20 Pages Posted: 13 Mar 2007
Date Written: December 2006
Risk management is a challenge for hedge funds because traditional risk measurement methods based on return data are unreliable with dynamic trading strategies. This paper illustrates how Value at Risk (VAR) methods can be used to measure and control the market risk of hedge funds. VAR methods have two key features: (1) they are based on current position information, and (2) they focus on a lower quantile of the distribution of losses or some other risk metric. For rapidly changing positions, VAR should be measured at frequent interval, as is done for banks' proprietary trading portfolios. This paper demonstrates the usefulness of dynamic risk measures for a hypothetical hedge fund with short option positions, which are equivalent to dynamic trading. Imposing daily ex ante VAR limits using position information can be very successful at controlling realized risk.
Keywords: G11, G23, G32
JEL Classification: risk management, hedge funds, value at risk
Suggested Citation: Suggested Citation