Hedge Fund Issues

AIM 75.6: Explain why risk measurement problems exist in hedge funds.

Hedge funds are a very heterogeneous class of assets that include a variety of trading strategies. Since they often use leverage and trade a great deal, their risk characteristics may be more similar to the "sell side" of the industry. Hedge funds have some other risks like liquidity and low transparency. Liquidity risk has many facets. First, there is the obvious potential loss from having tó liquidate too quickly. Second, there is the difficulty of measuring the exact value of the fund to be able to ascertain its risk. Furthermore, the low liquidity tends to lower the volatility of historical prices as well as the correlations of the positions. These properties will lead to an underestimation of traditional measures of risk. In addition to these risks, there is the low level of transparency. This makes the risk measurement difficult with respect to both the size and type. Not knowing the type of risk increases the difficulty of risk management for the entire portfolio in which an investor might include hedge funds.

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