Download Systemic Risk in Hedge Funds

Systemic
Risk in
Hedge
Funds
Bachelor Thesis
Finance
Author: Jan Willem Eggink
ANR:
538020
Supervisor:
Drs. Jinqiang Guo
Bachelor Thesis Department of Finance (300TFI)
Faculty of Economics and Business Administration (FEB)
Tilburg University
Word Count: 7915
Abstract
This paper concerns the link between hedge
funds and the systemic risk. Previous
research on this topic faced some
difficulties in making concrete and definite
conclusions. However, this research was
able to succeed in its intentions. This
research determines the relevant factors in
creating and influencing systemic risk,
concludes on the role that hedge funds play
in the creation of systemic risk and finally,
assesses the contribution of systemic risk
factors in the case of Amaranth LLC and
discovers the reason for the relative small
market impact.
Characterization of hedge funds is
important in determining the potential to
influence risk factors. It is obvious that due
to the characteristics of hedge funds,
investors are frequently not aware of the
risk and reward profile of the concerned
fund. Besides, several attempts to limit risk
exposures of hedge funds by regulatory
institutions [e.g. the Counterparty Credit
Risk Management] do not have the desired
effect.
In addition, a clear definition of systemic
risk and its elements gives us insight on how
this type of risk can be created. Systemic
risk can, in essence, be regarded as the key
driver behind global financial instability.
Several studies have come to the solution
that illiquidity, serial correlations and the
correlation between financial institutions
should be closely monitored to limit the
creation of systemic risk. Therefore, we
should not deny the importance of banks as
financial intermediaries in this sense.
Investigating the role of hedge funds in the
creation of systemic risk leads to two
elements. Illiquidity exposure can severely
damage the ability for financial institutions
to meet obligations, resulting in potential
shocks in the financial market. Also, a high
correlation between institutions in the
market means that the shocks will be
absorbed by the institutions without
causing damage to other institutions. If
these two conditions are met, a hedge fund
holds a high degree of systemic risk with
capabilities of damaging the entire financial
market.
The case study on Amaranth Advisors LLC.
illustrates how these elements work in
practice. First of all, the market risk for
hedge funds can become excessive due to
the unregulated nature of both the hedge
funds and the ICE exchange market for
commodities. Also, in this case the holdings
of large positions with regard to the market
imply a high degree of liquidity risk.
Though, the absence of a high correlation
with related financial institutions leaded to
a relatively limited impact on the global
financial instability. Furthermore, the hedge
funds’ internal control was exposed to
operational risk.
As a conclusion to this report, we can state
that hedge funds create systemic risk. The
extent to which they create this risk
depends on the use of extreme trading
strategies that are often accompanied with
liquidity risk and correlations through other
financial institutions. Only if both of these
conditions are met, the hedge fund is able
to create significant system risk.
1
Table of Content
Abstract
1
Table of Content
2
1. Introduction
3
1.1. Problem Statement
3
1.2. Questions & Hypotheses
4
1.3. Methodology
4
2. Hedge Funds
5
2.1. Hedge Fund’ Characteristics
6
2.2. Hedge Funds’ Risk Management
7
3. Systemic Risk
8
3.1. Systemic Risk’ Elements
9
Financial Fragility Hypothesis
9-10
Other models
10
4. Hedge funds’ role in creating systemic risk
11
4.1. Research
12
4.2 Illiquidity
13-14
4.3. Correlations
15
5. Case study: Amaranth Advisors LLC.
16
5.1. Company description
16
5.2. Causes of the Collapse
17-18
5.3. Impact of the Amaranth collapse
18-19
5.4. Case Study Conclusion
19
6. Conclusion
20
Appendix
21-25
List of References
26
2
1. Introduction
1.1 Problem Statement
The last decade has seen an increase in the
hedge funds industry; the total assets under
the management of hedge funds are
currently estimated at $1.5 trillion and the
funds contribute more than half of average
trading volume in equity and corporate
bond markets (Adrian, 2006). Also, the
availability of data on hedge funds has
increased. The proliferation of hedge funds
is different from the traditional firms: hedge
funds alter the risk/reward profile of
financial investment by yielding double-digit
returns (Chan, Getmansky, Haas, & Lo,
2006). However, as can be derived from the
collapse of the hedge funds Long Term
Capital Management (1998) and Amaranth
Advisors LLC (2006), the realization of these
high rewards can not be achieved without
the commensurate systemic risk. Systemic
risk should not be confused with systematic
risk, which implies the market risk that
affects all financial assets and cannot be
avoided through diversification.
“Systemic risk is commonly used to describe
the possibility of a series of correlated
defaults among financial institutions that
occurs over a short period of time, often
caused by a single major event” (Chan,
Getmansky, Haas, & Lo, 2006). This risk is
dynamic in nature since it arises from the
continuous changes in hedge funds
decisions. In literature, the systemic risk is
ascribed to several factors. This research
will focus on the role that hedge funds can
have on the creation of systemic risk by
deciding on the factors ‘liquidity’ and the
‘correlations between institutions on the
financial market’. It has been proven that
leverage influences the required returns of
capital assets (Amihud, Mendelson, &
Pedersen, 2005). Furthermore, a high
degree of correlation and interrelation
ensures higher systemic risk for hedge
funds (Hartmann & De Bandt, 2000).
In addition, the collapse of hedge fund
Amaranth Advisors LLC in September 2006
will be examined in a case study. Amaranth
LLC was founded in 2000 and sited in
Greenwich (Connecticut, USA). Between
August 31 and September 21, 2006 they
incurred losses on assets that fell from 9.67
billion dollars to 5.32 billion dollars by
trading and speculating on the natural gas
market, resulting in a distress on the
financial
market (Chincarini, 2007).
Remarkably, the giant losses had a relatively
small impact on the industry as a whole
(Gupta & Kazemi, 2006).
The purpose of this paper is to 1) determine
the relevant factors that create and
influence systemic risk, 2) conclude on the
role that hedge funds play in the creation of
systemic risk and finally, 3) examine the
contribution of systemic risk factors in the
case of Amaranth LLC and discover the
reason(s) for the relative small market
impact.
3
1.2. Questions & Hypotheses
1.3. Methodology
Since there is still insufficient evidence in
literature for the definite relation between
hedge funds and systemic risk, this paper
tries to answer the following question:
First, hedge funds’ characteristics and the
differences with traditional firms will be
examined following existing studies on this
topic. Also, systemic risk will be studied
including the relevant factors and systems
that this type of risk could bear. Next,
secondary literature will help to determine
the relationship that systemic risk factors
have with hedge funds and hedge funds’
decisions. The in-depth investigation on
hedge funds and factors that affect the
systemic risk in the financial markets will be
derived from quality literature, e.g. Google
Scholar and the Tilburg University database.
The focus in this part lies on the two predetermined factors already mentioned:
‘liquidity’ and ‘correlation between financial
institutions’. Finally, the exact impact of
hedge funds on systemic risk must be
revealed from literature and thereby, the
H0-hypothesis will be confirmed or rejected.
What is the impact of hedge funds on the
systemic risk in financial markets?
To come to a conclusive answer of the main
question, a set of subjects will be used as a
guideline within the research. The first
chapter will be concerned with main factors
that could create systemic risk. In the
Subsequent chapter, these factors will be
investigated and the relationship with
hedge funds and hedge funds’ decisions will
become visible. These two chapters mainly
deal with the secondary literature studied
and at the end, a literature conclusion will
be drawn. Finally, in the last part of this
thesis the question arises how the decisions
of the American hedge fund Amaranth LLC
had affected the systemic risk factors and
how this could finally lead to a collapse.
After concise readings through the
literature, it is evident that hedge funds and
systemic risk are related. Although, the
exact impact of hedge funds on this type of
risk is still uncertain. In this research there
will be used a hypothesis that states that
hedge funds have the tendency to increase
the systematic risk exposure.
So,
H0 = Hedge funds increase
the systemic risk.
H1 = Hedge funds do not
increase the systemic risk.
Additionally, a case study will be used to
illustrate how hedge funds can create
systemic risk and how this risk had finally
leaded to the collapse of Amaranth Advisors
LLC. The reason why the Amaranth-case will
be discussed and not the Long Term Capital
Market case from August 1998, is that the
Amaranth-case is more recent and less
described by researchers. This case study
will answer why the collapse of a hedge
fund with the size of Amaranth LLC had a
relatively small impact on the industry as a
whole.
4
2. Hedge Funds
In short, hedge funds can be regarded as
largely unregulated private pools of capital
(Kambhu, Schuermann, & Stiroh, 2007). The
core activity of hedge funds is, like mutual
funds, to take a share in a firm with the
ultimate goal of create excess returns in the
form of dividends or increased stock prices.
Unlike traditional firms, hedge funds have
certain characteristics that enable them to
trade opportunistically and generate
spectacular returns, but which can also
generate great losses. In reality, the risk and
reward profiles of hedge funds are often
not widely appreciated and frequently
misunderstood (Chan N. , Getmansky, Haas,
& Lo, 2006). In the Appendix A, statistical
data on hedge funds and mutual funds
underpins the statement that hedge funds
generally have a higher expected return,
but also a higher volatility. Empirical
research by Liang illustrates that hedge
funds [with an undefined strategy] have an
average mean of 0,9044 and an average
standard deviation of 2,1038. In
comparison, mutual funds values are 0,7889
and 2,0389 for the average mean and
average standard deviation respectively.
However, not all of the hedge funds make
use of excessive trading strategies to ensure
high returns, so we should not generalize
negative aspects of hedge funds in this
sense (Smit, 2008).
Until a decade ago, it was unpopular to
invest in a hedge fund because information
about these funds was not widely available
to the investing public until the academic
research started on this topic in the 1990’s.
After the Internet bubble, the Assets Under
Management of hedge funds grew
exponentially and the number of hedge
funds has doubled over the last five years
(Fung & Hsieh, 2006). The growth of the
number and size of hedge funds in the
financial market resulted in a different way
of operating for hedge funds. The increased
clientele of hedge funds required that the
funds increased their transparency,
established better compliance and higher
operational standards (Fung & Hsieh, 2006).
Therefore, the availability of hedge funds’
data has increased on individual level as
well as in hedge fund’ indices (Getmansky,
Billio, & Pellizon, 2007). In many research
the change in operations of hedge funds is
attended. Occasionally, the term of
‘institutionalization’ is used to refer to this
change in the hedge fund industry.
In this section, the characteristics of hedge
funds will be highlighted in comparison with
the characteristics of more traditional
[mutual investment] firms. The focus here
will lay on the effect that hedge fund’
characteristics could have on the risks
involved.
5
2.1. Characteristics
As already mentioned, a hedge fund can be
regarded as an unregulated private fund.
One of the main differences between hedge
funds and mutual funds or traditional firms
is that hedge funds are less restricted by
regulations’ boundaries and therefore, have
the ability to pursue different strategies
which can differ to a great extent (Klein &
Zur, 2006). Hedge funds are, unlike mutual
funds, not obligated to disclose any
information concerning their asset holding.
Hence, hedge funds attract different types
of investors. According to Liang (1998),
hedge funds are either limited partnerships
with no more than 500 investors [within the
U.S.] or offshore corporations [outside the
U.S.]. This regulatory oversight gives hedge
funds’ managers incredible flexibility in
investment decisions. Because of the nature
of private partnerships, hedge funds are not
allowed to advertise to the public (Liang,
1988). This article argues that hedge funds
require 65% of their investors to be
‘accredited’, which means that each
individual investor should have a net worth
of at least $1 million. Therefore, investing in
hedge funds is only applicable to a select
group of wealthy and sophisticated private
investors or to institutional investors. These
investors have the ability to deal with the
hedge fund risk themselves, and thus do not
require a large body of regulatory
protection.
According to Kambhu et al. (2007), there
are four characteristics that can distinguish
hedge funds from other types of money
management funds. First, hedge funds are
not restricted by law to any type of trading
strategy or to any types of financial means
to use. A result of this is that hedge funds
have the ability to make use of exceptional
trading strategies that could involve high
degrees of leverage. Second, hedge funds
fall outside the regulation regarding the use
of leverage. This results in liberal use of
leverage that maximizes the possibilities of
debt. Third, opacity limits the possibilities
for investors to acquire full information
about the hedge fund (Kambhu,
Schuermann, & Stiroh, 2007). This is of
course partially due to hedge funds’
unregulated nature. Last, the managers of
hedge funds in general are paid based on
both scale and absolute performance
through dual fee structures.
These four characteristics can typify hedge
funds. Though, great differences between
hedge funds can still be found. For
delivering high returns the hedge funds can
practice a vast variety of strategies. A
classification of the TASS, one of the three
commercial databases of hedge funds,
makes a distinction between ten strategy
styles that hedge funds can carry out (Fung
& Hsieh, 2006). A listing of these different
types can be found in Appendix C.
One of the reasons that not all research
regarding hedge funds includes satisfying
results is that most research uses indirect
measures for the systemic risk in hedge
funds. This is the only option since hedge
funds are currently not required to disclose
any information about their risks and
returns to the public, so researchers can
only use limited information (Chan N. ,
Getmansky,
Haas,
&
Lo,
2006).
Nevertheless, institutionalization of the
industry has resulted in increased
possibilities to acquire this information. In
the case study with regard to Amaranth
6
Advisors LLC., a further investigation will
illustrate how limited information on the
risks of a hedge fund can potentially harm
the fund and the financial market.
2.2. Risk Management
As we could observe from the previous
chapter, hedge funds have little limitations
in acting on the financial market. At first,
the wealthy and institutional investors do
not need a risk management system for
hedge funds, since there are capable of
dealing with the risk themselves through
diversification. Though, financial institutions
should always have some sort of party that
can reduce the impact of the risk exposure
on financial markets that is out of control of
hedge funds and its investors and that will
supply credits.
One of the primary relations of hedge funds
with financial intermediaries is the
determination of the extent of credit
provided to hedge funds, or the extent to
which a financial institution is exposed to
counterparty
credit
risk
(Kambhu,
Schuermann, & Stiroh, 2007). Credit of
financial institutions is essential in pursuing
a hedge fund strategy, which generally
impose a high degree of leverage. However,
the degree of leverage could force some
risks with a systemic nature. As a buffer
against systemic risks associated with hedge
funds, the Counterpart Credit Risk
Management functioned between the
unregulated hedge funds and regulated
financial institutions. The most important
features of this system are margining and
practicing collateral to reduce credit risk in
leveraged trading. Ultimately, a financial
institution will only be willing to provide a
certain amount of credit when there is
sufficient collateral opposed to it.
Though, according to Chan et al. (2006) the
size of the position is often considerably
larger than the amount of collateral
supporting these positions. If this is the
case, the reduction of risk following the
CCRM system has also its limitation. More
frequently the question arises if systems
that limit the risk in hedge funds, systemic
risk in particular, function truly efficiently.
The CCRM system also finds some
difficulties in directing and regulating hedge
funds properly. How could it, for example,
be still possible for the hedge fund Long
Term Capital Management in 1998, and the
Amaranth Advisors LLC in 2006, to collapse
and create major distress on the financial
markets? In chapter 4 and 5 we will go
further into detail.
7
3. Systemic Risk
Hedge funds differ significantly from
traditional firms in the sense that they bear
other risks.
A common risk that is
associated with hedge funds is systematic
risk, which is the portion of the securities’
return variance that can be explained by
market movements that cannot be avoided
through diversification (Grinblatt & Titman,
2002). This risk should not be confused with
the risk we will deal with in this paper: the
systemic risk.
Systemic risk is the risk that one major
event can create distress on the entire
financial market. The event here can be
described as ‘bad news’ for a financial
institution. The most essential feature of
systemic risk is the potential of financial
shocks to lead to substantial, adverse
effects on the real economy (Kambhu,
Schuermann, & Stiroh, 2007). In the early
days, banking panics were not uncommon
as a result of systemic risk. If losses of a
bank resulted in withdrawals of a large
group of investors, the run on bank assets
could ultimately lead to significant distress
on the global financial system and anguish
for several major institutions, thus creating
systemic risk. This effect can also be called
the domino-effect (Chan N. , Getmansky,
Haas, & Lo, 2006). This effect is essential
and concerns the effect from one institution
to the other, or from one market to the
other, emanating from a limited shock
(Hartmann & De Bandt, 2000).However,
regulation and supervision on the financial
markets have resulted in a considerable
decrease of bank failures, but systemic risk
still exists in different forms now.
De Bandt & Hartmann (2000) mention a
difference between systemic risk in the
broad sense and systemic risk in the narrow
sense. They define systemic risk in the
narrow sense as an event, where the
release of ‘bad news’ leads in a sequential
fashion to considerable adverse effects on
one or several other financial institutions or
markets. However, the broad sense of
systemic risk more than only the events
described above. The broad sense of
systemic risk also includes simultaneous
adverse effects on a large number of
institutions or markets as a consequence of
severe and widespread shocks (Hartmann &
De Bandt, 2000). Defining two different
understandings of the systemic risk enables
us to make distinctions within this concept.
In this research, the focus will lie on
systemic risk in the broad sense, since this
can be regarded as the driver behind global
financial instability.
8
3.1. Systemic Risk’ Elements
The explanation of the concept systemic
risk already indicated that there is some
vagueness and misinterpretation attached
to the concept of systemic risk. Also,
systemic risk is not generally accepted,
unjustly according to Hartmann and De
Bandt (2000), as the fundamental
underlying concept in studying financial
instability and possible policy responses.
Some belief that due to the globalization,
financial events occur more frequently and
that this will possibly lead to more financial
crises. In this section, elements of systemic
risk will be described as investigated by
Hartmann & de Bandt. In addition, other
research on elements will prove whether
the elements described are significant in
determining systemic risk.
Financial Fragility Hypothesis
Philipp Hartmann and Olivier de Bandt
(2000) provide a framework that explains
which elements are crucial in creating
systemic risk. The ‘financial fragility
hypothesis’ mention three features that
potentially lead to systemic risk in financial
markets: the structure of banks, the
interrelation of financial institutions
through direct exposures and settlement
systems and finally, the information
intensity of financial contracts and related
credibility problems.
First, the structure of banks is relevant
when looking at the vulnerability of the
financial market. Normally, the trading
strategy of banks is aimed at only using a
small fraction of their assets as liquid, which
implies a low degree of liquidity. The use of
a fractional reserve holding can lead to
illiquidity and even default, when
exceptionally high withdrawals occur and
short term loans cannot be liquidated.
Nevertheless, the bank might be
fundamentally solvent in the long run
(Hartmann & De Bandt, 2000). Many
researchers argue that it is impossible for
banks to be efficient when they do not use
their leverage to an optimal level. So in this
sense, the success of banks not only
depends on its success in picking profitable
investment projects for lending, but also in
the confidence of depositors in the value of
the loan book and, most importantly, in
their confidence that other depositors will
not run the bank (Goodhart et al., 1998).
Problems arise when banks or other
financial institutions are overconfident;
there will be a greater probability on a bank
run. On the other side, when banks have
less confidence than can be justified, the
optimal leverage ratio will not be achieved,
which means that the bank functions
inefficient.
Second, the interrelation between financial
institutions can result in higher systemic risk
in financial markets. There is a complex
network of exposures among banks.
Humphrey (1986) assesses three types of
exposures among banks. The first is the
interbank money market, which can be
defined by the global financial market for
short term interbank borrowing and
lending. Second consists of the large-value
payments which are determined by the
interbank payments systems. And third, the
systems for delivering securities and
interest stated in the contractual
agreements, settlement systems, complete
the list of exposures among banks
(Humphrey, 1986). Sometimes, these
exposures can be very large, which means
that a failure of one financial institution to
meet obligations directly leads to a
9
decrease in the ability for other institutions
to meet their own obligations. It is likely
that financial shocks will substantially have
higher adverse effects on the economy
when the institutions in the financial market
are highly correlated.
Third, a contributing factor to systemic risk
is the information and control intensity of
financial contracts. Because the calculations
of financial institutions depend not only on
observable facts and figures, expectations
and estimations play an important role
here. Hence, when experts lack information
they include a certain degree of uncertainty
in their calculations, the expectations may
shift considerably and so do the investment
decisions.
“These three features together seem to be the
principle sources for the occasionally higher
vulnerability of financial systems to systemic risk
than other sectors of the economy” (Hartmann &
De Bandt, 2000).
Other models
In other research there is frequently
referred to the problem of insolvency for
banks. Insolvency leads to the failure of
meeting payment obligations and the
possibility of creating distress on the
financial market. A conference on Risk
Measurement and Systemic Risk states that
the source for this insolvency for banks is
liquidity (BIS, 2002). Banks are only able to
be competitive when they are only partially
liquid. However, the larger the degree of
illiquidity the greater becomes the problem
of systemic risk. As a solution, the
conference came up with limiting the effect
of contagion and increase systematic
monitoring (BIS, 2002).
Allen & Gale (2002) established the AG
model to analyze the welfare properties of
the model and understand the role of
central banks in dealing with banking
panics. According to this model it is clear
that the provision of liquidity to the market
plays an important role in the analysis of
financial fragility (Allen & Gale, 2002).
Concluding, the systemic risk is frequently
confused and misinterpreted by both
business people and researchers. Systemic
risk, in general, includes the effect that one
major event [or bad news] can have on
distress in the financial market. This
concept of systemic risk is due to the
globalization highly connected to the global
financial stability and fragility. We briefly
introduced three models that are dedicated
to systemic risk. First, de Bandt & Hartmann
(2000) identify three key features of
systemic risk that can create this type of
risk: the interconnection between financial
institutions, the information and control
intensity of banks and finally, the structure
of banks [including the liquidity].
Interconnection
between
financial
institutions is a synonymous to the term of
correlation, which increases the effect of
contagion described by the Bank of
International Settlements. The liquidity
element often occurs in research on the
topic of systemic risk. The survey by the
Bank of International Settlements underpins
this; because a high degree of illiquidity can
lead to insolvency, this eventually can result
in possible banking failures. Allen & Gale
(2002) share the opinion that liquidity is one
of the key players in systemic risk, which in
turn is the most important influencer of the
financial fragility worldwide.
10
4. Hedge funds’ role in creating systemic risk
After a preliminary investigation on the
characteristics of hedge funds in chapter 2
and an overview of research on systemic risk
and its elements in chapter 3, we are now
arrived at the centre of the discussion. This
chapter we will focus on the role that hedge
funds have on the creation of systemic risk
according to the literature.
measures for the relation between hedge
funds and systemic risk. Chan et al. (2004)
argue that systemic risk is directly related to
hedge fund failures, and the way to
investigate this is by looking at attrition
rates of hedge funds in the TASS database.
Though, the figures presented in the TASS
are from hedge funds that are voluntarily
willing to present the data. In this sense the
data could be slightly deceiving. However,
based on the information available it is still
possible to draw conclusions.
In the past, many authors highlighted the
link between systemic risk and hedge funds,
but frequently the results are less than
satisfying in the sense that they we unable
to draw definite conclusions. This is mainly
due to the lack of information that was
available on hedge funds and on their
intentions. However, there are still studies
that were able to find pleasing results from
their research. Since a decade ago, hedge
funds are more transparent and
information is becoming increasingly
obtainable. There are also some indirect
In this section we will briefly discuss
relevant papers on the role of hedge funds
in the creation of systemic risk.
Subsequently, we will go further into detail
on the elements that are vital in the
systemic risk creation according to
literature. Finally, a conclusion can be
drawn on the role of hedge funds in
creating systemic risk.
11
4.1. Research
Chan et al. (2007) conducted research on
the impact of hedge funds on systemic risk
by examining the risk-reward profile. They
assess two major themes on this topic: the
importance of illiquidity and leverage, and
the capriciousness of correlations among
instruments and portfolios that were
thought to be uncorrelated (Chan N. ,
Getmansky, Haas, & Lo, 2007). Though, due
to the current unavailability of required
information, they are unable to construct a
definite assessment of systemic risk posed
by hedge funds. They did find evidence that
there were some changes in correlations, a
reduced performance and increased
illiquidity. Also, the risks involved in hedge
funds are found to be nonlinear and more
complex than traditional asset classes.
In other research the link is made between
hedge funds’ risks, financial intermediation
and the ‘real economy’. Kambhu,
Schuermann & Stiroh (2007) draw the
attention to the role that banks play as
financial intermediaries between hedge
funds and the real economy: ‘Hedge funds
create systemic risk to the extent that they
can disrupt the ability of financial
intermediaries or financial markets to
efficiently
provide
credit
(Kambhu,
Schuermann, & Stiroh, 2007). Firstly, banks
and other financial intermediaries (e.g.
securities firms) are linked to hedge funds
through the counterparty exposures. Here,
high degrees of illiquidity and excessive
trading strategies of hedge funds will
increase the risk exposures for the financial
intermediary. The Bank for International
Settlements utters that the banks’ direct
exposure to hedge funds has been growing
proportionately with the hedge funds
industry itself. Secondly, hedge funds
difficulties can disrupt broad financial
market activity by interrupting the efficient
functioning of the capital markets and by
hindering the broader provision of credit.
The characteristics of hedge funds,
discussed in chapter 2, have the potential to
create this market disruption. Thirdly, the
banking system disrupts financial markets
and credit provisions in an indirect manner.
If banks or other financial institutions
provide credit to a hedge fund, there should
be a substantial amount of counterparty
credit exposure of trading positions,
collateralizing
financing,
providing
contingent credit lines, and making direct
equity stakes (Kambhu, Schuermann, &
Stiroh, 2007) .Here, the knock-on effect
could create significant disturbance. The
knock-on effect contains the impact of
existing risk exposures on future provision
of liquidity to other banks of hedge funds. If
there is a substantial amount of
counterparty risk exposure for banks, they
are less willing to provide liquidity to other
banks or to hedge funds in the future
trading.
Fung & Hsieh (2006) investigated potential
risks for hedge funds pursuing different
trading strategies. Next to the conclusion on
the risks for strategies separately, they also
conclude on the systemic risk posed by
hedge funds in general. Hedge funds can
become the transmission mechanism of
systemic risk because they borrow from and
trade with regulated financial institutions,
such as prime brokers and investment
banks. Large losses from one or more hedge
funds can cause financial distress to the
12
counterparties they deal with, which can in
turn generate a domino effect to other
financial institutions. This chain reaction is
referred to as systemic risk (Fung & Hsieh,
2006). An important point that Fung &
Hsieh make in this paper is that the focus
should not lie on one specific type of hedge
funds, but that we should be aware of the
risks included in different hedge funds.
As we can conclude from the described
literature, in determining the role that
hedge funds play in the creation of systemic
risk, the relation between hedge funds and
the financial intermediaries are of vital
importance. Since hedge funds interact and
trade heavily with banks and other credit
providers, we should not only look at the
direct role the hedge funds have on the
creation of systemic risk. The key is how
hedge funds influence the risk exposures for
financial institutions and how these
institutions are able to absorb shocks
without creating a domino or knock-on
effect. Here, we are able to make a
distinction between two elements.
Illiquidity can cause that hedge funds are
unable to meet obligations to stakeholders,
including financial intermediaries. The term
of illiquidity is closely linked to correlations.
Illiquidity exposure is the most likely source
for serial correlation (Getmansky, Lo, &
Makarov, 2003). Besides, the higher
correlation between financial institutions
causes that the shocks constituted by hedge
funds are less likely to be absorbed by the
specific institution and will probably lead to
shocks elsewhere in the financial market,
thus creating systemic risk.
4.2 Illiquidity
The term liquidity refers to the degree to
which an asset or security can be traded in
the market without affecting its price
(Grinblatt & Titman, 2002). Kambhu et al.
(2007) distinct two types of liquidity: the
market liquidity, which is the ability to trade
without affecting market prices, and
funding liquidity, which is the ability to
acquire funding in the event of credit
impairment or some other shock. The
influences of hedge funds can be found in
both forms of liquidity.
Chan et al. (2007) state that leverage has
the effect of a magnifying glass, expanding
small profit opportunities into larger ones
but also expanding small losses into larger
losses. Furthermore, the higher the degree
of illiquidity within the portfolio, the larger
is the price impact of a forced liquidation,
which erodes the fund’s risk capital that
much more quickly (Chan N. , Getmansky,
Haas, & Lo, 2007). By looking at the
characteristics of hedge funds, we can say
that hedge funds have the ability to make
use of excessive leverage which can result
in a higher liquidation rate.
Recent trends in the use of leverage have
shown that hedge funds increasingly move
towards less liquid markets. In the presence
of leverage, the combination of relatively
illiquid assets and short-term financing
exposes the hedge fund to possibly
significant liquidation risk (Kambhu,
Schuermann, & Stiroh, 2007). It is important
that both the hedge fund and the
counterparties are aware of the unique risks
involved in liquidity strategies. According to
Wyman (2006), hedge funds tend to
decrease the risk of large withdrawals by
13
adopting longer lock-up periods on their
investors’ ability to withdraw funds, which
gives funds managers more flexibility to ride
out any market fluctuations. However, it is
still of the utmost importance that hedge
funds deal with their liquidity management
because of the potential impact on the
financial market.
Most of all, the absence of sufficient
liquidity could lead to a higher amount of
liquidations, resulting in the creation of
systemic shocks in the financial market. If
the degree of liquidity is relatively low
regarding the accompanying positions, a
large shock can cause damage to the hedge
fund. Potential failures of these hedge
funds can cause shocks which have the
ability to disrupt financial markets if they
are large enough. The liquidation
probability for hedge funds between
January 1994 and August 2004 was
investigated by the TASS, one of the prime
hedge fund databases [stated in appendix
D]. As we can conclude from this empirical
research, the liquidation probabilities for
hedge funds have generally been increased
over this period. Only graveyard funds tend
to perform better. However, the difference
between the observations of graveyard
funds and other hedge funds is due to the
fact that widely-acknowledged successful
funds are likely to leave the database since
their advertising needs for their good
performance are reduced (Baba & Goko,
2006). Though, in general attrition rates
have been rising since 1994. Chan et al.
(2007) argue from these figures that
illiquidity exposure is associated with
attrition rates, which are directly related to
systemic risk. Nonetheless, this empirical
evidence could be slightly irrelevant since
the hedge fund data presented in the TASS
are based on voluntarily participation.
Moreover, liquidity is able to create
potential market instability due to a certain
mechanism, the so-called death spiral’ or a
‘downward spiral’. This mechanism explains
how the relations between market liquidity
and funding liquidity can lead to a higher
degree of financial instability. “Weak
market liquidity tends to increase volatility,
which leads to variation margin and
collateral calls that reduce funding liquidity.
Market liquidity shocks strain a trader’s
ability to fund its positions, as additional
funds (for instance, to meet variation
margin calls) can be raised only by selling
assets into a falling market (Kambhu,
Schuermann, & Stiroh, 2007).“ In the case
of hedge funds, trading losses or
liquidations can erode the capital of traders
like banks, which would typically lead to a
decline of the market liquidity. As a reaction
to this weak market liquidity, volatility for
financial intermediaries will increase and
will lead to a set of higher collateral and
margins, leading eventually to a decrease in
funding liquidity. A low funding liquidity
limits the ability for hedge funds to be
provided with credit. Also, as a reaction to
this, financial intermediaries will be
compelled to sell assets, which enhances
the financial shock to possibly other sectors
of the financial market. If these financial
shocks will lead to substantial shocks
elsewhere in the market, we can say that
this mechanism creates systemic risk.
Ultimately, the use of illiquidity by hedge
funds can lead to a substantial amount of
systemic risk in the financial market. As
research has proven, hedge funds are able
14
to make use of excessive illiquidity; leading
to a higher degree of liquidations which can
erodes the capital of traders. The
downward spiral mechanism explains how
this can eventually lead to a higher amount
of systemic risk in the financial market.
4.3. Correlations
Illiquidity alone does not have the ability to
create significant systemic risk. Though,
there are two forms of correlation which
are able to play a contributing role in
creating systemic risk. We will discuss the
role of serial correlation and correlations
between financial institutions.
Serial correlation, the correlation of a
variable with itself over successive time
intervals, has been proven to be essential in
the creation of systemic risk. The
implications of the serial correlation for
hedge funds are often misunderstood.
Serial
correlation
is a
significant
measurement in assessing the risk and
reward profile of hedge funds (Getmansky,
Lo, & Makarov, 2003). This element has
several potential sources, among which
illiquidity is the most likely explanation.
Getmansky et al. (2003) assess different
sources for serial correlations: market
inefficiencies, time varying expected
returns, time varying leverage and,
incentive fees with high water marks. In
most cases, serial correlation in hedge-fund
returns is not due to unexploited profit
opportunities, but is more likely the result
of illiquid securities that are contained in
the fund.
Second, the interrelation between financial
institutions can result in higher systemic risk
in financial markets. There is a complex
network of exposures among banks through
the interbank money market, the largevalue payment and settlement systems
(Humphrey, 1986). One of the key issues in
systemic risk, according to Hartmann & De
Bandt (2000), is the interconnection
between
financial
institutions.
This
interconnection
between
financial
institutions is synonymous to the term of
correlation, which increases the effect of
contagion described by the Bank of
International Settlements. If there is a high
correlation between institutions, shocks
created by hedge funds are less likely to be
absorbed by single institutions and are
expected to cause shocks elsewhere in the
financial market.
So, correlations can contribute in creating
systemic risk. Serial correlation is caused
mainly by illiquidity and implies that risk
and reward are frequently misleading.
Correlation between financial institutions
enables shocks to lead to significant distress
elsewhere in the market without being
absorbed by one institution.
15
5. Case study: Amaranth Advisors LLC.
In this chapter the theory with regard to
systemic risk involved in hedge funds will be
illustrated in a real life example. First, a
brief introduction on the company will give
the required backgrounds needed for
further investigations. Subsequently, the
causes of the Amaranth LLC. collapse will be
used to illustrate various characteristics of
hedge funds can influence certain elements
of systemic. Finally, this research tries to
give an explanation for the relatively little
impact that the collapse of this hedge fund
had on the financial market as a whole.
Kazemi, 2006). In 2002, Amaranth increased
its stake in energy commodity trading in
both the New York Mercantile Exchange
[NYMEX] and the Intercontinental Exchange
(ICE). The NYMEX is the largest exchange for
trading in natural gas futures, with futures
contracts up to consecutive delivery months
up to five years out. In addition, the ICE is
the leading exchange for the trading of
energy commodity swaps in natural gas and
electricity, but is unregulated by nature
(Chincarini, 2007).
Amaranth Advisors LLC. held positions in
the natural gas market that was too large to
carry. According to the literature, in the
events that followed in September 2006,
the hedge fund made losses of
approximately 3.53 billion dollars of a 7.85
billion dollar fund. Also, in the same period,
they lost 4.35 billion dollars out of total
assets of 9.668 billion dollars. This resulted
in the selling of the energy portfolio of
Amaranth Advisors LLCC. to J.P. Morgan and
Citadel and a liquidation of the remaining
portfolio on September the 20th in 2006.
5.1. Company description
The hedge fund Amaranth Advisors LLC. was
a hedge fund sited in Greenwich
(Connecticut, U.S.) which was an active
player on the global energy market. The
hedge fund was a multi-strategy hedge fund
with
beginning
operations
worth
approximately 600 million dollars in capital
(Chincarini, 2007). The fund sought to
employ a diverse group of arbitrage trading
strategies particularly featuring convertible
bonds, mergers and utilities (Gupta &
16
structural breaks in return patterns arise,
not al of the investors are able understand
this since the risk and reward profile of
hedge funds in unique and difficult to
recognize. This leads to the broad question
whether hedge funds should be obligated to
decrease opacity to the outsiders. In this
case, the unregulated nature of hedge
funds in combination with the unregulated
ICE market has leaded to a fatal strategy for
the hedge fund Amaranth. The Amaranth
Debacle could have been easily avoided if
the ICE had the same authority as NYMEX to
direct Amaranth to decrease its positions
(Gupta & Kazemi, 2006).
5.2. Causes of the Collapse
Chincarini (2006) was able to assess
different dimensions to the risks analyzed in
the case of Amaranth Advisors LLC: the
market risk, which occurs from volatility of
investment returns, and the liquidity risk,
already mentioned in the literature study
on systemic risk. In addition, other research
will help to explain the role of operational
risk in this case.
Market Risk
By holding massive positions with regard to
the energy market, the fund generated an
exceptional high value-at-risk (VaR). The
value-at-risk measures the maximum
amount of losses to the value under the
worst case scenario. The analysis of the VaR
on August 31, 2006 could explain about 65%
of the Amaranth’s losses (Chincarini, 2007).
This means that the company chose to be
involved in a very risky strategy. In the
Appendix E, the daily change in natural gas
positions conclude the high risk exposure
for Amaranth.
Many questions arise if this type of risk
could not have been prevented by
regulatory institutions. Gupta & Kazemi
(2006) argue that there are three issues on
how the collapse of the Amaranth could
have been avoided. First, structural breaks
in their returns pattern should have warned
for a clear change in strategy. Second, the
directing of the NYMEX to decrease the
positions should have constituted some
concern for the investors. Last, the broader
question arises of management of hedge
funds should be obligated to increase
transparency in their actions and intentions.
However, as can be deducted from the
characteristics of hedge funds, these three
issues could not be turned into practice. As
Liquidity Risk
Research by Chincarini (2006) states that
65% of the losses can be explained by the
strategy the company chose to pursue,
while 35% of the losses can be assigned to
the liquidity risk. In the same paper, a
measure to liquidity risk is described by the
size of he trades versus the average daily
trading volume of a security. In here, we
can conclude that the position Amaranth
held in the NYMEX and ICE were extremely
large relative to the average daily trading
volume of the largest natural gas futures
exchange (NYMEX) and were even large
with respect to the open interest. When the
NYMEX officials instructed Amaranth to
decrease the size of its positions with
respect to the NYMEX, Amaranth
responded with an increase in the positions
on the unregulated ICE. Thus, from all of the
losses Amaranth made, not all can be
accounted for by the VaR, but a closer look
should be taken to the liquidity risk involved
in hedge funds.
17
hedge fund Amaranth Advisors LLC.,
operational risk can have a great
contribution to a final collapse.
Operational Risk
In Business Week, Friedman (2006)
classifies the market risk and the liquidity
risk as typical investment risks, and
introduces the term op operational risk. For
researchers of the Amaranth-case, is
important to know how it was possible that
one single trader had access to these large
proportions of the funds assets. Operational
Risk can be accurately described as ‘risk
without reward’, as it is the only risk that
investors face that is not rewarded with the
potentially increased returns (Aldrich,
2006). Aldrich stresses out that investors of
hedge funds should be fully aware of the
operational infrastructure of the fund
concerned.
A
good
operational
infrastructure should increase transparency
which can optimize the internal controls
and procedures. No manager should be
allow assets to be moved outside the fund
on the basis of a single signature and there
should be effective segregation of duties
over cash movement (Aldrich, 2006).
Though, there are no legal limitations for
hedge fund’ traders concerning the size or
concerning the type of asset. Friedman
(2006) states that there are no rules to
prevent a fund's traders from placing
audaciously large bets with assets on hand,
no matter what the fund's investment style
is supposed to be. The head of energy
trading for Amaranth, Brian Hunter, was
responsible for taking too large positions in
the energy market. The fact that he was
successful in the past gave him the
permission and authorization to trade
individually on large scale. Brain Hunter
sometimes held open positions to buy or
sell tens of billions of dollars on
commodities (Till, 2007).
As we can
conclude from the consequences of the
5.3. Impact of the Amaranth
collapse
The giant losses faced by the hedge fund
Amaranth Advisors LLC. had a relatively
little impact on the global financial
instability. This is remarkable, since a similar
collapse of the Long Term Capital
Management hedge fund (1998) had caused
some severe damage in the financial
market. How come, that a collapse with a
similar amount of losses had a relatively
limited impact on the market as a whole?
To answer this question we should refer to
the theory on hedge funds and on systemic
risk as described above.
In the theory as described, there is referred
to two investment concepts that have the
ability to create systemic risk: illiquidity and
correlations. In the case of Amaranth, these
concepts in combination with the
operational risk will explain why the impact
on the financial market was remarkably
small.
First, the concept of illiquidity can provide a
higher risk for the fund and its stakeholders
is applicable to Amaranth. By holding
positions that were too large compared to
the market, they engaged in a strategy
which imposes significant risks besides the
market risk. Operational risk, as identified,
contributed to the possibility to hold these
large positions. Second, correlations can
determine how the shock can be absorbed
by a small number of institutions or
whether the shock leads to significant
shocks elsewhere in the market. Though,
potential shocks somewhere else in the
18
market due to the collapse of the hedge
fund Amaranth, were relatively little. In first
instance, the NYMEX was able to limit the
shock to the financial market by daily
margining and directing the hedge fund
concerned. More importantly, the capital of
Amaranth was divided by a relative high
number of investors. The largest investor
amounted to 8% of the total firms’ capital.
This could be the reasons why the shocks
caused by the hedge fund are absorbed by
the high number of investors and the
reason why the shocks elsewhere in the
market where limited. Ferguson & Laster
(2007) conclude that the Amaranth collapse
posed little systemic risk since the losses
occurred in a relatively small and isolated
market. This is in line with the conclusion
from literature, that correlations between
the other financial institutions and
Amaranth were relatively small, resulting in
relatively low systemic risk.
5.4. Case Study Conclusion
With respect to the case of Amaranth
Advisors LLC., we can conclude that it
illustrates what is described in literature. In
order to create systemic risk, two
conditions must be met next to a strategy
which imposes a high degree of market risk.
First, a high degree of liquidity risk can
cause severe shocks in the financial market.
Subsequently, correlations can explain that
these shocks cause shocks somewhere else
in the financial market and by doing so,
creating systemic risk. However, the
operational risk involved in hedge funds
should not be underestimated. As the
Amaranth-case showed, operational risk
can lead to a significant increase in
investment risks, which have the potential
to lead to a collapse eventually.
19
6. Conclusion
After investigating the role of hedge funds
in the creation of systemic risk, it is evident
that hedge funds create systemic risk. So,
the H0-hypothesis, hedge funds create
systemic risk, can be accepted. The extent
to which hedge funds create systemic risk is
dependent on several factors: the hedge
funds strategy which includes the use of
liquidity, the serial correlation and the
correlation between financial institutions
From the case study it becomes apparent
that operational risk can also be crucial.
2000). Research on systemic risk underpins
the role that financial intermediaries (e.g.
banks or securities’ funds) have in the
creation of this type of risk. Illiquidity
exposure can severely damage the ability
for institutions to meet obligations,
resulting in potential shocks in the financial
market. If institutions in the market are not
highly correlated, this means that the
shocks will be absorbed by the institutions
without causing damage to other
institutions. Furthermore, empirical studies
argue that illiquidity itself is the cause for
serial correlation, making securities and
portfolio’s more responsive to systemic risk.
However, there are some remarks to make
on this statement. First of all, research on
this topic is limited to the information
available. Thus data presented could be
little misrepresentative or slightly outdated.
In addition, the ability of hedge funds to
create systemic risk does not necessarily
mean that every hedge fund does create
systemic risk separately.
The case study on Amaranth Advisors LLC.
illustrates the operational risks that can be
involved in hedge funds. Amaranth was
exposed to operational risk by permitting an
individual to trade individually. Though, the
absence of a high correlation with related
financial institutions leaded to a relatively
limited impact on the global financial
instability.
Though, we can conclude that hedge funds
in general create more systemic risk than
mutual funds. The characteristics of hedge
funds enables them to make use of extreme
strategies, sometimes not fully understood
by every party involved. Therefore, the
counterparty credit risk management
system (CCRM) regulates and directs the
risk exposure faced by hedge funds. Yet,
there are still possibilities for systemic risk
to occur. Systemic risk is often considered
as the fundamental underlying concept in
studying financial instability and possible
policy responses (Hartmann & De Bandt,
Thus, hedge funds have the ability to create
systemic risk and can disrupt financial
markets. The extent to which they can
create this risk is determined by two
investment concepts: illiquidity and
correlations. In addition, operational risk
has proven that it can have a definite and
negative contribution to the creation of
systemic risk.
20
Appendix
Appendix A: Distribution Statistics of Hedge Funds and Mutual Funds
According to Bing Liang: On the Performance of Hedge Funds (1998)
21
Appendix B: Growth of the Hedge Funds Industry
1. Institutional Assets Allocated to Hedge Funds in the US
2. Total Assets under Global Management of Hedge Fund,
according to Hedge Fund Research, Inc.
22
Appendix C: The number of different hedge funds in the TASS-database (1977-2004)
According to the Federal Reserve Bank in Atlanta (2007)
23
Appendix D: Liquidations probabilities for Hedge Funds
Attrition Rates according to the TASS Database (1994-2004)
24
Appendix E: Amaranth’s Exposure to the natural gas market
According to Ms. Hilary TillCo-editor, Intelligent Commodity Investing,
25
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