Hedge Fund Modelling and Analysis using MATLAB

CHAPTER 7 Market Risk Management

We often encounter problems relating to the risk that the value of a hedge fund will decrease due to the impact of various market factors, for example changes in interest or foreign currency rates. Moreover, with the heightened publicity of recent financial events, hedge fund managers have come under increased pressure from investors and regulators to efficiently manage, monitor, measure and report such market risk inherent in their investment strategies. Indeed, experience has clearly shown that the measurement and management of extreme market conditions is of paramount importance for hedge funds.

Chapter 7 provides an introduction to market risk management for hedge funds and presents the fundamentals of quantitative risk measures and models used in the industry today. The chapter also covers some of the more advanced risk measures available that can more effectively manage risk in a hedge fund in light of the limitations encountered with traditional market risk measures.

7.1 VALUE-AT-RISK

The Value-at-Risk (VaR)¹ for a portfolio of assets is the worst estimated loss over a given time horizon (e.g. monthly) at a specified level of confidence (e.g. 95%). That is, the riskiness of the hedge fund portfolio at a specific level of probability in the left-tail of the P&L distribution. VaR is often based on the assumption that asset returns follow a normal distribution and that the performance of the hedge fund portfolio is affected by a set of ...