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Managing Hedge Fund Risk and Financing: Adapting to a New Era by DAVID P. BELMONT, CFA

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Chapter 5

Managing Funding Risk

The global financial system periodically undergoes periods of massive turbulence where funding stability and liquidity are essential to a fund's survival. The events which began in the summer of 2007 are an example. The increasing default rate in subprime mortgages triggered escalating losses on subprime mortgage backed securities, which then created enormous losses at various financial institutions. System-wide distrust in the creditworthiness of financial institutions led to a significant contraction in the tenor and amount of funding available in the interbank market. Brokers then faced funding pressure when global markets and market liquidity declined further. In particular, prime brokers such as Morgan Stanley, Goldman Sachs, Lehman Brothers, and Bear Stearns suffered from a maturity mismatch in their funding structure. All struggled, but Bear and Lehman failed to roll over their short-term liabilities. In such a situation of declining confidence in the interbank market, the banks' willingness and ability to continue extending credit to hedge funds was reduced. In addition, the worldwide decline in asset prices caused severe losses at hedge funds, causing investors to rush to redeem their investments and to put their money into cash. According to Albourne Partners databases, at the peak of the crisis approximately 25 percent of hedge fund assets were gated, locked or suspended. The end result was a dramatic funding crisis at many funds which ...

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