Measuring Loss Potential of Hedge Fund Strategies
Marcos Lopez de Prado
Hess Energy Trading Company; Lawrence Berkeley National Laboratory; RCC at Harvard University
UBS Wealth Managment Research
Journal of Alternative Investments, Vol. 7, No. 1, pp. 7-31, Summer 2004
We measure the loss potential of Hedge Funds by combining three market risk measures: VaR, Draw-Down and Time Under-The-Water. Calculations are carried out considering three different frameworks regarding Hedge Fund returns: i) Normality and time-independence, ii) Non-normality and time-independence and iii) Non-normality and time-dependence.
In the case of Hedge Funds, our results clearly state that market risk may be substantially underestimated by those models which assume Normality or, even considering Non-Normality, neglect to model time-dependence. Moreover, VaR is an incomplete measure of market risk whenever the Normality assumption does not hold. In this case, VaR results must be compared with Draw-Down and Time Under-The-Water measures in order to accurately assess about Hedge Funds loss potential.
Number of Pages in PDF File: 25
Keywords: Hedge Fund, Value-at-Risk, risk, performance, drawdown, under-the-water, normal returns, non-normal returns, time-dependence, ARMA, Monte Carlo, skewness, kurtosis, mixture of gaussian distributions, survival probability, styles, investment strategies
JEL Classification: G0, G1, G2, G15, G24, E44Accepted Paper Series
Date posted: January 4, 2005
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