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Explain why both what hedge funds do and the extent to which others are exposed to them may heighten systemic risk.

FRM® Part II · Risk Management and Investment Management · Risk, Regulation and Organizational Structure · FRM2.IM.9.b

The idea

Hedge funds are small next to banks. Yet they can add to systemic risk through what they do and through who is exposed to them. Leverage means a modest loss forces large asset sales to restore margin or leverage targets. Those fire sales push prices down and hit other holders of the same assets. Crowded trades, where many funds hold similar positions, spread losses without any direct link between funds. Margin and haircut increases are procyclical. Stress raises volatility, lenders demand more collateral, funds sell, and volatility rises again. This loop is a margin spiral. Funds also supply liquidity, so their retreat dries up markets. Exposure arises because banks and prime brokers lend to funds, so a large default transmits losses to counterparties, as with LTCM in 1998. Opacity makes these links hard to see. Exam point: the channels are leverage, forced liquidation, common positions, procyclical funding and counterparty links, not the size of assets alone.

Formulas

Asset sale needed to restore a leverage target after a loss

sale = A′ − L × E′

A′
assets after the loss
L
the target leverage, assets over equity
E′
equity after the loss

Debt is unchanged by the loss, so equity absorbs it all. Selling only the equity loss forgets that debt must be repaid too.

Maximum positions that equity can support under a haircut

maximum positions = E ÷ h

E
the fund's equity
h
the haircut on its collateral

Doubling the haircut halves permitted leverage, forcing sales of current positions minus this amount. That is how procyclical margins force sales.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which feature of hedge funds is most directly linked to forced asset sales that can spread losses to other market participants?

  1. Performance fees, which pay the manager directly when markets fall.Why not: Performance fees pay the manager only on gains; they are not a channel for fire sales.
  2. High leverage, since a small loss triggers margin calls and sales. - correct
  3. Offshore domicile, which keeps assets away from regulators and so increases price volatility.Why not: Domicile affects tax and regulation, not the mechanism that forces sales.
  4. Lock-up periods, which force investors to sell fund units when markets fall.Why not: Lock-ups restrict redemptions and so tend to dampen, not trigger, forced selling.

Leverage links small losses to large forced sales: margin calls and leverage limits require selling assets, pushing prices down and hurting other holders of those assets. Lock-ups and fees are not the transmission mechanism.

A harder one

A fund has equity of 100 and assets of 500, so leverage is 5 times. Asset values fall 4 percent. If the fund must restore leverage to 5 times by selling assets and repaying debt, how much must it sell?

  1. 80 - correct
  2. 20Why not: Sells only an amount equal to the equity loss, forgetting that debt must be repaid so equity supports five times as much in assets.
  3. 100Why not: Applies the 20 percent fall in equity to the original 500 of assets.
  4. 16Why not: Applies the 4 percent asset decline to the 400 of borrowing instead of re-levering equity.

Assets fall to 480, so equity falls to 80 and debt stays 400. Target assets are 5 x 80 = 400, so the fund sells 480 - 400 = 80. A 4 percent loss forces an asset sale of about 17 percent, showing how leverage amplifies the market impact.

The hardest tier

Fund A and Fund B have no contracts with each other but hold the same illiquid credit positions. Fund A suffers redemptions and sells aggressively, and prices fall, so Fund B posts losses and is margin called. Which transmission channel is shown?

  1. Direct counterparty contagion, as Fund A's default causes losses on Fund B's contracts.Why not: There are no contracts between the funds; the channel here is price impact.
  2. Regulatory arbitrage, as Fund B moves its positions to avoid capital charges.Why not: Nothing in the scenario involves moving positions to avoid rules.
  3. Operational contagion, as a failure of Fund A's administrator also disrupts Fund B.Why not: Only the shared holdings are described, not a shared service provider.
  4. Indirect contagion through asset prices and common holdings. - correct

Funds with common holdings are linked through prices. Forced selling by one pushes prices down, and mark-to-market losses and margin calls at the other trigger further selling, a loss spiral.

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