Quantification of Hedge Fund Default Risk

Abstract

The structure of hedge funds exposes the investor to numerous risk factors such as volatility, counterparty, or liquidity risk. Exposure to these risk factors is not only a source of superior risk-return trade-off but also the very essence of hedge funds' extensive diversification possibilities compared to traditional investments. This article examines the statistical properties of hedge fund failures and attempts to identify essential risk factors that can tentatively explain why certain funds are more likely to default on their investors and creditors than others. In total, 109 cases of hedge fund default between 1994 and 2005 are used in the analyses. Two statistical methods are employed to study the risk profile of these failed hedge funds. First, the mechanisms behind a hedge fund failure are explored in detail and a causal model that can explain the various scenarios in case of a default is proposed. Second, through a stochastic analysis of the sample database, a loss model is proposed for operational failures with the goal of reducing the loss from a single event by decreasing its share in the overall portfolio.