As discussed in Chapter 3, the degree and type of risk varies substantially among strat- egy sectors. Global Macro, Long/Short equity, Short Sellers and Futures/Currency strategies are strongly exposed to broad market risk, while credit risk is an important element of the risk profile for Distressed Securities and Regulation D strategies. Some Relative Value (Convertible Arbitrage) and Event Driven strategies (Risk Arbitrage and Distressed Securities) are highly exposed to corporate event risk. Liquidity risk requires significant attention for Fixed Income Arbitrage, Regulation D and Distressed Securities strategies.
AIS strategies are often distinguished in terms of their exposure to market risk (equity, interest rates, FX, commodities) and credit risk.15Sometimes liquidity risk is added as an extra dimension. Figures 5.1–5.10 introduce a further differenti- ated view on AIS risk and illustrate the various risk types for each of the strategy sectors using a scale from zero to five (zero represents no sensitivity to the risk factor and five represents maximal sensitivity). The illustration is of rather a descriptive nature here and should serve its illustrative purpose.
5 ■Risk in Alternative Investment Strategies 8409 Chapter 5 p136-170 11/4/02 1:14 PM Page 145
MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES
0 1 2 3 4 5
Equity Market Direction
Convertible ArbitrageFixed Income ArbitrageEquity Market Neutral Risk Arbitrage
Distr
essed SecuritiesRegulation DGlobal Macr o
Long/Short Equity Equity Market T
iming Short Selling
Futur es Discr
etionary Active
Futur
es Systematic Passive Futur
es Systematic Active
FIGURE 5.1■Directional market risk: Sensitivity to falling (for Short Selling: rising) stock markets
0 1 2 3 4 5
Equity Volatility
Futur es Discr
etionary Active Convertible ArbitrageFixed Income ArbitrageEquity Market Neutral
Risk Arbitrage Distr
essed SecuritiesRegulation DGlobal Macr o
Long/Short Equity Equity Market T
iming Short Selling
Futur
es Systematic Passive Futur
es Systematic Active
FIGURE 5.2■Non-directional equity risk: Sensitivity to stock market volatility (note that Convertible Arbitrage usually displays an inverse sensitivity to equity volatility)
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5 ■Risk in Alternative Investment Strategies
0 1 2 3 4 5
Yield curve
Convertible ArbitrageFixed Income ArbitrageEquity Market Neutral Risk Arbitrage
Distr
essed SecuritiesRegulation DGlobal Macr o
Long/Short Equity Equity Market T
iming Short Selling
Futur es Discr
etionary Active
Futur
es Systematic Passive Futur
es Systematic Active
FIGURE 5.3■Yield curve risk: Sensitivity to parallel shift in interest rate term structure
0 1 2 3 4 5
Credit risk (default and credit spreads)
Convertible ArbitrageFixed Income ArbitrageEquity Market Neutral Risk Arbitrage
Distr
essed SecuritiesRegulation DGlobal Macr o
Long/Short Equity Equity Market T
iming Short Selling
Futur es Discr
etionary Active
Futur
es Systematic Passive Futur
es Systematic Active
FIGURE 5.4■Credit risk: Sensitivity to increasing default probability and widening credit spreads 8409 Chapter 5 p136-170 11/4/02 1:14 PM Page 147
MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES
0 1 2 3 4 5
Liquidity
Convertible ArbitrageFixed Income ArbitrageEquity Market Neutral Risk Arbitrage
Distr
essed SecuritiesRegulation DGlobal Macr o
Long/Short Equity Equity Market T
iming Short Selling
Futur es Discr
etionary Active
Futur
es Systematic Passive Futur
es Systematic Active
FIGURE 5.5■Liquidity risk: Sensitivity to liquidity decreasing in financial markets
0 1 2 3 4 5
Operational risk (including model risk)
Convertible ArbitrageFixed Income ArbitrageEquity Market Neutral Risk Arbitrage
Distr
essed SecuritiesRegulation DGlobal Macr o
Long/Short Equity Equity Market T
iming Short Selling
Futur es Discr
etionary Active
Futur
es Systematic Passive Futur
es Systematic Active
FIGURE 5.6■Operational risk: Risk of failure due to internal systems, technology, people, external systems or physical events (including model risk)
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5 ■Risk in Alternative Investment Strategies
0 1 2 3 4 5
Corporate event
Convertible ArbitrageFixed Income ArbitrageEquity Market Neutral Risk Arbitrage
Distr
essed SecuritiesRegulation DGlobal Macr o
Long/Short Equity Equity Market T
iming Short Selling
Futur es Discr
etionary Active
Futur
es Systematic Passive Futur
es Systematic Active
FIGURE 5.7■Idiosyncratic equity risk: Risk of corporate event
0 1 2 3 4 5
Transparency
Convertible ArbitrageFixed Income ArbitrageEquity Market Neutral Risk Arbitrage
Distr
essed SecuritiesRegulation DGlobal Macr o
Long/Short Equity Equity Market T
iming Short Selling
Futur es Discr
etionary Active
Futur
es Systematic Passive Futur
es Systematic Active
FIGURE 5.8■Lack of transparency 8409 Chapter 5 p136-170 11/4/02 1:14 PM Page 149
MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES
0 1 2 3 4 5
Leverage
Convertible ArbitrageFixed Income ArbitrageEquity Market Neutral Risk Arbitrage
Distr
essed SecuritiesRegulation DGlobal Macr o
Long/Short Equity Equity Market T
iming Short Selling
Futur es Discr
etionary Active
Futur
es Systematic Passive Futur
es Systematic Active
FIGURE 5.9■Leverage risk
0 1 2 3 4 5
Capacity
Convertible ArbitrageFixed Income ArbitrageEquity Market Neutral Risk Arbitrage
Distr
essed SecuritiesRegulation DGlobal Macr o
Long/Short Equity Equity Market T
iming Short Selling
Futur es Discr
etionary Active
Futur
es Systematic Passive Futur
es Systematic Active
FIGURE 5.10■Capacity constraints 8409 Chapter 5 p136-170 11/4/02 1:14 PM Page 150
5 ■Risk in Alternative Investment Strategies
Broad equity market (‘beta’) risk comes in two forms: directional (price) and non- directional (volatility) risk (Figures 5.1 and 5.2). Next to the ‘beta’ risk (also called
‘systemic risk’), financial market theory (the CAPM) differentiates the idiosyncratic (residual) portion of equity risk, which is denoted ‘corporate event risk’ in Figure 5.7. Interest rate risk is a function of possible yield curve shifts (Figures 5.3). Credit and liquidity risk (Figures 5.4 and 5.5 respectively) often appear simultaneously (except in the case of short sellers, where liquidity risk represents the risk of a ‘short squeeze’). Figures 5.6, 5.8, 5.9 and 5.10 display the different strategies’ exposure to operational risk, the risk of insufficient transparency, leverage risk and the degree of capacity constraints.
Directional and corporate specific equity market risk ranges from high for opportunistic equity strategies (Long/Short Equity, Short Selling) and certain Event Driven strategies (Regulation D, Distressed Securities) to low or non-existent for most Futures strategies. By making bets on the direction of certain equity market sectors and other financial markets (e.g. currencies) Global Macro strategies are directly exposed to directional price risk (in equity, fixed income, FX markets).
Convertible Arbitrage, Equity Market Neutral and Fixed Income Arbitrage in con- trast bear little exposure to directional price moves in the broad equity markets and Risk Arbitrage strategies find themselves in an intermediate range for directional equity risk. But some Relative Value strategies (Convertible Arbitrage and Equity Market Neutral) are exposed to changes in the volatility of equity markets as well as corporate event risk. Note that Convertible Arbitrage carries an inverse sensitivity to equity market volatility, performing well in periods of increasing volatility and showing lower returns in periods of decreasing volatility.
Yield curve risk is most prevalent for Fixed Income Arbitrage strategies, which tend to also be exposed to credit and liquidity risk. The most illiquid strategies, namely Distressed Securities and Regulation D, also come with significant credit risk.
Operational risk in the form of model risk is present in those strategies that rely on pricing and technical trading models, which are mostly Relative Value and Futures strategies. Finally, the strategies with the lowest capacities are the illiquid Event Driven strategies (Distressed Securities, Regulation D) and Equity Market Timing. This last strategy is facing increasing problems in its operation due to the fact that Mutual fund managers are less willing to accept market timers trading in their funds.
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