HEDGE FUND LIQUIDITY MANAGEMENT
AIM 37.12: Explain the challenges posed by liquidity constraints on hedge funds during times of financial distress, with an emphasis on handling redemptions
Redemption requests,especiallyin timesof marketstress, may requirehedgefund managers
to unwindpositionsrapidly,exposing thefundto transactionsliquidityrisk.If this happens
tomany fundsatonce,lire sales mayresult. Hedge hindsmanage liquidityvia:
* Cash.Cashcan heheldin moneymarket accountsorTreasury billsand unencumbered liqnidity.Cashisnotwhollywithoutrisk, however, becausemoney marketfundsmay suspendredemptionsin timesofstressor crisis,and broker balancesareatrisk if the
broker fails.
* Unpledgedassets. Unpledgedassets,alsocalledassetsin thebox,areassets notcurrently being used as collateral.Theyareoften held writha broker. Price volatilityof theassets affects theirliquidity. OnlyTreasurysecurities,andmorespecificallyTreasurybills, may he usedascollateralduringafinancial crisis.Even governmentagencysecurities were not
sufficient collateral duringthe2007-2008financialcrisis. Unpledgedassetscan besold, rather than pledged, togenerateliquidity.However,intimesof marketstress,asset prices areoftensignificantlydepressed.
* Unusedborrowingcapacity. Thisisnot anunfetteredsourceofliquidityas unused borrowingcapacitycan berevoked by counterpartiesby raising haircutsordecliningro
acceptpledgedassetsascollateralwhen it is time torollover the loan.Theseloansare
typicallyvery short termandcreditcan,asitdid duringthe2007-2008 financialcrisis,
disappear quickly.
During thecrisis, asystemic riskevent,hedgefunds thathad notexperiencedlargelosses still faceda liquiditycrisisas investors,seeking liquiditythemselves,issued redemption
requests.
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Topic37 CrossReferencetoCARPAssignedReading—Maiz,Chapter12
KEY CONCEPTS
AIM37.1
Liquidityhis twoessential properties, which relaceto twoessential forms of risk.
Transactionsliquiditydeals with financialassetsand financial markets andis rekcedto the abilitytosell anassetquickly, cheaplyandwithout moving theprice toomuch.Flanding liquidityis related to individual’sorfirm’s creditworthiness.
AIM37.2
Banksonlyexpect afractionofdepositsandother liabilitiestobe redeemedatany pointin time.Asaresult, theydonot bold alldepositsin liquidassets,butmakeloans withdeposits instead. Thisisknown asafractional-reserve hank andthe process of usingdeposits to finance loansisknown asasset-liabilitymanagement(ALM).
AIM37.3
LSystematicfundingriskswere apparentin manymarketsectorsduringdiesubprime mortgagecrisis.Liquidityissues aroseduring therecentfinancialcrisisforavariety of investmentstrategies,
AIM37.4
Money marketmutual funds (MMMFs) havenetassetvalues(NAVs)equalto$1.00, However, creditwrite-downscan resultin net assetvalues (NAVs) fallingbelow$1.00.This
isknownasbreakingthe buck. Liquidity riskcanalso causeNAVstofall below$1,00.
AIM37.5
Collateral markets enhance dieabilityof firms toborrowmoney.Theyalso makeit possible
toestablish short positionsinsecurities. Cashandsecuritiesmay he borrowedin the market for collateral.
Firmswithexcesscashare morewillingtolendatalowrateofinterest if the loanissecured bycollateral. The fullvalueof thesecurities is notlent. The difference iscalledahaircut.
Collateralizedloansare used tofinancesecurities or otherassetsor trades. The securities pledged toonefirmareoftenloanedor pledgedagain,hencethecollateral circulates. This processisknownasrehypothecationor repledging.
Topic
CrossReferencetoGASPAssignedReading-Mali,Chapter 12
AIM37.6
A firm’sleverageratio isequal toitsassetsdividedbyequity. Thatis:
L_A_(E + D)_1+ D
?
F. E
Returnon equity(ROE) ishigherasleverageincreases, aslongas the firm’sreturnonassets
(ROA)exceeds thecostofborrowingfunds.This iscalled theleverageeffect.The leverage effectcan heexpressedas:
rE-LrA-CL-l)rD
AIM 37.7
Thereisembedded leverageinshort positionsandderivatives suchasoptions andswaps.
Economicbalancesheets canbe constructed tohelp investorsand/or firms measure the implicitleverageof these transactions.
AIM 37.8
Transactionsliquidityimplies thatanasseLcanbe boughtorsold withoutmovingits price.Transactionsliquidityriskisfundamentallyrelated to thecostsofsearchingfora counterparty, die institutionsrequired toassistin diatsearch,andthecostsofinducinga counterpartytoholda position.
To understand transactionsliquidityrisk, onemust understand market microstructure fundamentals.Trade processingcosts,inventorymanagement,adverse selection(i.e.,dealing withinformedversusuninformed traders),and differencesof opinionsregardingasset prices affect transactionsliquidity.
AIM 37.9
Assuming thatdaily changesin the bid-ask spreadare normallydistributed, the 99%
confidenceintervalon the transactionscostindollarsis:
+/- Px +2.33os}
Thespreadriskfactorisequal toVi{s+2.33o5}.
AIM 37-10
Liquidity-adjustedVaR is atoolused tomeasure the risk of adverse price impact. Traders willoftenliquidate positionsoveraperiod ofdaysinorder toensureanorderly liquidation of theposition.
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Topic37 CrossReferencetoGARPAssignedReading—Maiz, Chapter 12 AIM 37.11
Factorssuch as tightness,depth, andresiliencyarecharacteristicsused tomeasuremarket liquidity.Tightness(orwidth) refers to thecostofa round-trip transaction,measured by the bid-askspread and brokers’commissions. Depth describes howlargeanordermustbe
tomovediepriceadversely. Resiliencyreferstothelengthoftime it cakeslumpyorders to
movedie marketawayfrom theequilibrium price.
AIM37.12
Hedgefunds manage liquidityviacash, unpledgedassets,and unused borrowingcapacity.
In timesof marketstress, redemption requestsmay requirehedgefund managerstounwind positions rapidly, exposingthe fundto transactionsliquidityrisk.Ifthishappens to many fundsatonce, hre sales mayresult.
Topic37
CrossReferencetoGASPAssigned Reading—Mali,Chapter12
CONCEPT CHECKERS
JacksonGrimes, a traderfor GlennFunds,worksontherepurchaseagreement
(repo)deskathisfirm* Marketshaveheenhighlyvolatilehut Glenn Funds ha*sa
largecapital base andissound.GrimesreportstotheCEOthatin the last month, thefirmGlenn Funds borrowsfrom hasbeen consistentlyincreasing collateral requirementsto rolloyerrepos. From the perspective of Glenn Funds,diis represents:
A. systematic risk*
B. transactionsliquidityrisk.
C. balancesheet risk.
D* maturity transformation risk.
ChrisClayton,ananalystforaprivate equityfund, noticedthat mergerarbitrage strategiesatseveral hedgefundsexperienced largelossesinlate 2007toearly2008.
These losseswerelikelydueto:
A. abandoned merger plans duetoalackof availablefinancing*
B* targetpricesfalling precipitouslyduetostock marketcorrections.
C. acquirersfilingfor bankruptcyas thesubprunemortgagecrisisunfolded.
D. idiosyncraticriskssurroundingthemerger arbitragestrategy.
With respecttothe valuation ofmoneymarketmutualfund (MMMF)assets, funds:
A. arenotrequiredtomark-to-market theunderlyingassetsdaily.
B. must reflectchangesinthevaluesof underlyingassetsthataredie resultof changesincredit risks butmayignorevaluechanges thataredie resultof changes ininterest rates.
C. willsetthe notional values of each of theunderlyingassetsequal to$1.00.
D. arenotallowedtoinvestinanyassetwitharatingbelowAAA becauseasset valuesmustnotfluctuateoutsideofa10% rangearound the historicalvaluein order tokeepdie notional valueequal to$1.00.
CharlestonFundsintendstouseleveragetoincreasethereturnsonaconvertible arbitragestrategy.Thereturnon assets(ROA)of diestrategy is8%.Thefundhas
$1,000investedin die strategyand will finance theinvestmentwith 75% horrowed funds.Thecostofborrowing is4%.Thereturnonequity (ROE) isclosestto:
A. 4%.
B. 32%*
C. 20%.
D. 12%.
1.
2.
3.
4.
Brett Doningerrecently placedanorder tosell a stock when the market pricewas
$42.12.The marketwasvoladleand,bythe timeDoningeFs broker sold diestock, the pricehadfallento$41.88. In themarket,thisphenomenonisknownas:
A. adverse .selection.
B. transactionalimbalance.
C. slippage.
D. thespreadriskfactor.
Foradditional Book3, Topic 37practice questionssee:
5.
Self-Test Questions:#3(page272)
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Topic37 CI'OMReferenceto CARPAssigned Reading—Mali,Chapter12
CONCEPT CHECKER ANSWERS
C Fundingliquidityriskorbalancesheet risk resultswhena borrowers creditpositioniseither deterioratingorisperceived bymarketparricipantstobedeteriorating. Italsooccurswhen themarkerasawhole deteriorates.Undertheseconditions,creditorsmaywithdraw credit orchange thetermsof credit. Tn thiscase,theLenderisincreasingthehaircutand is thus changingthetermsofcredit. Glenn Fund’screditworthiness docsnotactuallyhavetodecline foralendertowithdraw creditorchangethetermsof credit.
1.
2. A Systematicfundingriskswere apparentin manymarketsectorsduringthesuhprime
mortgagecrisis.Hedgefundsengagedinmerger arbitrageexperiencedlosses in theearly stagesof thesuhprimemortgage crisis.Afteramerger isannounced,thetarget'sstock price typicallyincreasesand the acquirers pricesometimesdeclinesdueto increased debt.
Themergerarbitragestrategyexploitsthedifference between thecurrentand announced acquisition prices. fledgefundsexperienced largelossesasmergerswereabandoned when financingdriedup.
MMVIFsuseaformof accounting called theamortizedcostmethod, under theSecurities audExchangeCommission’s(SEC) Rule2a 7. ThismeansthatMMMFassetsdo uot have
to bemarked-to-marketeachday,as requiredfor othertypesofmutual funds.However,die
valuesofdie underlyingassetsin thefund,despitetheir relativesafety,aresubjecttochange.
Assuch, redemptionsmaybe limitedifassetvalues fall.
3. A
4. C debt=$1,000x0.75=$750
leverageratio=rota!assets/equity'
leverageratio=$1,000/ $250= 4
W-(L"
wherei
=return onassets
rÿ =return onequity
rLJ =costof debt
I. =leverage ratio
return onequitym4(8%) j(4—])(4%)] =32%-12%=20%
5. C Liquidity risksareintroduced when bid-askspieads fluctuate,when thetrader’sownactions impacttheequilibrium priceof theasset(calledadverseprice impact),andwhen thepriceof
anassetdeterioratesinthetime it takesatradetogetdone. When the pricedeteriorates in thetime it takestogetatradedone,it iscalledslippage.
theAIMsiiiemeriLSsetthrillhyGART®.This topicis also covered in: