Measuring Loss Potential of Hedge Fund Strategies

25 Pages Posted: 4 Jan 2005  

Marcos Lopez de Prado

Guggenheim Partners, LLC; Lawrence Berkeley National Laboratory; Harvard University - RCC

Achim Peijan

UBS Wealth Managment Research

Abstract

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.

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, E44

Suggested Citation

Lopez de Prado, Marcos and Peijan, Achim, Measuring Loss Potential of Hedge Fund Strategies. Journal of Alternative Investments, Vol. 7, No. 1, pp. 7-31, Summer 2004. Available at SSRN: https://ssrn.com/abstract=641702

Marcos Lopez de Prado (Contact Author)

Guggenheim Partners, LLC ( email )

330 Madison Avenue
New York, NY 10017
United States

HOME PAGE: http://www.QuantResearch.org

Lawrence Berkeley National Laboratory ( email )

1 Cyclotron Road
Berkeley, CA 94720
United States

HOME PAGE: http://www.lbl.gov

Harvard University - RCC ( email )

26 Trowbridge Street
Cambridge, MA 02138
United States

HOME PAGE: http://www.rcc.harvard.edu

Achim Peijan

UBS Wealth Managment Research ( email )

Zurich, CH-8098
Switzerland

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