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

Funding-based Failure Model

As the experience of the credit crisis showed, the hedge fund business model collapses when funds are unable to fund themselves on an ongoing basis. This may be due to a run on the fund by investors seeking to redeem their shares in a magnitude that exceeds the cash on hand and the cash that can be generated by liquidating the investment portfolio in the short term. It can also be due to increasing margin calls by prime brokers that require immediate posting of cash greater than the cash on hand and the cash that can be generated by liquidating the investment portfolio. Consequently, a simpler and more conservative conceptual framework for modeling hedge fund failure could be one where the failure rule is set at when the hedge fund's unencumbered cash and potential cash from immediate liquidation of its investments is less than the cash required to fund net redemptions and margin. Conceptually, the fund's net cash distribution replaces the net asset value distribution used in the structural model.

Formally, a framework determining the probability of failure over any investor redemption window would be:

where

A = Distribution of Potential Cash Generated by Liquidation of the Investment Portfolio between T₀ and R

B = Distribution of Potential Cash Required due to Net Redemptions payable on R

C = Distribution of Potential Cash Required due to Change in Margin ...