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Hedge Fund Modelling and Analysis Using Excel and VBA by David Hampton, Paul Darbyshire

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5

Risk-Adjusted Return Metrics

Since hedge funds use mainly derivatives (e.g. futures, forwards and options) and collateralised over-the-counter (OTC) instruments (e.g. interbank foreign exchange, contracts for difference, credit and correlation products) for investment and trading purposes, the degree of exposure to each underlying instrument may vary from low to high and is not necessarily a function of the AuM available for investment as in the world of traditional investing. In other words, in the world of hedge funds, leverage is a variable controlled directly by the fund manager and can typically vary dynamically from zero to 20 times or even higher. Leverage is typically accomplished using real-time margining and collateralisation facilities through prime brokers or banks for OTC instruments and via futures contracts which are traded through futures commission merchants (FCMs). It is therefore not good enough to use historical returns only (as in traditional investments) to measure the performance of a hedge fund manager since they could be an average performer who simply use excessive leverage to produce high returns.

The essence of modern-day hedge fund appraisal therefore lies in the ability to measure risk-adjusted returns which show how well each hedge fund manager performs on a net basis per unit risk. As we progress through this chapter and into Chapter 6, other methods will be introduced to show that it is not just how well a manager performs in a risk-adjusted way ...

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