Dai, John and Sundaresan, Suresh (2009): Risk Management Framework for Hedge Funds: Role of Funding and Redemption Options on Leverage.
Download (318kB) | Preview
We develop a model of hedge fund returns, which reflect the contractual relationships between a hedge fund, its investors and its prime brokers. These relationships are modelled as short option positions held by the hedge fund, wherein the “funding option” reflects the short option position with prime brokers and the “redemption option” reflects the short option position with the investors. Given an alpha producing human capital, the hedge fund’s ability to deploy leverage to magnify its alpha is shown to be sharply constrained by the presence of these short options, which have a high probability of being exercised in “bad states” of the world, either due to poor performance or due to macroeconomic developments that are performance-independent. We show that the hedge funds typically have an optimal level of leverage that trades off rationally the ability to increase alpha with the risk of early exercise of short options, which may precipitate the liquidation of the fund. Optimal leverage is shown to differ across hedge funds reflecting their de-levering costs, Sharpe ratios, correlation of assets, secondary market liquidity of their assets, and the volatility of the assets. Using a minimum level of unencumbered cash level as a risk limit, we show how a hedge fund can optimally choose aggregate risk capital and then allocate its risk capital across different risk-taking units to maximize alpha in the presence of these short option positions. Implications of our analysis for hedge fund investors and policy makers are summarized. Our framework can be easily modified to study portfolio selection problem facing any fund, which has granted redemption rights to its investors (money market funds, long-only funds, etc).
|Item Type:||MPRA Paper|
|Original Title:||Risk Management Framework for Hedge Funds: Role of Funding and Redemption Options on Leverage|
|Keywords:||Leverage; Unencumbered cash; funding option; redemption option; prime brokers; funding counterparties; hair cuts; margin multiplier.|
|Subjects:||G - Financial Economics > G1 - General Financial Markets
G - Financial Economics > G2 - Financial Institutions and Services
|Depositing User:||Suresh Sundaresan|
|Date Deposited:||29. Jul 2009 23:41|
|Last Modified:||19. May 2015 14:36|
1. Agarwal, Vikas, and Narayan Y. Naik (2000), “Multi-Period Performance Persistence Analysis of Hedge Funds,” Journal of Financial and Quantitative Analysis, 35, (September), 327-342.
2. Agarwal, V and N Naik (2004): “Risks and portfolio decisions involving hedge funds”, The Review of Financial Studies, spring, vol 17, no 1, pp 63–98.
3. Ang, A. and N.P.B Bollen (2009), Locked Up by a Lockup: Valuing Liquidity as a Real Option, Columbia University, Working paper.
4. Aragon, George, (2007) “Share Restrictions and Asset pricing: Evidence from the Hedge Fund Industry,” Journal of Financial Economics, Volume 83, pages 33-58.
5. Brown, Stephen J., William N. Goetzmann, and Roger G. Ibbotson, 1999, Offshore hedge funds: Survival and performance, 1989-1995, Journal of Business 72, 91-119.
6. Brown, Stephen J., William N. Goetzmann, Roger G. Ibbotson, and Stephen A Ross, 1992, Survivorship Bias in Performance Studies, Review of Financial Studies 5, 553-580.
7. Brown, Stephen J., William N. Goetzmann, Roger G. Ibbotson, and Stephen A. Ross, 1997, Rejoinder: The J-shape of performance persistence given survivorship bias, Review of Economics and Statistics 79, 167-170.
8. Brown, Stephen J, William N. Goetzmann, James Park, “Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry,” The Journal of Finance, 56, (October 2001), 1869-1886.
9. Brunnermeier, M K and S Nagel (2004): “Hedge funds and the technology bubble”, The Journal of Finance, vol LIX, no 5, October, pp 2013–40.
10. Chany, Nicholas, Getmansky, Mila, Haas Shane, and Lo, Andrew W., “Systemic Risk and Hedge Funds,” February 2005.
11. Duffie, D, C. Wang and H. Wang, (2008), “Leverage Management,” Stanford University.
12. Harrison, Michael (1985), “Brownian Motion and Stochastic Flow Systems”, Wiley Series in Probability and Statistics.
13. Hildebrand, Philip M., “Hedge funds and prime broker dealers: steps towards a “best practice proposal”, Financial Stability Review, Special issue on hedge funds, Bank of France, April 2007.
14. Hombert, J. and Thesmar, “Limits of Arbitrage: Theory and Evidence,” Working paper, SSRN Working paper, March 2009.
15. Kambhu, J., T. Schuermann, and K.J. Stiroh, “Hedge Funds, Financial Intermediation, and Systemic Risk,” Economic Policy Review, Federal Reserve Bank of New York (2007).
16. Lo, Andrew, “Hedge Funds, Systemic Risk, and the Financial Crisis of 2007–2008,” Written Testimony Prepared for the U.S. House of Representatives, Committee on Oversight and Government Reform, November 13, 2008 Hearing on Hedge Funds.
17. Papademos, Lucas D., “Monitoring hedge funds: a financial stability perspective, Financial Stability Review – Special issue on hedge funds, No. 10, April 2007, Bank of France.
18. Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, Report of The President’s Working Group on Financial Markets (1999).
19. Fung, William, and David Hsieh, 1997a, Empirical characteristics of dynamic trading strategies: The case of hedge funds, The Review of Financial Studies 10, 275-302.
20. Fung, William, and David Hsieh, 1997b, Survivorship bias and investment style in the returns of CTAs: The information content of performance track records, Journal of Portfolio Management 24, 30-41.
21. Fung, William, and David Hsieh, 2000, Performance characteristics of hedge funds and CTA funds: Natural versus spurious biases, Journal of Financial and Quantitative Analysis 35, 291-308.
22. McGuire Patrick and Kostas Tsatsaronis, “Estimating Hedge fund leverage,” BIS working papers, (No 260), September 2008.
23. Goetzmann, William N., Jonathan Ingersoll Jr., and Stephen A. Ross, 2003, High-Water Marks and Hedge Fund Management Contracts, Journal of Finance 58, 1685-1717.
24. Pangeas Stavros, and Mark M. Westerfield, “High Water Marks: High Risk Appetites? Hedge Fund Compensation and Portfolio Choice,” Journal of Finance, (2009).