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

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Introduction: Managing Complexity and Uncertainty

Hedge funds and hedge fund investing is complex. Managing the risk of a hedge fund is similarly complex. At its core a hedge fund is a portfolio of securities whose future value is uncertain because of investment risk. However, the use of leverage, the operational realities of derivatives trading, the pledging of securities as collateral, and the asymmetric rights granted to investors, prime brokers, and hedge fund managers introduce funding, counterparty, and operational risk. Together these dramatically increase the complexity of the total risk management challenge for the hedge fund and the investment risks faced by investors.

Every hedge fund is unique in terms of its strategies, capabilities, investors, risk appetite, funding profile and legal structure. Collectively, however, hedge funds represent a fragile business model where investors' equity and prime broker funding should be balanced against investment risks and leverage if sustainable alpha is to be generated.

The risk profile of a given hedge fund can appear unique but thoughtful inspection reveals that hedge funds are not in fact a distinct risk species but, rather, share a common risk genus. Aspects of the risk management challenge and priorities for a given fund may be distinct but, fundamentally, hedge fund risks are more similar than they are different. Hedge funds share common vulnerabilities to investment, funding, counterparty and operational risks.

Hedge fund ...

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