Crises and Hedge Fund Risk

1
Crises and Hedge Fund Risk

• Monica Billio, Mila Getmansky
• and Loriana Pelizzon
• Financial Analysis and Decisions
• SCH-MGMT 640

2
Correlation and Risk

• During Crises
• Average correlation among hedge fund strategies
  increased by 33
• Average volatility of hedge fund returns jumped
  by 90

3
Objectives

• Main Question What are the Effects of Financial
  Crises on Hedge Funds?
• During financial crises
• Do traditional risk models work can they capture
  the increase in risk and correlations?
• Are there common sources of risk?
• Are there new sources of risk?
• Can diversification benefits still be achieved?

4
Beware of Traditional Risk Models in Crises

• Traditional models often underestimate the
  importance of common sources of risk during
  crises
• Traditional models do not consider latent
  (hidden) sources of risk
• Commonality in classical and latent risk factor
  exposures during financial crises can lead to
• Demise of the hedge fund industry
• Systemic risk (spillover to other financial
  institutions)
• Less diversification across HF styles as a source
  of downside protection
• Less diversification for traditional portfolios
  by including HF

5
Traditional Models Underestimate True Risk and
Correlation

• Average hedge fund volatility increased by 90
• 15 due to the increase in Var-Cov of classical
  systematic risk factors
• 46 due to the increase in hedge fund exposures
  to classical systematic risk factors
• 39 due to the increase in idiosyncratic risk
• Average correlation among hedge fund strategies
  increased by 33
• 34 due to the change in Var-Cov of classical
  systematic risk factors
• 33 due to the increase in hedge fund exposures
  to common classical risk factors
• 33 due to the increase in correlation of
  idiosyncratic returns

6
Econometric/Measurement Problems

• How do we identify financial crises?
• How do we measure hedge fund risk exposure during
  financial distress?
• How do we measure the presence of a common latent
  risk factor exposure among hedge fund strategies?

7
How do we identify financial crises?

• Endogenously determined regime-switching model
  on SP 500
• Identify three market states based on endogenous
  change in mean and volatility of the market risk
  factor Up-state, Tranquil-state, Down-state
  (often associated with well identified financial
  crises)
• Exogenously determined Dummy variable during
  crisis periods (Rigobons windows)

8
Endogenous Crisis Definition Regime-Switching
Model for SP 500
Sample Jan 1994-Dec 2008
9
Exogenous Crisis Definition

• A crisis dummy is equal to one during the
  following crises
• Mexican (December 1994-March 1995),
• Asian (June 1997-January 1998),
• Russian and LTCM (August 1998-October 1998),
• Brazilian (January 1999 - February 1999),
• Internet Crash (March 2000 - May 2000),
• Argentinean (October 2000 - December 2000),
• September 11, 2001,
• Drying up of merger activities, and WorldCom
  accounting problems crises (middle 2002)
• Subprime (August 2007-January 2008)
• Global financial crisis (September 2008-November
  2008)

10
How do we measure hedge fund risk exposure during
financial distress?
11
Common Risk Factor Exposures

• During crises, common classical risk factor
  exposure to
• SP 500 (market risk) (reduced)
• Large-Small (liquidity risk) (increased)
• Credit spread (credit risk) (increased)
• Change in VIX (volatility risk) (increased)
• Magnitudes

12
How do we measure the presence of a common latent
risk factor exposure among hedge fund strategies?

• Idiosyncratic risk is characterized by a
  switching mean and volatility with a two state
  Markov chain () )
• Capture common hidden risk factor exposure
  (latent factor exposure) by determining the joint
  high volatility regime

13
Common Latent Factor Exposure
14
Common Latent Factor Exposure 1998 and 2008
15
Mutual Funds

• Same sample period (1994-2008)
• U.S. open-ended mutual fund indices from
  Morningstar
• Large Blend
• Large Growth
• Large Value
• Mid-Cap Blend
• Mid-Cap Growth
• Mid-Cap Value
• Small Blend
• Small Growth
• Small Value

16
Conclusion

• Traditional models underestimate risk for hedge
  funds
• Common classical risk factor exposures exist
• SP 500 (market), Large-Small (liquidity risk),
  Credit Spread (credit risk), and change in VIX
  (volatility risk) mostly during financial
  distress
• Common latent risk factor exposure is present
• LTCM/Russian crisis (1998)
• Global financial crisis (2008)
• Risk managers should account for
• common classical and latent risk factors
• time-varying risk exposure (especially crisis
  state)