Thursday, June 07, 2007

Hedge Fund Leverage Risks

Today's Wall Street Journal carried a piece on the back page of the Money & Investing Section, describing the state of credit derivative hedge fund investments.

According to the article, over $300B is currently invested in these funds, on a leveraged basis, 6-1, for roughly $1.8T of controlled assets. One of the eye-opening pieces of arithmetic the authors did was to point out that a credit derivative fund with only 4x leverage, experiencing a decline of just 5% in the value of its portfolio, would be required to liquidate as much as 25% of its total assets to meet a 20% margin requirement. Multiply this by many hedge funds engaged in similar investing, with similar exposures, and you understand a fundamental underpinning of my partner's and my own options strategy.

We have a static options strategy in place which works automatically, without any recourse to a change in positions, in the event of severe market declines.

During a lunch meeting today with some associates in the financial sector, to explain in more detail our recent options-based implementation of our equity portfolio strategy, we discussed precisely this aspect of risk management. Ranging in ages from the 60s through 40s, we had enough cumulative and historical experience in the markets to all agree on one thing- the time at which you need to deploy a dynamic risk management strategy is precisely when it will be unable to be deployed, due to unforeseen market conditions involving illiquidity. This illiquidity could take the form of a failure for markets to be made in the instruments in question, or their quotes and prices to be impractical to take, due to an overall shortage of liquidity at affordable prices.

Thus, reading this recent piece on the implicit current risk of rapid and dysfunctional declines in prices and liquidity in the credit derivative markets, I am pleased that we are putting in place a 'no moving parts' risk management approach which relies on the simple attribute of a call or put option to allow for, but not necessitate, a trade, in order to limit downside risk to value.

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