Counterparty Credit Risk Hedge Funds Date 23 Jan

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Counterparty Credit Risk - Hedge Funds Date : 23 Jan 2015 Produced by :

Counterparty Credit Risk - Hedge Funds Date : 23 Jan 2015 Produced by : Angelo De Pol

Contents 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Introduction

Contents 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Introduction Counterparty credit risk What are Hedge Funds? Hedge Funds vs Traditional Funds Who are the Managers? Who are the Investors? Hedge Fund Strategies Funds of Hedge Funds Hedge Fund Market Impact of the Credit Crisis Key Risks Risk Management Produced by Angelo De Pol Slide 2

Counterparty Credit Risk § Since the Credit crisis and Lehman Default, counterparty credit risk

Counterparty Credit Risk § Since the Credit crisis and Lehman Default, counterparty credit risk has become one of the highest-profile risks § Counterparty risk is the exposure to the default on the obligations of that counterparty § Accountants and traders value this risk as an “option to default”, often referred to as “CVA” (Counterparty Valuation Adjustment) § There are many different classes of counterparties : Corporates, Financial Institutions, Sovereigns, Hedge Funds etc § This lecture will focus on Hedge Funds Produced by Angelo De Pol Slide 3

What are Hedge Funds? Ø Umbrella term for collective investment vehicles employing a huge

What are Hedge Funds? Ø Umbrella term for collective investment vehicles employing a huge range of different strategies Ø Highly specialised…rely on specific expertise of manager Ø Largely offered as private investments Ø Typically structured as limited partnerships Ø Generally set up in tax havens Ø Narrow range of investors Ø Use of leverage and derivatives is widespread Ø Hedge Funds aim to i) Preserve capital, ii) Reduce volatility and risk and iii) Deliver positive returns under all market conditions Produced by Angelo De Pol Slide 4

Comparison of Hedge Funds vs Traditional Funds Hedge Funds Industry Size $26 trillion $2.

Comparison of Hedge Funds vs Traditional Funds Hedge Funds Industry Size $26 trillion $2. 6 trillion Returns Versus a benchmark Absolute Investment Long Only Long or Short Strategy Complexity Low High Correlation to Market High Lower Leverage No Yes Trading Presence Lower Turnover Higher Turnover Fees Low - Based on AUM Liquidity Relatively Liquid High - based on AUM and Performance Restrictions & Lock-ups Transparency Relatively High Low Minimum Investment Relatively Small Large Produced by Angelo De Pol Slide 5

Who are the Managers? Ø Ex bankers typically with investor contacts and trading expertise

Who are the Managers? Ø Ex bankers typically with investor contacts and trading expertise Ø Vary considerably in size - Top 15% control 75% of Industry Assets Ø Most managers based in New York, Connecticut and London Ø But funds typically registered in tax havens like Cayman Islands New York London Cayman Islands Produced by Angelo De Pol Slide 6

Who are the Investors? Ø High Net Worth individuals, Funds of Fund Managers &

Who are the Investors? Ø High Net Worth individuals, Funds of Fund Managers & Institutional investors Ø Minimum Investment size is very high – usually at least $1 million Ø Acceptance has grown substantially…viable alternative to traditional markets Ø Investors seek attractive, stable and non-market correlated returns Produced by Angelo De Pol Slide 7

Hedge Fund Strategies…help represent the hedge fund universe Breakdown as at end of 2009;

Hedge Fund Strategies…help represent the hedge fund universe Breakdown as at end of 2009; Source : CS/Tremont Produced by Angelo De Pol Slide 8

Hedge Fund Strategies Statistics for 2009 Produced by Angelo De Pol Slide 9

Hedge Fund Strategies Statistics for 2009 Produced by Angelo De Pol Slide 9

Event Driven Strategy Exploits pricing inefficiencies caused by anticipated corporate events. Many variations… Event

Event Driven Strategy Exploits pricing inefficiencies caused by anticipated corporate events. Many variations… Event Driven Distressed Merger Securities Arbitrage Special Credit Situations Arbitrage Companies Merging Restructuring Corporate near companies Fixed bankruptcy Income Securities Reg’n D Private Equity Activist Active management and influence of companies Produced by Angelo De Pol Slide 10

Managed Futures Strategy Ø Also called Commodity Trading Advisors (“CTAs”) Ø Systematic approach to

Managed Futures Strategy Ø Also called Commodity Trading Advisors (“CTAs”) Ø Systematic approach to investing in futures contracts in bond, equity, commodity and currency markets Ø Highly quantitative model based trading Ø No trader decisions – all model based Ø Use mean reversion, trend and pattern recognition models Ø Operate in highly liquid markets, providing flexibility Ø Models can break down in very volatile markets Produced by Angelo De Pol Slide 11

Funds of Hedge Funds Ø Invest in other Hedge Funds Ø Portfolio diversification main

Funds of Hedge Funds Ø Invest in other Hedge Funds Ø Portfolio diversification main aim (strategy, manager and fund) Ø Important and very influential in industry Ø Have access to extensive resources and systems Ø Regularly rebalance portfolio and perform due diligence Ø But additional layer of fees and leverage Ø Suffered major blow in crisis as diversification benefit muted Produced by Angelo De Pol Slide 12

Growth of Hedge Fund Market (Assets Under Management in $ Billions) LIQUIDIT Y CORRELATIO

Growth of Hedge Fund Market (Assets Under Management in $ Billions) LIQUIDIT Y CORRELATIO N REGULATION LEVERAGE INFLUENCE STABILITY TRANSPARENC Y Data Source : Barclay Hedge AI Database Produced by Angelo De Pol Slide 13

Hedge Fund Market Performance vs. Equities Russia/ LTCM Crisis Equity Bear Market Correlation Increasing

Hedge Fund Market Performance vs. Equities Russia/ LTCM Crisis Equity Bear Market Correlation Increasing Credit Crisis Average Annualised Volatility - Hedge Funds : 6%, Equities : 15% Produced by Angelo De Pol Slide 14

Impact of the Credit Crisis…Performance vs. Equities Peak -5% -20% Trough -27% -53% Hedge

Impact of the Credit Crisis…Performance vs. Equities Peak -5% -20% Trough -27% -53% Hedge Funds : Credit Suisse / Tremont Hedge Fund Index Equities : MSCI World Index Produced by Angelo De Pol Slide 15

Impact of the Credit Crisis…the perfect storm Gates & Suspensions Madoff Fraud Redemptions Lehman

Impact of the Credit Crisis…the perfect storm Gates & Suspensions Madoff Fraud Redemptions Lehman Failure Deleveraging Short selling ban § 2000 hedge funds liquidated (25%), industry benchmarks lost 20% § Industry AUM down $1. 2 trillion (42%), massive risk & leverage reduction § Huge loss of investor confidence and lots of litigation Produced by Angelo De Pol Slide 16

Hedge Fund Industry Outlook Ø Growth has recovered since 2008… § Industry Assets Under

Hedge Fund Industry Outlook Ø Growth has recovered since 2008… § Industry Assets Under Management (AUM) nearly $2. 5 trillion § Before Credit Crisis Growth was around 20% per year § 2009 one of best performing years ever in industry Ø But Investors much more demanding now… § More transparency and liquidity demanded § Also better controls, risk management and infrastructure § And of course lower fees and overall costs Ø Industry consolidation… § Largest managers continue to get bigger and more influential § Managers targeting more traditional institutional investors Produced by Angelo De Pol Slide 17

Key Risks Lack of Transparency Operational Risks Poor Liquidity Lack of Regulation High Leverage

Key Risks Lack of Transparency Operational Risks Poor Liquidity Lack of Regulation High Leverage Produced by Angelo De Pol Slide 18

Key Risks - Operational Risk Distribution of Reasons for Fund Failures Breakdown of Operational

Key Risks - Operational Risk Distribution of Reasons for Fund Failures Breakdown of Operational Risk Failures Source : Understanding and Mitigating Operational Risk in Hedge Fund Investments: A Capco White Paper Produced by Angelo De Pol Slide 19

What is CPPI? Ø Constant Proportion Portfolio Insurance Ø Helps ensure 100% of investor’s

What is CPPI? Ø Constant Proportion Portfolio Insurance Ø Helps ensure 100% of investor’s capital is protected (at maturity) Ø And investor also gets participation in underlying asset growth Ø Simple formula based hedging mechanism with set minimum “cushion” Ø Determines composition of investment between : 1. Risky Asset (e. g. Hedge Fund of Funds) and 2. Non- Risky Asset (Cash, Fixed Term Deposits) Ø Poor Performance Deleverage • Sell Risky Asset to buy more Non- Risky Asset • Possibly end up with no Risky Asset exposure Ø Good Performance Leverage up Risky Asset exposure Produced by Angelo De Pol Slide 20

Key Risks - Hedge Fund Portfolio Risks Gap Risk • CPPI notes have built

Key Risks - Hedge Fund Portfolio Risks Gap Risk • CPPI notes have built in rebalancing mechanism • But in stressed markets this mechanism can fail… • Bank would make-up shortfall • Collateral has gap risk too Liquidity Risk • Hedge Fund Liquidity is poor • Hedging effectiveness is reduced • In stressed markets actual liquidity may be worse • High levels of operational risk Concentration • Poor transparency in industry • Manager, fund and strategy diversification critical Produced by Angelo De Pol Slide 21

Risk Management • Active risk management at all levels is critical • Market, Credit,

Risk Management • Active risk management at all levels is critical • Market, Credit, Operational and Legal risk management overlap • Successful risk management is dependent upon : Crash Scenario Limits Gap Option Hedges Diversification Good Manager Relationships Active Due Diligence Conservative Model Reserves Strong Legal Documentation Produced by Angelo De Pol Slide 22

Suggested Research Topics and Sources § Non-traditional performance statistics more suitable for Hedge Funds

Suggested Research Topics and Sources § Non-traditional performance statistics more suitable for Hedge Funds (e. g. moving away from Sharpe ratios) § Unbiased hedge fund industry benchmarks (industry replication via strategies, investable indices vs. non-investable indices) § Hedge Fund portfolio risk management techniques and scenario development (to include operational risks, leverage, funding risk and liquidity) § Implied leverage in the hedge fund industry based upon available performance, costs and strategy information Sources § www. hedgeindex. com § www. hedgefundresearch. com § Bloomberg Markets Magazine (Feb 2010) § www. emagazine. credit-suisse. com (About Us / In Focus / Dossiers / Derivatives & Hedge Funds) § www. credit-suisse. com § www. hedgefundintelligence. com § www. hedgefund. net § www. greenwich. com Produced by Angelo De Pol Slide 23