Hedge Funds Semantics

Hedge funds are very risky investments. They invest in derivatives, employ unconventional trading strategies, and are usually greatly leveraged... All for the pursuit of extraordinary profits. A lot of hedge funds have come and gone and the survival rate is not encouraging. So why are they called "hedge" funds in the first place?

When we hear the word "hedge" we usually think of protection and safety. In finance, a hedge, usually in the form of derivatives, is used to protect an investment from loss. But it also limits the gains of the position as well. This makes potential earnings predictable and constant. Risk is eliminated since risk is defined as "uncertainty".

But looking at the hedging instrument individually, it is just as exposed to losses as other instruments. Moreover, derivatives are leveraged and losses are potentially greater than conventional assets. The hedge only takes shape if the hedging instrument is taken together with another position, and their reaction to changes in market factors should cancel each other out.

Hedge funds act in the same way. Taken alone, hedge funds are risky investments. But when combined with conventional funds, they can provide diversification benefits and even enhanced returns due unconventional strategies and assets employed. These unconventional strategies and assets result into low correlations with conventional funds.

I guess a lot of people assume that hedge funds are supposed to be safe investments because of the word "hedge". But if these funds are meant to safe in the first place, they should be called "hedged" funds instead.

Tags: finance derivatives hedge funds investments

CFA Institute Defends the CFA Brand

CFA charterholders will be delighted to know that their organization is pretty busy upholding the integrity of the CFA brand.

Just this month, the Delhi High Court told the Institute of Chartered Financial Analysts of India (ICFAI) to stop (temporarily?) the use of the CFA marks. ICFAI runs a post-graduate program that eventually leads to a CFA Charter from the Council of Chartered Financial Analysts. The court stated that "Chartered Financial Analyst" and "CFA" is not a generic term to be used by any organization and is a recognized trademark owned by CFA Institute.

CFA Institute press release
ICFAI program details

Tags: CFA

Basel II Implementation in the Philippines

The Bangko Sentral ng Pilipinas (BSP) has set June 2007 as the date of implementation of the revised capital adequacy framework. The latest version of the framework is very much in line with Basel II. Major changes that are expected to have significant impact on the ratios would be the addition of an operational risk capital charge and the revision of the risk weight for Philippine government foreign currency bonds (ROP) from 0% to 100%.

In a previous circular, securities booked under Available for Sale (AFS) are taken out of market risk charge and are now considered as Banking Book exposures. I'm not sure why this is the case because these positions clearly have exposure to fluctuation in rates and are revalued accordingly. Profit or loss are then recognized in equity. This actually prompts banks to book everything under AFS (especially Philippine Gov't Peso bonds which have 0% credit risk weight) to avoid market risk charges.

As with Basel II, the framework does not directly address market risks in the banking book and leaves these as Pillar II issues.

Read more about Basel II initiatives in the Philippines:

Bangko Sentral ng Pilipinas (BSP)
The Asian Banker

Tags: finance risk management capital adequacy basel ii bsp philippines

An Option with a Negative Implied Volatility?

Previously, we talked about cases when an option will have a negative value. This time, it was asked in Wilmott if there are real-life cases where options have negative implied vols.

Here's my take on the subject matter:

Since implied volatilities are derived values, based on observed market parameters and a model or formula, it is indeed possible to have negative results. But does it make sense? Intuitively, we would think that the volatility measure should only be positive and it does not make sense if negative. I think negative implied vols are a result of either a misspecification in the model, or mispricing by the market (an arbitrage opportunity, as mutley pointed out).

Tags: finance derivatives options valuation volatility

Are fund managers really overcompensated?

CFA Magazine recently published an interview with Barton Biggs in its July-August 2006 Issue. Mr. Biggs has been with Morgan Stanley for 30 years acting as chief global strategist and is well respected by Wall Street. In 2003, He retired from Morgan Stanley to form Traxis Partners (hedge fund) with colleagues. In the interview, the following quote struck me the most...

"The hedge fund is another way for people to run money. It happens to be a way in which there are high fees charged. Eventually, the sheer size of the money going into hedge funds and the number of hedge funds that exist are going to inevitably result in a decline in hedge fund fees. In fact, my guess is that compensation across the investment management business is beginning a secular decline. It's the most overcompensated business in the world. Never have so many been paid so much for adding so little. It's an evolutionary process."

I am aware that competition forces fees in a downward trend and compensation will surely follow. But I still don't see the evidence of this happening at the moment based on the postings I see in jobs boards and the number of fresh grads wanting to go into the business (because it pays well).

I think it's all a matter of supply and demand. As more and more fund managers are needed, it becomes more difficult to get really good managers. The lack of supply raises the price for talents. The lack of supply also forces some funds to employ sub-standard managers (whether intentional or not) which results into Mr. Biggs observation of so little value added.

Some articles about Barton Biggs:
Morgan Stanley
Turtle Trader
Weeden & Co.

Tags: finance investing hedge funds CFA

Running Government Finances Like a Bank

Many investors are concerned about the increase in public debt of Asian countries since the Asian Financial Crisis. As justification, governments need to issue debt to support the financial markets, jump start the economy, and develop infrastructure, etc. Sovereigns with large outstanding debt are seen to be more credit risky and more more susceptible to something going wrong. Thus, the IMF issued guidelines on Public Debt Management (PDM).

In a nutshell PDM takes Asset-Liability Management best practice from banks and insurance companies and applies them in managing government debt. This makes sense since the biggest financial portfolio in a country is the government's finances anyway.

Governments should focus on ALM issues like liquidity and interest rate risk management. It should analyze the cost-benefit trade off of borrowing in the short term - which is cheap but risky and volatile, as opposed to borrowing long term - which is expensive but predictable. They should also focus on minimizing unhedged foreign exchange exposures, debt with embedded put options (unpredictable maturities), and implicit contingent liabilities.

Governments should also push for the development of their domestic currency capital markets. A developed capital market would mean that there are a lot of investors and variety of issued securities. Development of derivatives markets will also be beneficial as investors are more willing to take and hedge risks. A developed capital market will also allow the government to issue longer-dated debt since there are willing investors.

Having a large public debt portfolio is not such as bad thing as it can be a catalyst for economic growth. The key here is proper risk management. All they (governments) have to do is to look at what the banks and other financial institutions are doing.

Sources:

International Monetary Fund
Financial Engineering News

Tags: finance derivatives risk management alm government debt bonds capital markets

Do you use Bloomberg for Risk Measurement?

Bloomberg is holding a Market Risk Seminar this month. But before the details, here are my comments.

I've attended Bloomberg seminars before and there is usually a sales pitch somewhere. Looking at the event's lineup of speakers, 4 out of 5 speakers are from Bloomberg (an Algo risk solution is embedded in Bloomberg). Although the topics may sound relevant, they're just intro material to Bloomberg functionalities and add-on services. For those looking for risk management solutions for their organization and looking to comply with Basel II, Bloomberg will present itself as a viable option in this seminar. Bloomberg would more likely say: "Since you are already Bloomberg users, why not leverage on your subscription and use our built-in risk solutions (at an added cost of course)?"

Generally, practitioners I know would trust Bloomberg in a majority of the raw figures that they give out. But when it comes to calculations, some would take them with a grain of salt. Personally, I find the risk solutions of Bloomberg to be less than adequate for the following reasons:

• Limited instrument coverage
• Not flexible
• Lack of transparency (Black Box)

But of course, it would never hurt to sit in a Bloomberg seminar and learn best practice (if ever they are presented) and to discover some new things that our beloved system has to offer.

And now for the seminar details.

Topics:

• Importance of Market Risk Management
• Risk measures for fixed income securities and derivatives
• Reliable data for your risk management systems
• Market risk management in alignment with Basel Accord
• Algo Risk on Bloomberg - a pre-integrated, real time market risk solution

Speakers:

• Nestor A. Espenilla, Jr. - Deputy Governor, Bangko Sentral ng Pilipinas
• Seet Kok Leong - Head of Algo Risk (Asia Pacific), Algorithmics
• Jiten Bhanap - Product Specialist, Bloomberg L.P.
• Ivan Koh - Regional Data Solutions Manager, Bloomberg L.P.
• Neo Siang Noi - Trading Systems Sales Specialist, Bloomberg L.P.

Date:

15 August 2006

Venue:

Makati Shangri-la Manila, Ayala Avenue corner Makati Avenue, Makati City 1200, Philippines

Time:

9:30am - 2:00 pm

Registration:

BU on Bloomberg

email: awang@bloomberg.net

tel: +63 2 849 7100 loc. 4794

*Lunch will be served

Tags: finance derivatives market risk risk management bloomberg seminars courses

Modelling Financial Risk Seminar

Just got an invitation through email to participate in a class offered by Macquire University's Advanced Finance Centre and PRMIA. It is a course designed for Risk Management Professionals. It involves lectures by Dr. Elizabeth Sheedy and some computer workshops after each topic.

Topics for Discussion

• Introduction
• Measuring Risk Under the Normal Distribution
• Historical Simulations for Measuring Risk
• Monte Carlo Simulations for Measuring Risk
• Stress Testing
• VaR in the Absence of Normality
• Liquidity Risk
• Model Risk
• Maximum Likelihood Estimation

Course Schedule

• Thursday 17 August 2006 - 5:30pm to 8:30pm
• Friday 18 August 2006 - 5:30pm to 8:30pm
• Saturday 19 August 2006 - 9:00am to 5:00pm
• Sunday 20 August 2006 - 9:00am to 5:00pm

Fees

• SGD 1785 (includes GST) - per person
• SGD 1575 (includes GST) - per person from the same entity

Venue

School of Financial Services and Risk Management, Singapore Human Resources Institute, Singapore Conference Hall, 7 Shenton Way #01-02 Singapore 068810

Contacts

• 65 6438 0012
• shortcourses@mafc.mq.edu.au

An outline is available at this link.

I'm quite knowledgeable in risk measurement so the initial topics are just the same old stuff. The latter topics though are quite interesting. Too bad I'm not in Singapore.

Tags: finance risk risk management seminars courses