between the US S&P 500 and the US 10Y govt bond may average .6, this can reverse to -.9 in a major crisis). A common complaint is that, diversification doesnt work because correlations increase in bear markets exactly when you need diversification the most. Its worth noting, however, that the flight to safety phenomenon sees actually increases the diversification benefit between risky and perceived risk-free assets in a crisis. Note that correlation risk can be further explored by running through historical or hypothetical correlation scenarios in a stress testing framework, which will be discussed in more detail below.

HOW TO CHOOSE AN APPROPRIATE VAR APPROACH

As we just discussed, risk methodologies are not created equally and there are tradeoffs to consider. When choosing an approach, take into account the type and complexity of your portfolio. Youll need a more sophisticated methodology and analytics for handing a multi-asset class portfolio with options than a simple equities portfolio. When choosing a methodology, the key assumptions to understand are:

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Are securities re-priced fully for each market move or are approximations used? If full repricing is not possible due to analytical or data gaps, proxies should be used and disclosed and basis risk stress testing applied. What return data are being used to estimate volatilities? Are all risk factors included (for example, implied volatility changes) and what proxies are applied if security specific information is not available? How are volatilities and correlations estimated (and is the approach responsive or static)? What distributional assumption is being used (i.e., Normal, Student, historical)?

Here is a comparison of the major three methodologies and key assumptions:

Parametric VaR Advantages Key constraints

Very fast to calculate. Immediate convergence.

Normal distribution assumption. Linear approximation for revaluing instruments, which is not appropriate for options and other non-linear instruments.

Monte Carlo Simulation Advantages Key constraints

Rigorous and flexible approach that can accommodate a range of distributional assumptions. Can accommodate full repricing of instruments and hence appropriate for all asset types and a requirement for options.

Longer processing time complicated and large portfolios. Accuracy depends on input volatility and correlations and distributional assumptions.

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Historical Simulation Advantages Key constraints

Relatively simple to calculate, generally by revaluing the portfolio for the past 1 to 2 years of changes, and does not require Normal distribution assumption.

Not dynamic and inappropriate for regime shifts. Will not show extreme tail events unless in current dataset.

The methodology with greatest flexibility and accuracy is Monte Carlo simulation with full repricing of instruments (using responsive volatility estimation and Student t-distribution as current best practice). Many global banks, however, preferred simplicity and stable risk results over predictive power and therefore used historical simulation as their primary risk reporting methodology. This explains the great number of excessions many experienced during the credit crisis. Akin to looking in the rear view mirror, historical simulation is slow to adapt to new market conditions. See Chris Fingers How Historical Simulation Made Me Lazy for more thoughts on the topic. While most firms choose one primary VaR approach, multiple risk methodologies can be used side by side for additional insights. For example, its useful to know if a responsive volatility estimator shows much higher risk than historical simulation and vice versa.

HOW TO USE VAR

Its useful to monitor aggregate portfolio VaR and subcomponents (i.e., equity, FX, IR, Commodity), and to analyze concentration risks in as many ways as possible (e.g., by country, industry, company, investment theme, etc.). Incremental VaR is useful for creating hot spot reports and to quantify percentage risk contribution to various sectors. Marginal VaR is useful for quickly calculating the impact of eliminating a position or risk category.

Conditional VaR (CVaR)

One limitation of the standard VaR measure is that it defines risk at a specific confidence interval (say 99%) without consideration of potential losses beyond that point. So by definition, it will not capture tail risk due to OTM options that are struck beyond the 99% level, for example. CVaR (also known as Conditional / Expected Shortfall) is a useful measure of tail risk.

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Its simply defined as the Expected Loss in the event of losing more than VaR. When a portfolios CVaR is large relative to VaR we know that tail risk is an issue. CVaR can be used in all the same dimensions as VaR (i.e., absolute or relative, marginal or incremental), and is often used in portfolio optimization.

Monitoring Changes in Risk

Its important to monitor changes in VaR. For example, its useful to know whether were at a high or low range in VaR, and a large spike is a warning sign. To use a medical analogy, you could think of VaR as measuring pulse or blood pressure. If theres a sudden spike, risk managers need to immediately probe and discuss further, and be ready to aggressively mitigate escalating risks.

VAR LIMITS
VaR based limits can be very useful for expressing risk tolerance and to monitor ongoing risk taking across an organization. As opposed to being hard limits (such as notional liquidity or credit limits), the primary purpose of VaR limits to set expectations of risk taking and to encourage dialogue when risk levels significantly deviate from target. We recommend setting VaR limits at a level where they are exceeded once of twice a month to encourage regular discussions. Furthermore, if actual risk taking is consistently below risk limits, this should also trigger conversations about whether capital is being deployed effectively.

STRESS TESTING
Stress testing is an essential risk management practice and is a useful complement to VaR. While VaR focuses on day to day volatility, stress tests explore the potential for outliers. Furthermore, VaR can help guide the magnitude of stress tests, as larger shocks are more likely during periods of high volatility. Stress tests should be defined at various time intervals (i.e., 1 day, 5 days, 10 days, or 1 month). The process for stress testing is simple, and starts with creating scenarios and translating these into market movements, and then revaluing the portfolio and making observations about whether there is the potential for excessive losses or whether there are significant risk concentrations across strategies. The most challenging aspect to stress testing is to create relevant scenarios. There are three major approaches to creating stress scenarios.

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HISTORICAL SCENARIOS
A very popular approach is to use historical scenarios, such as Black Monday, Gulf War I & II, the Mexican Peso devaluation, Russian Default & LTCM, 911, Dot Com Crash, and the Subprime Crisis to mention a few. To make historical stress tests relevant to current market conditions, we need to make a historical scenario relevant to todays market conditions. In recreating the 87 stock market crash, for example, well need to forecast how Asian IPOs, CDS spreads, and other instruments were not available in 87 would move. One way to accomplish this is using predictive stress testing, where scenarios are flushed out using current correlations and volatilities.

HYPOTHETICAL SCENARIOS
A second method of stress testing is using hypothetical scenarios. The objective is to develop credible potential future scenarios, and to translate these into market moves. An example of a hypothetical scenario might be Professor Nouriel Roubinis credit contagion scenario, which involves a contagion from subprime to the broad financial market and economy, with a 18+ month L shaped recession and U.S. defaults rates averaging over 10%. After translating the above scenario into anticipated worst case market movements over specified time horizons (i.e., 1 day, 1 week, 1 month) we can use predictive stress testing to forecast the effect of this scenario on a specific portfolio.

PORTFOLIO BASED REVERSE STRESS TESTS

Reverse Stress Tests have recently been recommended by the U.K.s FSA for banks to identify high risk scenarios. In a Reverse Stress Test, you start with your portfolio and then reverse engineer scenarios that could result in significant losses. At JPMorgan, Steve Thieke introduced a process by which traders were asked what would have to happen to their portfolios for them to suffer a large ($50mm) loss. These scenarios were gathered across the organization and filtered up to the CFO and the risk management group, who selected scenarios that seemed to pose firm wide-risk (i.e., common scenarios instead of diversifying scenarios). This brings up another important point about stress testing and systemic risk. The worst systemic crises happen when everyones trying to get out of the same door. The Asian Crisis comes to mind, when Asian corporates and financials all had borrowed excessively in foreign currencies (in particular USD, JPY, EUR) to minimize funding costs and had expected their pegged or managed currencies to remain stable. It was not long after the THB started to wobble that Asian banks, financials, and investors engaged in a similar carry trade had to
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unwind their positions en-masse causing a huge meltdown. A similar phenomenon triggered the recent credit crisis, where a large number of global banks had excessively leveraged U.S. subprime bond exposures. The recent credit crisis points out an important risk management lesson, which is to focus on the whole, not the individual pieces. Investors who focused on the pieces (AAA and AA rated bonds backed by subprime paper) missed the huge concentration risk they posed to bank portfolios. The problem was not that banks had exposure to subprime bonds. The problem was that they had too much of it. And its the risk managers job to identify excessive concentrations, and to figure out how much is too much. Another important recommendation to stress basis risk by perturbing risk factors where data quality is poor or lacking, such as with unavailable implied volatilities or credit spread data. And any illiquid structures should also be extensively stress tested. Stress testing should also consider hedge fund ALM management and catastrophic risk management. In addition to day-today trade sizing and hedge optimization, hedge funds need to plan for redemptions and manage portfolio in line with their management agreements even in stressed markets. A tour of stress testing practices can be found in Chris Fingers Fishing for Complements article at www.riskmetrics.com/publications/research_monthly.html.

CREDIT RISK
We can define credit risk as the risk due to counterparty default and rating change. Credit risk is different from market risk in several important ways. The most important observation is that credit risk is has a much larger potential downside than upside return. You can lose everything if a bond defaults. If everything goes well and theres no default, the most you can get back is your principal plus coupon. Therefore, understanding downside risk is essential for modeling credit risk appropriately. The chart below shows the distribution of a typical credit portfolio.

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Chart: Loss distribution of credit portfolio

The Merton model for understanding credit risk is useful. The holder of a corporate bond is short a put option on the value of assets struck at the level of liabilities. The credit spread the holder of a corporate bond holder receives can therefore be viewed as an option premium to compensate for the downside crash risk. In most cases, the corporate bond holder receives this premium, but in an extreme event like the current credit crisis bond holders can lose the entire value of the bond. See the CreditGrades Technical Document for more information on modeling a Merton-based default process. As opposed to relying purely on observed historical bond prices (which will obviously not have reflected a default scenario), we need to model a jump to default process (and potentially transition to different ratings categories). On a portfolio basis, we need to make an assessment on joint default probability, which we can assess by finding proxies for asset correlation (equity price information can help in this process). Note that as with other asset classes, correlations are the single most important risk factor for diversified portfolios. Credit ratings are less important they drive Expected Losses more than Unexpected Losses, or risk. This is why the excessive focus on credit ratings often misleads investors into believing they have a safe portfolio (were safe, we only invest in AAA and AA rated bonds). To the contrary, if you have very limited ratings categories to invest in, youre more likely to run a concentrated portfolio. A diversified portfolio will never blow up because of any individual default. We have a major problem only when many bonds default together. On that note, supersenior CDO tranches are especially unattractive because they represent pure correlation risk and therefore offer little diversification. A supersenior CDO will only experience losses when a large number of constituents default together (see the Sachsen Bank LB case study of leveraged AAA & AA subprime CDO investments which wiped out the banks capital). Once the model has been calibrated with default and ratings probabilities and correlations, VaR type analysis can be performed on credit portfolios. In contrast to market risk analysis, where 99% VaR forecast horizons generally range from 1 day to 1 month, generally Credit VaR is

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modeled on an annual horizon at much higher confidence intervals (99.5 to 99.9%)using Monte Carlo simulation. CVaR is also especially useful for Credit VaR analysis as its a measure of expected tail risk. The CreditMetrics Technical Document provides a detailed discussion of credit portfolio risk.

LIQUIDITY RISK
Liquidity risk is a recurring theme in stressed markets. In a global liquidity crunch, all asset classes are affected as investors sell assets to raise funds. Particularly badly hit by the current credit crisis were small and mid cap Asian stocks, where liquidity often vanished. Liquidity risk is particularly difficult to manage, because it is dynamic and instrument specific. Liquidating a large position during stressed markets is very different from liquidating a position in normally functioning markets. While no global standards have been set for liquidity risk analysis, monitoring the range of data available for various asset classes can help hedge better analyze liquidity risk.

Equities
Average daily volume data is useful to determine an expected unwind period. Liquidity generally decreases with smaller market cap. Free float data is useful information when compared to short interest on a company, as in the recent squeeze on VW from the Porsche announcement.

Bonds
Information of the percent of total issued debt is useful for assessing how liquid a bond may be in the secondary market. Yield volatility and yield dispersion as well as ratings could be liquidity drivers. Other general factors to consider would be width of bid-ask spreads, quote sizes on each side of a bid-ask, sizes of actual trades, and timing (how frequently during a day the item is quoted or traded). If the asset is exchange traded, open interest would be relevant. For many bonds, option, and futures, maturity date plays a role (or time to maturity or expiration). The currency of an instrument could matter. Please do contact us if you have suggestions for data or methodologies to better manage liquidity risk, as we are actively soliciting practitioner input as we develop our methodologies.

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Some hedge funds use VaR to help quantify liquidity risk by extending the forecast horizon for less liquid instruments, for example from 1 day to 1 week or longer. However not this application VaR is only appropriate if a sufficient amount of liquid transaction price history is available for that specific instrument. If the instrument is too thinly traded to provide a useful trading history, then a proxy should be used. Note that some of the largest subprime bank and hedge fund losses came from illiquid nontrade subprime CDOs, like the ones the Bear Stearns Credit Enhanced funds held. It was apparent from analyzing the extremely high autocorrelation and low volatility of monthly NAVs that market prices were not used for revaluing their CDOs, which pointed to liquidity risk. Combined with leverage, this was a toxic situation for a hedge fund with monthly redemptions and limited access to funding (unlike banks that can tap central bank liquidity and their deposit base). Please see Chris Fingers A Subprimer on Risk, for an analysis of this case study. Special care needs to be taken to rigorously analyze illiquid securities by proxying then to more liquid traded comparables (if possible) and stress basis risk. There is a now infamous claim from a global bank risk manager who thought it was inappropriate for them to proxy their subprime exposures to the ABX indices due to their superior structuring. After hedging the first 2-4% losses on these structures, the securities were deemed risk free and omitted from risk reports entirely. Actual losses on these securities exceeded 30% in many cases and this bank recorded some of the largest subprime losses in the world. The lesson is that even if there is not a perfect proxy, a reasonable proxy is better than nothing (but a bad proxy can be misleading for example proxying AAA subprime to generic AAA corporate spreads). The use of proxies should be disclosed, and basis risk needs to be stress tested.

RISK REPORTING
Its important to design accessible and intuitive risk summary reports to facilitate regular risk communication. Attributes of good market risk reporting:

Summarize enterprise market risk on one single page, with ability to drill down to the position level. Additional reports can be provided for detail, but Apply a spectrum of risk measures and approaches (i.e., VaR + stress testing). Highlight any significant concentration risks, whether to a particular country, sector, firm, or trading strategy. Graphs VaR bands vs. P&L bands to test how well the models are doing and to get a visual understanding of how risks are evolving over time.

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Highlight any significant changes in risk levels, and identify if these come from larger positions or changes in market volatility or correlations. Include written commentary after each risk discussion.

See Risk Management: A Practical Guide for more extensive advice on risk reporting best practice and sample reports.

Client Reporting
Its also useful to provide monthly risk transparency to clients. These reports should be less detailed than internal reports and should not include any confidential position information, but should include an overview of portfolio risk and highlight any significant country / sector / strategy concentrations and changes. Investors can use these reports to better monitor their aggregate portfolio concentrations across investment strategies and asset classes. For sample client hedge fund risk reports, please see www.riskmetrics.com/hedgeplatform.

Conclusions
Setting up a risk management process at a hedge fund varies greatly depending on the size and type of strategies employed. But these core principles are worth keeping in mind:

Risk is best managed at the enterprise wide level, not in silos. Grow a pervasive risk management culture, and challenge all to identify and communicate potential risks & scenarios. Pay attention to early warning signs, qualitative and quantitative. Dont reduce risk management to just numbers, probe qualitative aspects of risk. Implement the Seven Attributes of Risk Management.

There is much more to risk management that just risk measurement. Indeed, perhaps too much public focus has been placed on the sophistication and apparent precision of risk estimation models, and not enough on the more important managerial and judgmental elements of a strong risk management framework. These include the clarity of risk policies, the strength of internal control, the degree of management discipline, the level of internal risk transparency, and ultimately, the experience and market knowledge of risk management professionals. Steve Thieke For more information, please visit http://www.riskmetrics.com/contact or contact your Account Representative.
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