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Risk management: Hedge funds take stress test

Better guide to risk than VaR. According to some hedge fund industry participants, stress testing is becoming a more widely used measure of risk among prime brokers and managers.

“We’re seeing a growing number of hedge fund managers look at stress testing, in addition to VaR [value at risk], as part of their risk management,” says Lance Smith, CEO of Imagine Software, a software developer for investment management solutions. “The limitations of VaR have become more obvious in the light of some extreme market events such as [hedge fund] Amaranth’s blow-up.”

Smith continues: “VaR looks at historical correlation of risk factors, which is essentially a type of average. But in calculating risk in the event of an extreme situation, stress testing is more appropriate. VaR is expressed as a multiple of a typical daily movement. You can estimate the daily volatility of returns and then, if you see frequent P&L swings greater than that, you know there is something awry in the portfolio. It’s a good calculation of likely events. But in low probability and extreme situations, correlations are very different and stress testing against different criteria can help show what level of risk a portfolio has.”

Geoff Allan, director of prime services at Credit Suisse in London, points out other limitations of VaR. “VaR is not appropriate for illiquid securities, such as emerging market equities or small-cap stocks that lack trading volumes.

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