What that Fed Report Actually Said…
May 6th, 2007 | Filed under: Hedge Fund Industry TrendsThe highly publicized Fed report last week (see previous posting) on hedge fund risk gives a useful lesson on the potential folly of using only one variable to asses “risk”.
It’s often said that “correlation goes to 1″ in times of distress. The report acknowledges the materiality of cross-strategy correlation in assessing hedge fund risk.
“A key determinant of hedge fund risk is the degree of similarity between the trading strategies of different funds. Similar trading strategies can heighten risk when funds have to close out comparable positions in response to a common shock. For example, many funds had to close out positions during the LTCM crisis to meet margin calls and satisfy risk management constraints.”
Tobias Adrian, author of the report, says that covariance is a better risk measure than correlation because it “captures the extent to which their returns move together (or apart, in the case of negative covariance) in dollar terms”.
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