CFA Level 1 Alternative Investments - Hedge Funds - 3

Leverage and unique risks of hedge funds
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LOS
k. discuss the leverage and unique risks of hedge funds;
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Leverage in hedge funds often runs fron 2:1 to 10:1 and can run higher than 100:1.

It is interesting to note that at one point in time, a well known hedge fund that got into problems LTCM, had leverage over 500:1 (Lhabitant, Hedge Funds: Myths and Limits, Jon Wiley, 2002).

Unique risks:

Liquidity risk
The liquidity risk is common to all investors who trade in securities. The risk is much more in the case of trading in illiquid or thin markets. Many hedgefund strategies rely on the presence of liquidity in markets. Because of this, lack of liquidity in extreme market conditions can cause irreversible damage to hedge funds. The failure of the hedge fund Longterm Capital Management (LTCM) was attributed to the unexpected disappearnce of liquidity in the market.

Pricing risk
Hedge funds invest in over the counter traded products. Pricing of those securities or products is a difficult task. In periods of high volatility, broker dealers adopt an extremely conservative policy of pricing them and demand margin based on those prices. This can create severe cash needs for hedge funds to maintain their positions. Pricing risk is more when liquidity is a problem and so they appear together.

Counterparty credit risk
As hedge funds deal in over the counter products, counterparty credit risk arises.

Settlement risk
This is the risk that the counterparty fails to deliver the securities or money involved in a transaction on the settlement day. If the hedge fund planned to utilise the securities or money in turn to settle its other trades, there will be a problem because of settlement failures.

Short squeeze risk
This risk comes into appearance when short sold stock has to be bought at rising prices. This could come about because the lenders of the stock want their stock back. Because some hedge funds use short positions, this can be a risk.

Financing squeeze
If the hedge fund has reached its borrowing limits, and still needs cash to maintain positions by paying margin calls, there is a problem. To tide over the problem, the fund has to square up some its positions under adverse circumstances. This risk is termed financing squeeze risk.