Operational Risk toward Basel III: Best Practices and Issues in Modeling, Management, and Regulation

CHAPTER 21

Case Studies in Hedge Fund Operational Risks: From Amaranth to Wood River

Keith H. Black

 

 

ABSTRACT

The majority of catastrophic losses experienced by hedge fund investors were in some part related to operational risks. While we cannot discount the role of market risk, operational risk is likely more detectable and more preventable. This chapter describes the debacles at Amaranth, Bayou, Lancer, and Wood River, with a focus on explaining the role of operational risks in these prominent hedge fund failures. Hedge funds that fail for operational reasons often have not submitted data to auditors or third-party pricing or risk management services. Investors who require the use of quality auditors and third-party risk management services may be able to reduce the probability and severity of financial losses due to hedge fund operational risk. A checklist of operational risk issues is included, which can be used as a vital part of the due diligence process.

21.1 INTRODUCTION

While the subject of hedge fund frauds and failures may be uncomfortable to discuss, these discussions are important to increase our understanding of how to prevent future occurrences. Many constituents may be harmed when a hedge fund fails. Clearly, we are concerned about the investors who have lost money during these failures. However, we must also consider the impact on the prime broker and the external partners of the hedge fund firm, including third-party marketers, funds-of-funds managers ...