Corporate & Financial Risk Analysis, Defining Hedge Funds - Essay Example

? Corporate & Financial Risk Analysis Table of Contents Introduction 3 Risk Functions and their use in MATLAB 12 References 16 Introduction Corporate and financial risk analysis involves the use of various strategies to and method. Proper implementation by investment managers helps them identify the various risks that they may incur during the trading process. It however, requires a well-trained eye and experience specialist. This is because the final decision making process is not as easy as 1, 2, 3. This dissertation explores the various strategies, quality measurement methods, risk analysis, and quantitative methods used by investment managers. A comprehensive definition of hedge funds is also contained herein. Thereafter is a description of how they managers implement various strategies to gain profits, recover losses, avoid losses, as well as maintain an inflow of income. This dissertation also details various risk functions and how they are used to ensure that to predict the market’s reaction as well as results after certain possible events. Defining Hedge Funds A hedge fund is a privately owned and managed investment (Goldberg & Korajcsyk, 2010). Such a fund would invest in a wide range of elements. This would include various strategies, markets, and investment methods. Hedge funds provide the investor a means by which he/she can comfortably navigate market rules. However, the fund is not autonomous. The fund manager has to follow specific rules set aside for hedge funds. Each country has specific rules that govern the hedge fund systems (Alexander, 2008). Hedge funds have a particularly characteristic of being open-ended. The investor has room to add to the investment or withdraw all together. This is unlike other custom funds that only allow specific times for addition and withdrawal (Chavas, 2004). Other funds also have specific categories within which they allow certain amounts of withdrawal or addition. The calculation of a hedge fund value involves the use of the asset value. Each fund has a specific net value. This value helps determine the share value of the fund. Hedge funds are like mutual funds for the rich. This is because for one to participate in hedge fund, the investor needs to meet certain requirements. They need to have a particular experience in investment and have to have certain net value. This locks out the commoner from engaging in hedge funds. Hedge funds are playground for sophisticated investors. Hedging is an investment method that reduces the risk while increasing return on investment. However, this is part truth. Modern day hedging makes use of several other strategies. Such strategies include aggressive growth, funds of funds, and market timing (Alexander, 2008a). There are many more strategies employed by hedge fund managers. One thing that is common among all hedge funds is specialization. Each hedge fund manager has his or her strength and weakness (Agarwal & Naik, 2005). It is obvious that one would have to rely mainly on their own strength. This means that a manager would apply his or her own expertise in managing the fund. This results in the fund having special characteristics. The managers are very professional and deliver on their promises. They perform their duties exemplarily thus being awarded the opportunity to manage such large sums of money. Investment Strategies used by Hedge funds Hedge funds employ several strategies. One of the main strategies involves aggressive growth. In this strategy, the manager would find equities expected to grow aggressively, and he/she would invest in them (Lerner, 1995). Aggressive growth is with respect to earnings per share. The P.E ratios for such equities are often high while the dividend are meager or not present at all. Small cap stocks often experience rapid growth. This is because they are often specialized into banking, technology, or biotechnology. The means for hedging in such a strategy are by shorting equities with poor projections. This type of strategy is highly volatile and requires due diligence. Another strategy is taking advantage of distressed securities. In this strategy, the manager buys equities from companies that are experiencing a form of distress (Knapp, 2010). This could be bankruptcy or new leadership. Such equities are often discounted greatly and do not cost as they should be costing. The rest of the market will not notice the true value of such equity. This needs the manager to know the value of discounted securities. This strategy has a moderate volatility level. Another strategy involves trading in the emerging market. These markets are lucrative in that their debts and securities have high inflation rates. They also experience large volume growth. Hedging options in this strategy are limited. This is mainly because one of the major rules is that short selling is not allowed in this category (Goldberg & Korajcsyk, 2010). The manager needs to do their homework really well before taking this strategy. This strategy is therefore, highly volatile but the returns are often very lucrative. Making use of funds of funds is also another strategy employed by hedge fund managers. This method is mostly used for those looking to make long-term investments. A fund of fund makes use of several funds in one hedge fund (Agarwal & Naik, 2005). The mixing of such funds works to limit the level of risk incurred by the whole hedge fund. This strategy makes use of other underlying strategies to manage each fund individually. The main goal for this strategy is to preserve and maintain capital. This strategy has a relative volatile level. This is because the various strategies involve determining the volatility of the whole hedge fund. Another strategy commonly used by hedge fund managers is income. This strategy looks to yield a general income on the part of the fund (Agarwal & Naik, 2005). The fund’s directive is to focus on income and not capital gains. Leveraging on bonds or fixed income sources so that they can benefit from interest and appreciation is one of the ways to work around this strategy. The level at which this strategy is volatile is often minimal. The macro strategy works to profit from drastic changes in global economies. Some of the most influential elements in global economies are politics. When governments introduce new laws that influence trading, macro strategy is a good way to go. A good example is laws that change interest rates. This in turn, influences stocks, bonds, and currency. The use of this strategy is effective in all markets. Leveraging is very common in this strategy (Alexander, 2008b). This is in order to influence certain moves in the market. However, the best way to go with this strategy is leveraging debts as they produce the best turnover. This type of strategy is extremely volatile and requires great management. Another common strategy with hedge fund managers is market neutral arbitrage. This strategy allows the manager to hedge out risks. The manager will take certain positions in the market that will change the market reaction. The difference with other strategies is that these different positions are within securities offered by the same issuer. For example, the manager may short certain equities while longing the issuers bonds. This type of strategy mainly takes hold of maintaining returns. This all the while is with no relations with equities or bonds. Volatility is relatively low for this strategy (Camerinelli, 2009). This strategy also makes use of structure arbitrage mortgage backed securities, fixed income arbitrage, and closed end fund arbitrage. Another strategy closely similar to the previously mentioned strategy is the market neutral securities hedging strategy. This strategy allows the manager to invest in long and short equities within the same area of a market. This is done intentionally to reduce the general market risk. However, the manager needs to have a great stock picking techniques. This is after extensive analysis. The analysis results then guide the manager to find which stock is appropriate for this type of strategy. This strategy allows the use of leveraging to increase returns (Nelson & Winter, 1982). This strategy may also employ market indices to hedge out risks. The volatility of this strategy is particularly low and makes use of T-bills. Another strategy employed by this strategy is the use of market timing. The manager will allocate various assets into specific asset classes. This depends on the manager’s outlook on the market at the time of allocation. Equity portfolios are seen to move between various asset classes. The unpredictability of the market and the inability to tell how the market will change makes this strategy one of the most volatile strategies (Helpman, 2004). It is also difficult to decide the time when to enter the market and when to leave. Hedge fund managers also employ opportunistic strategies. Using this strategy, the manager will change strategies depending on the opportunities that arise. This means that the manager is using a whole assortment of strategies but not similar ones at the same time. Such opportunities may include sudden price surges, IPOs, hostile bids, among other opportunities (Barro & Grilli, 1994). The manager may use several investment strategies at any one given moment and is never under the impression of making use of only one asset class. The level of volatility within this strategy is variable. Another strategy common with hedge fund managers is multi strategy. This means the use of several strategies at once. This makes the investments made by the manager diversified. The manager however eventually receives and achieves the final goals. This strategy also incorporates systems trading. It allows one to follow certain trends and several other technical strategies. Volatility for this strategy is normally very variably. Another important strategy used by hedge fund managers is short selling. This means selling equities, securities, or debts that are expected to hike in price. The seller sells these investments when they are low. It is essential to note that this is not just a hunch. The manager researches and performs mathematical projections that help determine whether the strategy will work or not (Chavas, 2004). These equities lower in price due to issues such as accounting irregularities, competition, or introduction of new management. This strategy is very volatile. It is used as a hedge to minimize losses resulting from portfolios that may result in a bearish cycle within the market. Another strategy involves identifying special situations. Special situations are such as those that are event driven (Camerinelli, 2009). The hedge fund manager invests in such situations because they put him in a position to bargain and make a better sale or buy out. Events that may lead to such situations involve hostile take over’s, reorganization or even buyouts. This strategy may cumulatively involve simultaneously buying stock from other companies as they are being acquired. The buyer is the person acquiring the product. The hedge fund manager is of the hope that the price of the stock will be spread out within the current market price. This will mask the actual value of the market share. The hedge fund manager will then profit from the sale of such stock shares (Alexander, 2008b). This strategy employs derivatives. This is in order to leverage returns. This is also s way to hedge out interest, as well as market risks. The final strategy that is used by hedge fund managers is value. This means buying into and investing in securities thought to be sold in high discounts. This lowers the cost of such securities making them seem valueless. The hedge fund manager however sees otherwise. He buys them knowing how valuable these securities are actually priceless. Such securities are normally not followed up on by analyst and are usually out of favor by many in the stock market. The manager then holds such securities for a long period. He/she then patiently waits until the value of these securities is finally realized. This requires tremendous discipline on the part of the hedge fund manager. Volatility of this strategy is moderate and, therefore raises no alarms. Excessive returns & performance Measures Excessive returns refer to an investment portfolio, equity, or security that surpasses the benchmark/index for the other investments with similar risk. In nonprofessional’s language, what this means is that the investment has a return ratio bigger that the risk involved. The benchmark is the highest level of risk an investor is willing to undertake (Needham & Brause, 2007). Upon investing on the security, the returns reflect that they are far much greater than expected. The result is actually that the risk is diminished. Excessive returns are used to measure the value added by a hedge fund manager. This means that this is a means to determine whether a hedge fund manager is actually efficient. It provides a bigger picture concerning the manager’s prowess. This shows whether the manager is an alpha (Mulford & Comiskey, 2005). Performance measures, on the other hand are used to define the level of success for a portfolio. This is the performance standard for the investment itself. Unlike excessive returns, these measures do not necessarily show how well a manager performed. There is three main measures use. These include the Treynor measure, the Sharpe ratio, and the Jensen measure. These measures also include, risk unlike previous measures. They are preferred because they factor in situations that actually affect a portfolio’s performance in the market. The treynor measure includes the portfolio's performance and the risk included. This is a ratio of reward versus volatility (Rhode Island, 1999). It is a comparison of the type of returns made, and to what extent it superseded the risks. If the risks are not beaten, then the portfolio performed badly. The basic formula is this: (Portfolio Return – Risk-free Rate)/Beta The Numerator refers to the risk premium while the denominator refers to the risk portfolio. The result is a representation the portfolio in comparison to the unit task. The result is gauged by comparing the numbers recorded. The higher the result, the better the portfolio. The Sharpe ratio on the other hand, is similar to the treynor measure in that it measures both the portfolio performance and the risk involved. The main difference between them is that the risk measure is a deviation of the invested portfolio (Knapp, 2010). This method does not make use of beta like the treynor measure. It makes an all-round comparison by not taking into consideration a systemic risk. The basic formula for this method is: (Portfolio Return – Risk-free Rate)/Standard deviation The other measure that is commonly used to measure performance is the Jensen measure. This measure calculates the excess return that is generated by a portfolio. This is then compared to the expected return from the same portfolio with comparison to standard risks. In essence, it compares the rate of return to the hedge fund manager’s ability to perform and deliver above that, which is expected. This method is adjusted to cater for risks that are above those in the market. This is in line with excessive returns. The result is then compared with the normal returns. In case the return rate is high, then the better the risk adjustment (MathWorks, 2012). The general formulae for this method are: JA + PR – BPR BPR = RFRR + (RoM - RFRoR) Where: JA = Jensen’s Alpha PR = Portfolio Return BPR = Benchmark Portfolio Return RFRoR = Risk-Free Rate of Return B = Beta RoM = Return of Market. Risk Functions and their use in MATLAB Risk functions are methods used to calculate risks undertaken when investing in portfolios in the stock market. Some of the common risk functions used includes VaR, Expected tail loss, Omega, and MDD (Alexander, 2008). These functions provide a way for the manager of the investment to determine the level of risk for the investment he/she is managing. This is while considering the prevailing market conditions. Var, in full known as portfolio value at risk represents the minimum amount of money that is at risk when the portfolio invested is at its worst. This is in comparison to the worst-case scenario. The formulae used to calculate the Var is VaR? (Camerinelli, 2009). Where ? are a representation of the least possible percentage of loss for an investment. It is possible to calculate the risk facing a portfolio in a market. For example, in a market where a portfolio has a 5% VaR of $500, then there is a 0.05 probability of that portfolio falling in value if there is no trading during the whole day. This of course shows the worst-case scenario for the investment process. The diagram bellow shows how the above procedure would be applied to implement the solution to the problem in MATLAB (MathWorks, 2012) Another risk function that is commonly used is the Expected tail loss. It is also known as the Conditional Value at risk (CVaR?). This risk function, like the VaR?, is a representation of the expected loss on a portfolio in the worst scenario within the market. Just like the previous example, the portfolio is €500 and the trading stops for a whole day. The conditional value at risk is stated as €500 at the tail. This is calculated in MATLAB as shown below: The third risk function normally used is Omega. This is a weighted measure of the ratio between gains above a predefined threshold, and loss bellow threshold. The formula for calculation is shown below: An example for the application for the Omega risk function is a situation whereby the omega function tabulates a value ? (0.1) = 2.0. This means that the returns exceeding 2% are two times the returns less than 2%. This of course refers to expected values. The final risk function that is used is the drawdown. This function is also referred to as the maximum draw down. It refers to the maximum loss incurred by a manager or investor holding a sub-period investment. The formula for calculating draw down is as shown below: An MDD equal to 40% shows us that an investor bought a portfolio at the highest price and sells at the lowest price making the 40% loss. This is a representation of the worst-case scenario for the unlucky investor. Risk Control Strategy A good overall risk control strategy involves identifying the best investment portfolio first. This will depend on the specific expectations of the client. To limit the risk, the best thing to do would be to use the risk functions identified earlier to assess the market (Mulford & Comiskey, 2005). This will also depend on the strategy selected for the trading process within the market. Defining Quality Quality refers to the level at which the performance of a portfolio or investment is rated (Barro & Grilli, 1994). This is in comparison to the various quality measurement methods availed to the management teams. Quality is then measured in comparison to the way a manager works and how well he satisfies the investor. Quality measurement Quality measurement is a subset of performance measurement. If the performance is great, quality is equally good without saying. Performance measures are for both the portfolios and their managers. The same would be done in this situation. The performance of the portfolio and the manager would be determined appropriately so that the final identification of the quality level can be determined (Gray & Malone, 2008). The treynor measure will provide the quality level of the portfolio in comparison to the risk involved under the current market conditions. Systemic, Quantitative approach on how to control risk Controlling of risk in this case scenario involves the selection of the best strategy in the trading process (Helpman, 2004). The next thing to do is identify the best way to calculate the various risks that are expected in the market. In this case, the use of the value at risk function best describes the way in which this market may function and the kind of risks that are involved. Identifying this risk and mitigating them gives the manager an upper hand in the trading process, thus limiting the various risks involved. Conclusion The best investment portfolio requires a good manager; otherwise, it will crash and fall. Management and constant analysis of the market keeps the manager on his toes. This gives him/her the ability to identify the smallest of changes and act appropriately. It may also help in changing various decisions that may be used in the near future. Even with a good manager, certain market elements are completely out of his/her control. It takes a great team with a great leader to recover from that. References Agarwal, V. & Naik, N. Y., 2005. Hedge funds. 3rd ed. Boston: Now Publishers. Alexander, C., 2008a. Market risk analysis. Chichester: John Wiley and Sons. Alexander, C., 2008b. Market risk analysis Volume 2, Practical financial econometrics. 2nd ed. Chichester: Wiley. Alexander, C., 2008. Market risk analysis Volume 1, Quantitative methods in finance. Chichester: Wiley. Barro, R. & Grilli, V., 1994. European Macroeconomics. 2nd ed. London: Macmillan. Camerinelli, E., 2009. Measuring the value of supply chain linking financial performance and supply chain decisions. 2nd ed. Farnham: Gower. Chavas, J. P., 2004. Risk analysis in theory and practice. 5th ed. Amsterdam: Elsevier/Butterworth Heinemann. Goldberg, L. R. & Korajcsyk, R. A., 2010. 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