Do Hedge Funds Have Enough Capital? A Value-at-Risk Approach

We examine the risk characteristics and capital adequacy of hedge funds through the Value-at-Risk approach. Using extensive data on nearly fifteen hundred hedge funds, we find that only 3.7% live and 10.9% dead funds are under-capitalized as of March 2003. Moreover, the under-capitalized funds are relatively small and constitute a tiny fraction of the total fund assets in our sample. Cross-sectionally, the variability in fund capitalization is related to size, investment style, age, and management fee. Hedge fund risk and capitalization also display significant time variation. Traditional risk measures like standard deviation or leverage ratios fail to detect these trends.

[1]  W. Fung,et al.  Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds , 1997 .

[2]  W. Sharpe.  Asset allocation , 1992 .

[3]  William N. Goetzmann,et al.  Offshore Hedge Funds: Survival and Performance 1989-1995 , 1997 .

[4]  William N. Goetzmann,et al.  Hedge Funds and the Asian Currency Crisis of 1997 , 1998 .

[5]  David Hsieh,et al.  Performance Characteristics of Hedge Funds and Commodity Funds: Natural vs. Spurious Biases , 2000, Journal of Financial and Quantitative Analysis.

[6]  Three cheers , 2005, Nature.

[7]  Richard W. McEnally,et al.  The Performance of Hedge Funds: Risk, Return, and Incentives , 1999 .

[8]  B. Tabachnick,et al.  Using Multivariate Statistics , 1983 .

[9]  A. McNeil.  Extreme Value Theory for Risk Managers , 1999 .

[10]  Andrew W. Lo,et al.  Risk Management for Hedge Funds: Introduction and Overview , 2001 .

[11]  Philippe Jorion,et al.  Risk Management Lessons from Long-Term Capital Management , 1999 .

[12]  Igor Makarov,et al.  An econometric model of serial correlation and illiquidity in hedge fund returns , 2004 .

[13]  J. Pickands.  Statistical Inference Using Extreme Order Statistics , 1975 .

[14]  Manfred Gilli,et al.  Extreme Value Theory for Tail-Related Risk Measures , 2000 .

[15]  François-Serge Lhabitant,et al.  Assessing Market Risk for Hedge Funds and Hedge Fund Portfolios , 2001 .

[16]  Alexander J. McNeil,et al.  Calculating quantile risk measures for financial return series using extreme value theory , 1998 .

[17]  A. Silva,et al.  Value-at-risk and Extreme Returns in Asian Stock Markets , 2003 .

[18]  Stefan Letott,et al.  Statistical Inference Based on the Likelihood , 1999, Technometrics.

[19]  David A. Hsieh,et al.  Measuring the market impact of hedge funds , 2000 .

[20]  R. Sundaram,et al.  Of Smiles and Smirks: A Term Structure Perspective , 1998, Journal of Financial and Quantitative Analysis.

[21]  Phhilippe Jorion.  Value at Risk: The New Benchmark for Managing Financial Risk , 2000 .

[22]  Philippe Jorion,et al.  Fallacies about the effects of market risk management systems , 2002 .

[23]  R. Fisher,et al.  Limiting forms of the frequency distribution of the largest or smallest member of a sample , 1928, Mathematical Proceedings of the Cambridge Philosophical Society.

[24]  Richard L. Smith.  Estimating tails of probability distributions , 1987 .

[25]  Bing Liang.  On the Performance of Hedge Funds , 1998 .

[26]  Paul H. Kupiec,et al.  Techniques for Verifying the Accuracy of Risk Measurement Models , 1995 .

[27]  Philippe Jorion.  On Jump Processes in the Foreign Exchange and Stock Markets , 1988 .

[28]  A. Azzalini.  Statistical Inference Based on the likelihood , 1996 .

[29]  R. C. Merton,et al.  Option pricing when underlying stock returns are discontinuous , 1976 .

[30]  Turan G. Bali.  An Extreme Value Approach to Estimating Volatility and Value at Risk , 2003 .

[31]  Bing Liang.  Hedge Funds: The Living and the Dead , 2000, Journal of Financial and Quantitative Analysis.

[32]  William N. Goetzmann,et al.  Careers and Survival: Competition and Risk in the Hedge Fund and Cta Industry , 2000 .

[33]  F. Longin,et al.  From value at risk to stress testing : The extreme value approach Franc ß ois , 2000 .

[34]  Stephen E. Wilcox.  Offshore Hedge Funds: Survival and Performance, 1989–95 , 1999 .

[35]  Jeremy Berkowitz,et al.  How Accurate are Value-at-Risk Models at Commercial Banks , 2001 .

[36]  William N. Goetzmann,et al.  Hedge Funds and the Asian Currency Crisis , 2000 .

[37]  V. Agarwal,et al.  Risks and Portfolio Decisions Involving Hedge Funds , 2004 .