Risk Management is the process of analysing risk exposure and deciding how to manage the risk. Financial Risk Management is determining and managing current and potential financial risk in a business in an attempt to reduce the business’ level of risk.
The role of a risk manager is to identify what the risk is and what the level of risk is to the company, determine possible remedies to alleviate risk and implement the necessary solutions to eradicate the risks. Risks may be eliminated by the use of financial instruments (also known as securities, which are tradable assets of any kind). However, it is important to note that risk management cannot eliminate all risks facing a business; this is because not all risk can be predicted and thereafter it is difficult to try and remedy the situation promptly.
Andrew W. Lo (2001) suggests that there are at least five aspects of hedge fund investments that pose unique challenges for existing risk management protocols and analytics:
- Survivorship bias
- Dynamic risk analytics
- Liquidity and credit
- Risk preferences
Survivorship bias risk is often misleading to potential investors because the results from performance studies may be skewed on the basis that unsuccessful companies are excluded from the study or poorly performing funds are closed in a fund’s portfolio and thus excluded, resulting in unrealistically high fund return data.
Dynamic risk analytics is a valuable decision-making tool when there are only three options available: gain, loss or breakeven. Dynamic risk analytics refer to the changes in the environment, regulatory requirements or changes in consumer preference; it is thus the exposure to loss as a result of these changes.
Nonlinearities occur where the relationship between variables is considered unpredictable and not directly proportional to the input. Instead, it is seen as dynamic. That is to say that returns seem relatively uncorrelated with market indexes according to A. W. Lo (2001) thus convincing a potential investor of the benefits of diversification. However, the diversification needs to be approached with caution. This is because if there is a vast change in the economy of the country it may result in a phrase known as “phase-locking”. Phase-locking occurs when otherwise uncorrelated actions, suddenly become synchronised. Thus nonlinear risk models need to factor in different variables of change that can impact the return on investment. It must also be noted that the model should be based specifically on the various types of securities the fund trades rather than a general model.
Liquidity risk occurs when there is a likelihood of loss as a result of insufficient cash or cash equivalents to meet the needs of a borrower. It may also occur when a sale cannot take place in the market as there is a lack of buyers; some illiquid assets sell at below fair value to attract more willing buyers. Credit risk occurs as a result of default on the part of the debtor; this means the debtor fails to pay the money due on his part resulting in financial loss for the creditor.
According to Lo (2001), risk preferences of both the investor and the fund manager must be taken into account in determining the appropriate risk exposures of a hedge fund. The risk behaviour of an investor influences the behaviour of the manager. The risk manager must take into account the price, probabilities and preferences involved in the relationship between the fund manager and potential investor.
The 2008-2009 recession affected the hedge fund industry negatively due to the industry being unprepared for the financial crisis. As a result, a greater emphasis is on the investment of hedge fund risk managers. The proposal of risk managers is intended to weaken the blow of financial instability by having the fund equipped to deal with such situations.
Currently, hedge funds are placing emphasis on short-term downside risk measures according to C. Dickinson (2013). Downside risk refers to the possibility that investments or securities will weaken in price or refer to the amount of loss that will occur as a result of the decline in a portfolio.
Laurence Wormald of SunGard APT suggests that hedge fund risk managers should focus on “stress testing” which is about future risk and the improvement of downside performance. There are several risk measures hedge fund’s risk managers can adopt to evaluate the risk the fund is facing, this includes:
- Value at Risk
- Conditional Value at Risk
- Stress Testing
- Counterparty risk
- Historical Scenarios
- Risk Attribution
- Tracking error
Value at risk is the statistical analysis of historical market trends and volatilities in percentage form, to determine the possibility that a fund’s losses will exceed a certain amount within a specific time frame. The risk manager’s job is then to provide that risks are not taken above the predetermined risk level. If risks are taken above this level, the fund may not be able to absorb the probable loss associated with the risk.
Conditional Value at Risk is also known as expected shortfall; it is seen as the conservative approach of evaluating risk and determining the expected return over a period. This method is used to reduce the portfolio’s risk of obtaining large losses, by determining that a specific loss will exceed the value at risk.
Stress testing is used to determine the stability of a financial institution, or fund portfolio, in a hypothetical scenario of economic instability. Stress testing is a technique used on asset and liability portfolios to determine their reactions to different financial situations, and whether or not the portfolio has enough capital on hand to outlast an economic scenario.
Volatility refers to the instability of the price of a security, and it is the rate at which the price either increases or decreases. Volatility is determined by calculating the annual standard deviation of daily price changes. If the price fluctuates rapidly within a short period, the portfolio is considered to have a high volatility rate. If the price is predominantly stable, the portfolio is deemed to have a low volatility rate. Another type of volatility measurement tool is implied volatility; which takes into consideration market price, strike price, interest rate and expiration date. This method is used to determine an option’s premium.
Counterparty risk occurs between two contracting parties, and it is the risk that either of the parties will fail to perform their obligations of the agreement. It may sometimes be referred to as default risk. Counterparty risk may in certain circumstances be reduced by the introduction of a third party with excellent credit, who then acts as an intermediary between the contracting parties.
Historical scenarios operate on the assumption that the value pattern of a portfolio follows the same value pattern of a similar portfolio from previous years. The use of historical data is helpful in the application of how the information, regarding the trend, is followed by the previous portfolio.
Risk attribution may formulate the relative risk in correlation to active investment decisions in a hedge fund portfolio. The purpose of risk attribution is to enable the fund manager to determine the rate of return for the risk given for each investment decision, thus risk attribution assists in the rebalancing and construction of a portfolio. This tool is also used by potential investors, to evaluate a fund’s decision making regarding risk.
Tracking error is the difference between the price patterns of a portfolio in comparison to the price pattern of an industry benchmark. It is also known as the “standard deviation percentage” as it is the difference in the return of the investor, to that of the benchmark it was trying to emulate.
The arrival for the need of risk management has become more and more dominant in recent years. The need for risk managers is not only due to the fund’s need to be prepared in the event of potential loss through various financial circumstances; it is also needed with respect to investors and fund managers alike, for risk transparency. The use of a risk manager can provide insight to an investor as to the structure of the risk exposure of the fund, without compromising important information concerning the fund and its managers. Risk managers are capable of creating a stable and competitive method for managing both the business and portfolio risk, thus displaying professionalism and intention to grow.