What is the best way to measure market risk for hedge funds?

Market risk is the potential loss that a hedge fund may face due to adverse changes in market factors, such as interest rates, exchange rates, stock prices, or commodity prices. Measuring market risk is crucial for hedge funds to manage their exposures, optimize their portfolios, and comply with regulations. However, there is no single best way to measure market risk for hedge funds, as different methods have different advantages and limitations. In this article, we will discuss some of the most common and widely used methods for measuring market risk for hedge funds, and how to choose the most appropriate one for your specific objectives and strategies.

Key takeaways from this article

Use Expected Shortfall:

This metric considers not just the likelihood of losses but their potential magnitude, providing a more comprehensive picture of risk and helping you better prepare for extreme scenarios.
Stress testing scenarios:

By simulating your portfolio under various crisis conditions, you can anticipate possible outcomes and devise strategies to mitigate those risks, making your fund more resilient.

This summary is powered by AI and these experts

1 Value at Risk

Value at Risk (VaR) is a popular and simple measure of market risk that estimates the maximum loss that a hedge fund can expect to incur over a given time horizon and confidence level. For example, a VaR of $10 million at 95% confidence level for one day means that there is a 5% chance that the hedge fund will lose more than $10 million in one day. VaR can be calculated using historical data, parametric models, or Monte Carlo simulations. VaR is useful for setting risk limits, allocating capital, and reporting performance. However, VaR also has some drawbacks, such as ignoring extreme losses beyond the confidence level, assuming normal distributions of returns, and being sensitive to the choice of time horizon and confidence level.

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Anita NGONO©

Financial Markets Engineer 📈💻 | Project Manager📑🖇| Optimizing business processes, trading and portfolio management systems for Corporate and Investment Banking (CIB) and Asset Managers 🏛
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Les inconvénients de la VaR ne doivent pas être sous-estimés. L'un des principaux problèmes est qu'elle ne prend en compte que la perte maximale attendue dans un certain pourcentage de cas (par exemple, 95 % ou 99 %), mais elle ignore complètement la taille des pertes qui pourraient survenir dans les cas restants. Cela peut conduire à une fausse impression de sécurité. Par exemple, si un événement de marché extrême se produit qui dépasse le seuil de confiance de la VaR, les pertes peuvent être considérablement plus importantes que ce que la VaR suggère.

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Kailash Dholliwar MSc MCIPS, APM

London
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A Capital Asset Pricing Model (CAPM) can be useful to estimate risk exposure as it scrutinises the weight between the capital fund returns vs market factors. Stress testing is a commonly used method however, this would be useful when reviewing a number of other various risk techniques to provide a more robust output.

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2 Expected Shortfall

Expected Shortfall (ES) is a more conservative and robust measure of market risk that captures the average loss that a hedge fund can expect to incur in the worst-case scenarios beyond the confidence level. For example, an ES of $15 million at 95% confidence level for one day means that the average loss in the 5% worst-case scenarios is $15 million. ES can be calculated using similar methods as VaR, but it requires more data and computational power. ES is preferred by regulators and risk managers, as it accounts for tail risks, does not assume normal distributions of returns, and is coherent and subadditive.

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Mara Reilly (née Arikian)

⭐️ Global Head of Private Markets Risk ⭐️ Private Credit & Private Equity Specialist | Experienced Credit Strategist | Risk Management Expert | Capital Markets Structuring | Chief Member |
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The risk drivers of HFs typically fall into 1 of 4 categories: volatility, diversification, counterparty, or liquidity. Here, let’s define market risk loosely as the possibility of experiencing losses due to factors that affect the overall performance of investments in the financial markets. As such, there is no 1-right way to cut the data, but I would emphasize shortfall as an appropriate gauge of risk. Understanding what your institution can be at risk for after accounting for collateral in-house is a consistent, although conservative view. Owing on a leveraged position, investor capital could be depleted with nothing to return; therefore, measuring ES is not unreasonably conservative as it ensures your risk measure accounts for tail risk

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3 Stress Testing

Stress Testing is a complementary measure of market risk that evaluates the impact of extreme and unlikely events on the hedge fund's portfolio. Stress Testing can be done by applying historical scenarios, such as the 2008 financial crisis, or hypothetical scenarios, such as a war or a pandemic, to the current market positions and factors. Stress Testing can help hedge funds to identify and mitigate their vulnerabilities, assess their liquidity and solvency, and prepare contingency plans. However, Stress Testing also has some limitations, such as being subjective and arbitrary, requiring a lot of assumptions and judgments, and being difficult to compare and aggregate.

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Christian M. Döhnert, FRM, CGA, CFP®

Estratégia Segmento PF @ Sicredi
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The Stress Test is based on a series of scenario simulations (price variations of various assets) with the aim of simulating the investor's portfolio return under the imposed situation. In this case, scenarios of crisis and high correlation between assets are considered.

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4 Factor Models

Factor Models are another measure of market risk that decomposes the hedge fund's portfolio returns into a set of common and specific factors that drive the market movements. Factor Models can be based on macroeconomic variables, such as GDP growth or inflation, or on statistical methods, such as principal component analysis or factor analysis. Factor Models can help hedge funds to understand and diversify their sources of risk and return, optimize their asset allocation and hedging strategies, and enhance their performance attribution and analysis. However, Factor Models also have some challenges, such as selecting and estimating the relevant factors, capturing the nonlinear and dynamic relationships, and dealing with the data availability and quality issues.

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5 How to Choose

As we have seen, there is no single best way to measure market risk for hedge funds, as each method has its own strengths and weaknesses. Therefore, hedge funds should choose the most suitable method for their specific objectives and strategies, based on factors such as the type and complexity of their instruments, the level and frequency of their trading, the nature and horizon of their risk, and the regulatory and reporting requirements. Moreover, hedge funds should use a combination of methods to capture different aspects and dimensions of market risk, and to cross-check and validate their results. Finally, hedge funds should constantly update and review their market risk measurement methods, as the market conditions and factors change over time.

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Mara Reilly (née Arikian)

⭐️ Global Head of Private Markets Risk ⭐️ Private Credit & Private Equity Specialist | Experienced Credit Strategist | Risk Management Expert | Capital Markets Structuring | Chief Member |
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Unlike a corp or a private equity fund that, if defaulted, would go through a lengthy bankruptcy proceeding, HFs are often here today & gone tomorrow. In distress, liquidations can be voluntary or involuntary, whereby a forced closure typically occurs through unforeseen redemptions or quick capital erosion. Fire sales are not uncommon in defaulting HFs to get capital quickly; however, they can leave little to nothing for investors/creditors. Ensuring accurate and up-to-date data is key to staying abreast of portfolio risk. BEst practice would be to ensure multiple views of data to identify emerging risks that do not present in one risk measure (i.e. VaR) that may appear in another ( Stress)

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Christian M. Döhnert, FRM, CGA, CFP®

Estratégia Segmento PF @ Sicredi
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There is not a single and simple answer. Risk management requires a broad perspective that considers various indicators so that we have a complementary view.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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What is the best way to measure market risk for hedge funds?

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1 Value at Risk

2 Expected Shortfall

3 Stress Testing

4 Factor Models

5 How to Choose

6 Here’s what else to consider

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