Managing Hedge Fund Risk and Financing: Adapting to a New Era

Appendix 3

Cash Management and the Probability of Failure

Hedge funds are a new business model for which data for quantifying forward-looking and even historical default probabilities remain scant. Creating exposures to alternative risk factors and generating alpha entails undertaking less conventional trading activities compared to long-only funds. In addition, hedge funds seek to produce asymmetrical expected-return profiles with non-linear risk exposures compared to long-only funds. To do so, they make use of margin financing and high leverage; invest in illiquid instruments; and quickly seize and then exit market opportunities, which results in high portfolio turnover. These strategies for alpha generation originated in the proprietary trading groups of investment banks, which were supported by the large balance sheets and robust operational infrastructure of those banks. Such is not the case for hedge funds, however, which may carry a level of funding and operational risk for which the investor receives no premium.

The objective of this appendix is to present a conceptual framework for quantifying hedge fund failure that may serve as a useful mental model for CFOs and CROs to frame strategic decisions relating to their minimal-level unencumbered cash. Formal quantification of the variables described below and of failure probabilities requires significantly more data than are publicly available and is beyond the scope of this book.