FRM schweser part 2 book 4 2013 (2of 2)

Topic 62 Cross Reference to GASP AssignedReading— Consiantinides et aJ.,Chapter 17Emergingmarket funds invest in currencies, debt, equities,and other instruments incountries withemerging

SCHWESER KAPLAN

2 0f 2

Topic 62

Cross Reference to GASP AssignedReading— Consiantinides et ah*Chapter 17

KEY CONCEPTS

AIM 62.1

Hedgefundsareprivateinvestmentsand haveverylittle financial regulation.They tend to

hehighlyleveraged,and managersmake large bets.On the otherhand, mutual fundsare

regulatedand more structured.

AIM 62.2There have heen majoreventsaffectingdiehedgefundindustryincludinglargelossesfollowingachangeinFed policy in 1994, theLTCMcollapsein 199K,and die dot-comcollapsein 200 1

AIM62.3

Managedfutures funds focuson investments inbond, equity,commodityfutures,andcurrency marketsaroundtheworld.The payofffunctionof thisstrategy issimilar co a

lookbackstraddle

Globalmacromanagers makelargebetsondirectionalmovementsin interest rates,

exchangeraces,commodities,and stockindices, and do betterduringextreme moves in diecurrencymarkets

Mergerarbitrage fundsbetonspreads relatedtoproposed mergerandacquisition

transactions,and perform poorly duringmajormarket declines

Distressed hedgefundsinvest acrossthe capitalstructureof firms thatare underfinancial

oroperational distress,or are in themiddleofbankruptcy.The strategy tendsto have a

long-bias.These hedgefund managerstry co profit froman issuer’sabilitytoimproveits

operation,or come outofabankruptcy successfully

Fixedincomearbitragefunds try toobtain profits byexploitinginefficienciesand priceanomalies between fixedincomesecurities whicharerelated.Their performanceis

correlatedtochangesinthe convertible bond defaultspread

Convertiblearbitragefundsattempt DO profit from the purchase of convertiblesecuritiesandtheshortingofcorrespondingstock

LongAshorcequityfundstake bothlongand short positions in die equity markets,diversifyingorhedgingacross sectors,regions,or marketcapitalizations, and have

directional exposureto theoverallmarket andalso have exposure tolong small-cap/shortlarge-cappositions

Dedicatedshort bias funds tend to take netshortpositions in equities,and theirreturns are

negativelycorrelated with equities

Page 142 ©2013 Kaplan,Inc.

Topic 62 Cross Reference to GASP AssignedReading— Consiantinides et aJ.,Chapter 17Emergingmarket funds invest in currencies, debt, equities,and other instruments in

countries withemergingordevelopingmarkets

Equity marketneutral fundsattempt toachievezero heta(s}againsta broad, secof equity

indices

AIM62.4

The cop 50 hedge funds demonstrated statistically.significantalpha relative to theDJCSI

andHFR1hedge fundindices.Thestrategyof buying large hedge fundsappearstodeliver

superior performance, compared to justinvestinginhedgefundindices.Hedgefund

managersarestill deliveringalpha relativeto peers,and also have lowexposuretothe

U.S.equity market

AIM62.5

Diversificationamonghedgefund strategies maynotalwaysbe effective dueto the

convergenceofriskduring timesofextreme market stress,Thereissignificantcredit-driven

tail riskin ahedgefund portfolio Theuseof managed futuresmaybeapartial solution—it

hasbeen astrategy witha convex performance profilerelativetootherhedgefund strategies

Hedge fundinvestors need toconsider portfolio risks associated withdramaticmarket

events.

AIM62.6

In thehedgefundindustry,risksharingasymmetrybetween the principal(investor) and the

agent(fund manager) is a concernduetovariable compensation schemes

AIM62.7

Institutional investors flocked tohedgefundsbeginningin 2000.With theincreaseof

institutionalinvestment camegreaterdemandson hedge fundmanagementfor operational

integrity and governance

©2013 Kaplan,Inc. Page143

Topic 62

Cross Reference to GARP Assigned Reading-Constantinideset al.,Chapter 1?

CONCEPT CHECKERS

What critical iliifcoccurred inthehedgefundindustry followingdiecollapseof

Long-TermCapital Management (LTCM)in 199H and thedot-com bubbleburstin

2001?

A Therewas asignificantdrop inassetsundermanagementin thehedge fundindustry

B Therewas alargeinfluxofinstitutionalinvestorsinvestingin hedgefunds

C. Reportingwithin thehedgefundindustry became moreregulateddian mutualfunds

D Therewas asignificantincreaseinhedge fundfailures

Whichofdiefollowing hedgefundstrategieswould hecharacterizedas an“asset

allocation”strategythat performs hest duringextreme movesin thecurrencymarkets?

A. Global macro.

B Riskarbitrage

C. Dedicatedshort bias

D* Long/shortequity

Comparinghedgefund performanceduringthe timeperiod2002-2010 toearlier

timeperiods, howwouldmonthlyalphacompare,if lookingatlarge hedgefiruds?

A Alphawashigherin the2002-2010 rime period

B Alpharemained constant over both timeperiods

C A“foresight-assisted” portfoliodid nothaveastatistically significantalpha

duringthe2002-2010 rimeperiod

D Therewas adeclineinalphainthe2002-2010 rimeperiod

JamieChen,FRM, isconsidering investingaclientintodistressedhedgefunds

Whichofdiefollowinginvestmentswouldserve as thebest proxy for thetypesof

A. Focuson investinginfundsfor which the fund managers haveagoodportion oftheirownwealth invested

B Focuson diversifyingamongthevarious nichehedge fundstrategies

C. Focuson funds with improved operational efficiencyand transparent corporate

governance

D Focuson large fundsfrom the“foresight-assisted” group

Foradditional Book 4, Topic62practice questionssee:

Page 144 ©2013 Kaplan,Inc.

Topic 62 Cross Reference to CARPAssigned Reading-Constantin ides et aJ.,Chapter 17

CONCEPT CHECKER ANSWERS

1 B During the timeperiod fallowingthe dot-comcollapseÿ hedgefundsoutperformedthe

S&lP 500with a lower standard deviation, which attracted institutional investment,

2, A Aglobalmacro fund docsbetter if there arc extreme moves in the currency markets,

Alongwith managedfutures,globalmacro is an asset allocation strategy.Managerstafcc

opportunistic bets in different markets The strategy has a low correladon to equities,

3, D Comparing the two different time periods,there was a decline inalphadue to more

competition in the hedgefundindustry,

4, D Distressedhedgefunds haveJongexposure to credit risk of corporations with low credit

ratings.Puhliclytradedhigh-yield bonds are agoodproxy for the returns to expect.

5, A The incentive fee structure within thehedgefundindustryhas notreally changedover the

years; and there is incentive for managers to take undue risks in order to earn fees Thus,

thereshouldhe a focus on investing in funds for which the fund managers have agood

portion of their own wealth invested.

©2013 Kaplan,Inc. Page145

The fallowing is i review of the Risk Management atid Invesunem Management principles designed in address

the AIM statements set forth hy GARP® This topic Ls also covered in:

Topic 63

EXAM FOCUS

New risk measurement cools are required to capture risk exposures foravariety of dynamichedge fund strategies The investment perspective of hedge fund managers isvery differentfrominstitutionalinvestors.Thereis noposition transparency or risktransparencywithhedgefundsas theyare notsubject to thesamedegreeofaccountabilityorregulation requirements.Traditionalstatic risk measures such asvalueat risk(VaR);do not address diewide range ofrisksassociatedwithhedgefunds.Forexample,VaRis an unconditionalstatisticalmeasureofrisk, whilehedge funds varystrategies based on changingeconomicconditions Market VaRdoesnot capturetime-varying risks,creditrisks,liquidityrisks,event risks,orfactorexposurerisks In addition to the lackof transparency,empiricalstudiesof hedgefundsare subject to

survivorship bias, becauseinactivefundsareseldom includedin databasesforanalysis.Phase¬locking behavior and asymmetric correlations are furdier examples of nonlinear risks diat

traditionalriskmetricsdonot capture.Newmetrics,suchas theQ-statisticandtheanalysisofserial autocorrelations, provide valuable insightsregarding the underlying liquidity of hedgefunds

INSTITUTIONAL INVESTORS VS. HEDGE FUND MANAGERS

AIM63.1: Compareandcontrast theinvestmentperspectivesbetween institutional

investorsand hedgefundmanagers.

Hedge fund managersandinstitutionalinvestorshaveverydifferentinvestment

perspectives, but both desire superior investmentperformance.Institutionalinvestorshavespecific fiduciary responsibilities to understandand explain theinvestment process.Hedgefundmanagers,on theother hand, determine the appropriaterisk/returntradeoffwithout

the samelevelof fiduciarydisclosuresince theydonot operate underthesameregulatory

constraints asinstitutional investors.Theyareinstead allowedto protect proprietarystrategiesby not revealing position transparency Therefore,hedgefundmanagersenjoy die

freedom toswitchassetallocation and tradingstrategieswithoutapre-disclosed risk/return

structurethat institutionalinvestors are required to maintain.

The primaryandoftenonly objectiveforhedgefundsis to maximize return,whileinstitutionalinvestors aretypicallyconcernedwithreturn,risk, trackingerror,benchmarks,andpeercomparisons.Theuniquenatureof hedge fundscreateschallengesfor risk

managementduetothe lackof risktransparency.Thus, riskmanagementand risk

transparency areessentialforinstitutionalinvestors,butnotfor hedgefunds.Five unique

aspectsof risk managementforhedge fundsthatcreatechallengesforanalysisare:(1)survivorship hias, (2)dynamic risk analytics,(3) nonlinearities, (4}liquidity, and(5}riskpreferences

Topic 63 Cross Reference to GARPAssigned Reading-Lo

Hedgefundsaredesigned toavoidregulatory constraintsand complianceissues Conversely,

federalandstatecompliancelaws arevery restrictivelorpension plansponsorsand other

fiduciaries.Intellectual property is avaluableassetthat isownedbytheinstitutionand is

a product ofnumerousmanagers However,diereislittle intellectual propertywithhedge

funds, whereit is commonforonemanagerto have soleresponsibilityfor the fund

Figure1illustrates howhedgefund managersdifferfrom insdtudonalinvestorswithrespect

tothefollowingsixcharacteristics: (1) accountability,(2) tradingstrategies, (3) performance

objectives,(4) riskmanagement,(5) regulatoryenvironment,and (6)intellectualproperty.

Figure1:ComparisonofHedgeFundManagersandInstitutional Investors

Accountability Institutions hatvcfiduciary

responsibilityto understand and explain the investment process

Managerdetermines the appropriate risk/rcturn tradeoff

Proprietary and closelyguarded Managers must fully disclose

risk exposures to institutions

andmust maintain strategics

consistent with the institutions

objectives

Return, risk, tracking

error, benchmark, and peer comparisons arc all important

objectives

Risk management and risk

transparency arc essential

Highlyregulated environment

subjectto federal and state

compliance laws for pension plan

sponsors and otherfiduciaries

Trading strategics

Performanceobjective Return is the primary objective

Risk management Non-essential

Fund isdesignedto avoid

regulatoryconstraints and

complianceissues

Regulatoryenvironment

Intellectual property Little intellectual property since

generalpartner is the fund

Well-definedinstitutional

investment process that is not

dependenton arty one manager

GENERATING ALPHAWITH RISK MANAGEMENT

AIM 63.2: Explain howproper riskmanagementcanitself bea source

ahedgefund

ofalphafor

Hedge fund managersoftenaccept more riskinsearchof higherreturns However, amajor

axiomofmodern portfolio theory isdie tradeoffbetween risk and return.Higher returns

areassociatedwith higher risks If die managerisableto truncaterisk throughproperrisk

management, then alpha returns are possible.Thefollowing exampleillustrateshow risk

management can be used to createalpha fora hedgefond

Page147

©2013Kaplan,Inc.

Cross Reference to GARP AssignedReading-Lo

Supposeahedgefundhisanexpectedannualreturnof 10% andanannual standard

deviationof 50%.Thishedgefund manager uses arisk management strategythat limitsdownside returns to-10% Assumingreturnsfollowalognormaldistribution,we can

useagiven table oflognormallydistributed returnswithvariousexpectations, standard

deviations,andtruncation points (i.e.,return thresholds) to find die expected annual return

with the incorporation of the riskmanagement strategy.Wefindthat theexpected return

when eliminatingreturns below-10% will actuallyincrease to 18.9%, nearlydouble die

originalexpectedreturn,which illuscrates die valueofmanagingrisk

Anobvious downside to this risk management strategy is thecostof implementation.Forexample, thecostofimplementingaportfolioreturnfloor of —20%bypurchasingput

optionscouldbeestimatedat15.4%of totalassets basedonthe Black-Scholes-Merton

model.This assumes the risk-free rate is 5%,die strikefor theput is20%

out-of-the-money,and volatilityis75% Themoreeffective the riskmanagementstrategy,themoreitwill contribute to themanagersalphareturn.

Professor'sNote:Youare notexpectedtoknow how tosolvefor the above values

on theexam (e.g., the expectedreturn accordingto a lognormal distributiongiven a return threshold) Thefiguresare usedfor illustrationpurposesonly

Thecalculation methodologiesare notoutlinedin theassigned reading, nor are

they requiredby the AIMstatement.

LIMITATIONSOPVARWHENANALYZING HEDGE FUNDS

AIM63.3:Explainthe limitations of theVaR

hedgefund risks

incapturing thespectrumof

measure

Valueatrisk(VaR) it a commonlyused riskmeasurementtechnique thatestimates the

amount of loss foraspecifictimeperiod Theestimates are typicallycalculated using

volatilities andcorrelations from historical data In thissection, wewill discuss chelimitationsofusing theVaR technique when measuringhedge fund risks

The first limitationofVaRas a riskmeasurefor hedge fundsis related tothefact that hedgefunds exhibita wide spectrum ofrisks.Keycomponentsof hedge fundscanvarygready,

whichcontributes totheheterogeneity ofrisksforhedgefunds.For example,consider the

differences thatcan existbetween die risksofalong/shortequityhedgefund andafixed

incomehedgefund

Keycomponentsofatypicallong/shorthedgefundstrategyinclude diefollowing:

* Investmentstyle(value,growth,blended, etc.)*

* Fundamentalanalysis (earnings,forecasts, accounting techniques)

* Estimationof factorexposures (market indices, industries, characteristics)

* Portfolio optimization{mean-varianceanalysis,market neutrality)

* Short-sellinglimitations (hard-to-horrowsecurities,shortsqueezes)

• Execution costs(price impact, expenses,borrowingrate,shortrebate)

* Benchmarks andtrackingerrors (S&P500orT-billrate).

Topic 63 Cross Reference to GARPAssigned Reading-Lo

Key componentsofa typical Used-income hedgefundstrategyinclude thefollowing:

* Yieldcurvemodels(arbitrageorequilibrium}

* Prepayment models(usedfor mortgage-backedsecurities)

• Option features(call, convertible, put)

* Credit risk(default,interest racerisk, pricerisk).

• Inflationarypressuresand central bankdecisions

* Macroeconomiceventsandfactorsimpactingfixedincome instruments.

Asyoucan see, the keycomponentsand risksfor thesetwo typesof hedge fundsvary

greatly.Compounding these differences, hedge fund managers have much greater freedom

in managing theirinvestmentscomparedtoinstitutionalassetmanagers

Asecond limitationis thatVaRispurelyastatisticalmeasureof risk that doesnot capture

unique risks associated with different underlyingeconomic structures.VaRwasoriginally

designed tomeasurethe riskexposureof portfolios consisting ofderivativesin termsof the

amountoflosscorresponding to a5%tail probability.Thus,VaR maynotapply roother

rypes ofinvestmentscommonto hedgefunds(e.g.,emergingmarket debt, riskarbitrage,or

convertible bond arbitrage} Hedgefundmanagers often usedynamictradingstrategiesthat

vary with different market conditions.MarketVaR doesnot capture these time-varyingrisks

orothertypesof risks,suchasliquidityrisk, eventrisk,andcredit risk

Professor'sNote:Asyou willencounter in other partsofthe curriculum, VaR

has beenadaptedto measure risks other than market risk.Assuch,you will

seehowto calculateliquidity-adjusted VaR, operationalVaR,and credit VaR

However, referencesto VaR by itselftypically onlyrefer totheimpactofmarket

riskon the valueofassets.

Adfirdlimitation is chatVaR Isdifficult to estimatedueto die uncertaintyof tail exposure

fordifferingeconomic structures.Taileventshappen infrequendyandare thereforedifficult

LO associatewithaccurate probabilities.Historical data capturesonlyafewevents, and this

samplesize isoften toosmallfor reliableesdmares.Anodier problem related totailevents

occurswhenVaRisusedas a risk measureunderthe assumption that returns arenormally

distributed.In this case, tailevents areestimated basedonthe meanand standard deviation

of the underlyingdistribution rather than the occurrenceofrare events.Thisisproblematic

sincehedge fund returns are notnormallydistributed.Theyareoften highly skewed and

asymmetrically distributedwithfat tails that implya greaterprobability of dieoccurrenceof

raretailevents.

Afourthlimitation toVaRis that it is an unconditionalmeasureof risk Theterm

unconditionalreferencesthe underlyingdistribution.Thisis adrawback, becausehedge

fundsareoftenactivelymanagedbasedonconditional measures.Forexample,suppose

theVaR measureforaportfolio overdienextweekis $2Qmillion under normaleconomic

conditions Alternatively,aconditional probabilitymeasurebasedonchangingunderlying

marketconditionsyieldsaVaRof$100 million.Historicaldatasuggests thatassetclasses

are morehighlycorrelatedin marketcrises (referred to asasymmetriccorrelations).

Clearly,VaR was not designedto measurethe risks associatedwith hedge funds.Thus,

traditional riskmeasuresdesigned forstatic orconditionalenvironments havemany

limitations with respect tohedge fundanalysis.The unique characteristics ofhedge funds

requirenewrisk measurement tools toaddress dynamicstrategiesandconditions

Historicaldata isused to analyzethe riskofportfoliosandstrategies.However,aftera

hedgefundisclosed,the historical dataof thathedge fundisseldom includedindatafor

future studies.Tire reasonfor thehedgefund's removalit twofold, first,investorsdesire

theanalysisof funds diat areinvestible Second,hindsthatareshutdown donotwishto

disclosedatafor legalreasons*The exclusion of data from funds thatare nolonger active is known assurvivorshipbias A few studies that haveincludeddatafrom inactivefundshavefoundsignificantlydifferent resultswhen survivorship biasis not present.

Toillustrate theimportanceof survivorshipbias,supposethereare nfundswithreturns Jf,

through J?n. Excessreturnsperunitof riskaredefined using theSharperatio asfollows:

Rj ~RF

aj

where:

Rp= risk-freeraceofreturn

o,=standarddeviationofreturnsforassetj

In addition,assumethat die returns areindependentlyandidenticallydistributed (i.i.d.)wididistributionfunctionF(X)

Supposeagroupof hedge fund portfolio managers are ranked basedon their portfolio’sactual realized performance.In addition, assume that noneof thesemanagers possesssuperior selection skills{i.e., noalpha isgained).Thisimplies thattheexpected excess

return per unitof risk for all funds equalszero[E(X+)=0].Thehest-performing fund is no better than dieworst-performingfund, because thereis noalpha.Selection bias willoccur

ifwefalselyassume thatoneof these managers hassuperiorselection skills

Afundmayhe rankedassuperiorbased solelyon die realized performanceof thefundwithoutconsideringthefactthat weselecteditfrom a population of funds Figure2further

illustrates theconceptof selectionbias.Themeansand standarddeviationsof die realized

excess return per unit ofrisk,X*, arereported for the best performing funds outofasample

of nfunds.Assume arestandardnormal randomvariables.Hieselection biasfor a

sampleofonly five funds impliesan excess returnperunitofrisk ratioof 1.163.Asthesamplesize is increased,the bias increases to 2.0428forasampleof30funds

Figure 2:SelectionBiasof Manager Performance

mv fTjÿ n

1.1630

1.5388

1 8675 2.0428

1.0000

0.6690

0.5868 0.5251

0.4958

5

10 20 30

©2013 Kaplan,Inc.

Page 150

Topic 63 Cross Reference to CARP AssignedReading—Lo

Ifweassumenomanagerpossessessuperiorskills andno alphais present, then the historical

performanceisentirelyrandom and the bestperformingfund goingforwardis unknown

A majorityof databases of hedge funds onlyincludecurrentlyactivefunds This impliesa

survivorshipbias, because the fundsareranked basedon historicalrealizedreturnsofonly

thesurviving funds Theperformanceofinactivefundsisignoredandsurvivorshipbiasis

compoundedover rime asonly the hest fundsareselectedtobeincludedindata analysis

Thus, theinvestor mustadjust forsurvivorshipbias to construct anoptimal portfoliowhen

includinghedge funds

MEASURING RISK OF DYNAMIC INVESTMENT STRATEGIES

AIM 63.5:Describe how dynamicinvestmentstrategies complicatethe risk

measurement process forhedgefunds

Hedge fund managersincorporateavarietyof strategies dueto thefreedomfromregulatory

constraints.Theyareable to useleverage, tradeactively, adjustassetallocations, and switch

strategies fnequendy These dynamicinvestmentstrategiescreateconstantlychangingrisk

exposures.Asyou have learned,modern portfolio theoryevaluates systematic risk basedon

thebeta measure,whichisdesigned toonlyexplainrisksforstatic investments However,

withdynamicinvestmentstrategies, nosingleriskmeasure can explain the inherent risk

exposureused by hedgefund managers.Toconfound theproblemofaccuratelymeasuring

risk, thereis norequired position transparency withhedge fundstrategies.Thus,hedge fund

managersareableto protectdteir proprietary tradingstrategies

Ahypotheticalhedgefundcan be used toillustrate how difficultit is to measure the risk

forvariousstrategiesbycomparing the results ofa tradingstrategyand theS&P500index

SupposeahedgefundsstrategyisshortingS&P500 (SPX)putoptions with strikeprices

that are7%out-of-the-moneyand have maturitydatesless thanorequal to three months

foreach monthly expirationdate

Figure3 comparestheshort puthedgefundstrategywith theS&P500 index using

monthlyresults.Thefirst impression from Figure 3suggestsimpressive results for the

hedgefundstrategy,which hasa monthlymean returnof3.7%compared to theLS&P

500 monthlymean returnof1.4%.The annualSharperatioforthehedge fundis1*94

comparedto0.98for theS&P500 index.If this strategywasimplementedfromJanuary

1,1992 toDecember31, 1999,the totalreturnsfor the hedge fondwouldbe2,721.3%

compared to367.1% for theS&P500index

©2013 Kaplan,Inc. Page 151

Topic 63

Cross Reference to GARP AssignedReading-Lo

Figure 3: Performance of ShortSPXPut Hedge Fund andS&P500

Statistics are Based onMonthlyRe turns Short Pal Strategy S&P500

Mean

Standard-deviation

Minimummonthlyreturn

Maximummonthlyreturn

AnnualSharpe ratio

Number of months with negative returns

(total months for period is 96)

Correlation with SAP 500

1

Asnotedearlier, traditional risk measuresdo not capturethecorrect riskexposureforhedge funds-Hedgefundsare not requiredtodisclose their trading strategies, which

isproblematicsince somemanagers mayactually implementasimplisticstrategy.Itis

douhtfol thatinvestorswould payahedge fund manager performance feet forfollowing

such asimplestrategy However,duetothe lackoftransparencyfor mosthedge fund

strategies,investors are notable todetect such behavior without measures chatcapturemore

dynamicrisk exposures

Consider anotherexampleofahypodieticalhedgefund usingadelta-hedgingstrategy.Adelta-hedgingstrategysynthedcallyreplicatesshort posidons.Supposea hedgefundcreates

asyntheticEuropean putoptionfor$l(),O00,0O0insharesofXYZexpiring in twoyears.Also, assume thesynthetic puthasastrike price of $25 and die initial stock price Is$40

As youcan see, this strategyinvolves deep out-of-die-moneyputoptions, Titus, thisis

a contrarianstrategy, where the positioninXYZisincreased (decreased)when the price

declines(increases).

Now suppose thata hedgefondmanagerduplicates thisdelta-hedgingstrategyfor500

fundi.Thisstrategywouldrequireasignificantamountofleverage;however,withoutadditional riskanalysischat addresses the dynamicnatureof this strategy,itwould heimpossible foran investor to truly understandthestrategy'srisks.Evenif the funddisclosed

total position transparency,the underlyingrisks would still notbeclear,

Asdiscussed, traditional mean-variance risk measures basedon staticstrategiesare not

applicablefordynamictradingstrategies, -such asshortingout-of-the-moneyput options

ordelta-hedgingdeep out-of-the-money syntheticputs.Hedgefunds thatshort money putoptions willresult in positivereturns thatare greater than the S&P500index

out-of-the-mostof dietime However, asFigure 3indicates,when the returns arenegative, theyare

signiheandylowerfor theput strategy That is,the standard deviation doesnot capturethe

amount of tail risk from diisstrategy.Therefore,die standard riskmeasurement tools used

by thehedgefondindustryare notsufficientforcapturingthe risksof dynamicstrategies

©2013Kaplan,Inc.

Page152

Topic 63 Crass Reference to GARPAssigned Reading-Lo

NONLINEARITIESIN HEDGE FUND RETURNS

AJM 63.6: Describe haw the phase- Locking phenomenonandnonlineaiities in

hedgefund returns canheincorporated into risk models

“Phase-locking” behavioroccurswitheventsthatcausenormally uncorrelacedactions to

become highlycorrelated Forexample, in the summer of199&, theRussiangovernment

defaultedon itsdebt This defaultevent startedaglobalcrisiswhereassetsthatnormally

hadacorrelationof0 movedtogetherwitha correlationof closeto 1.Itisnecessaryco

explicidy allow dieoccurrenceofphase-lockingeventsinriskmodelsinorderto capture

their impact onhedgefunds.Supposereturns aregenerated by thefollowing two-factor

I,Z, -phase-lockingcomponent orcatastrophicmarketevent

ejf = idiosyncradc risk(error term)

In addition, assume that Zt,andejt areindependentandidenticallydistributed

(i.i.d.)variablesand the following expectedreturnsandvariancesapply:

When die probability ofaphase-lockingevent isvery small, then the expected return

for thefundiscomprised of just oj+PjMt.However, when a phase-lockingevent is

moreprobable, then the thirdcomponent, Z,impactsthe expected returnfor the fund

Thecommon factor,Z(,will dominate theexpected returnwhen there isphase-locking

behavior (i.e.,I,= 1)and thevolatility of thecommonfactor issignificantlylarger than the

volatilitiesof die market factor and theerror term.

The conditional correlation coefficientfor twofunds tandywhen there are nophase¬

lockingeventsoccurring(i.e*,I, =0) isshown below The betasfor thetwofunds,(1

©2013 Kaplan,Inc. Page153

Topic 63

Cross Reference to GARP AssignedReading-Lo

and3-j axeassumed tobe approximately equalat0 in order toreflect themarket-neutral

characteristicof mosthedge funds

PiPjÿM

Corr(R3t,Rjt 11,=0)=

Conversely,die conditional correlation coefficientfor twofunds i andÿcanalso hedefined

when phase-lockingevents are present(Le.,I(= 1).

volatilityof thecatastrophecomponentwill mostlikelybeveryhigh.Thiswill resultin

increasing the correlation to a point thatisclose to 1 for the twofunds chat, under normalconditions,would haveacorrelation close to0

The corneladon measuremostcommonly usedforVaR calculations, portfoliooptimization,

andrisk reports isknown as the unconditional correlation Thismeasure isformulated

by theunconditionalcovariancedivided by the product of thesquarerootsof theunconditional variances.Oneof die hiddenimplicadonsof Equation1 is that die

unconditionalcorrelation isvery small.However, it willtend to increase asthevarianceofthe phase-lockingcomponent increases.

Forexample, if thevarianceof the phase-lockingcomponent is ten times greater thanthe

varianceof the residuals, then the unconditionalcorrelation isapproximately equal to 0.01.

If thevarianceof the phase-lockingcomponent is10Gtimesgreater than thevarianceof theresiduals, dien die unconditionalcorrelationisapproximatelyequalto 0.10 Theexplicitrisk model defined byEquation1,allowsfor the detection ofa phase-lockingcomponent

from standard correlation coefficients Widioursuch arisk model,the phase-locking

component isvirtually impossibletodetect

Asymmetriccorrelation referstothenotion diat heta coefficientsare morehighlycorrelated

with the market indexindown markets dian dieyatein up markets.Thus, asymmetriccorrelationcreatesanother nonlinearityrisk that traditional riskmeasurement models do

not capture This concept isillustrated by thefollowing regression model:

R-it = + Pÿ + Pi +eitwhere:

Mcit Mt>0

6 otherwise

MtifMt<0

0 Otherwise

Mt = return ontheS&P500index

Pi =fundi sensitivityto themarket

MTH{

M7 = {

Page154 ©2013 Kaplan,Inc.

Cross Reference to GARPAssignedReading-Lo

The market returnfor theLS&P500 isseparatedinto an up-market return, M+, and

down-marketreturn, LIffund f$market returnsand betasareidenticalin

up-and-down markets,thenitwill beaspecialcase,whichisequivalent to astandardlinear

regression model

Thisregressionwasspecifically used toanalyzehedgefundsfor the periodJanuary19%

toNovember 1999* Monthly hedgefund returns wereseparatedintopositiveandnegative

returnsandanalyzed usingtheS&P500as the market index.Figure4illustratestheimpact

ofnonlinearitiesoftwohedge fundstrategies Results for theemerging market equities

indexandtheoptionarbitrageindexillustratethat betaasymmetries areinfactpresent

duringdiistime period.Theemergingmarket equities hedgefund hadan up-marketheta

of0.16and adown-market betaof1.49.The relative-valueopdon arbitrageindexhad an

up-market betaof-0.78and adown-market betaof 0.33 Numerousother typesof hedge

fundsweretested usingthesamemethodologyandyielded similarresults.Theseexamples

suggestthehedge fundsexaminedare not trulymarket-neutral

Figure4: NonlinearitiesinHedge FundStrategies

HedgefundStrategy If

Emerging market—equity

Relative value - optionarbitrage

3.78 0.16 1.49 0.11

Empirical resultssuggest theneedfordynamicrisk measurement modelsthatcan account

for phase-lockingbehavior, asymmetries infactor exposures,andother nojilinearities

thatoccurwithactive hedge fundstrategies Nonlinear risk models for all typesofhedge

fundsshouldaddress thefollowingfactors:credit, liquidity, market indexreturns, sectors,

investmentstyle, volatility,and macroeconomicindicators

MEASURING ASSET LIQUIDITY

AIM63.7:Explainhow autocorrelationofreturns canbe usedas a measureof

liquidity"of theasset.

Consideran unrealisticextreme version of marketefficiencywhereall market movements

aretotally random.Themartingalemodelis oneoftheearliestassetpricingmodels where

asset returns areassumedtoheserially uncorrelated In other words, the correlations for

allassetshaveacorrelationof0withoneanother.If markets areefficient with respect

toinformation, then pricechangescannot heforecasted.Thus,asmarkets become

moreefficientwith respect toinformation, pricechangesbecome more random.Market

inefficiencies that couldresultinprofitsare morequicklydiscoveredasthe numberof

market participantsseekinginefficienciesincreases.

En the real-world market, frictionsexist in theform oftransactions costs,borrowing

constraints, informationcosts,and institutionalrestrictions.These marketimperfections

cause asset returns toexhibit serial autocorrelations Illiquidityis oneof themost common

forms of marketfriction.Thus,autocorrelationsare auseful indicatorofliquidityfor die

Cross Reference to CARP Assigned Reading-Lo

underlyingasset*Thedegreeof serialautocorrelation in an asset s returns is a proxy for die

amountof illiquidity friction chat:is present,

Moreliquidassetsshouldexhibit less serial autocorrelation than illiquidassets.For example,residential realestate investments areveryilliquid,andhistorical returnsexhibitmuchhigherautocorrelations than thereturnsof theS&P 500 index*In1965,Samuelson1

suggested that predictabilityin asset returnswill heexploitedandeliminatedonlytothe

extentallowedbymarket frictions.Therefore,evenif residential real estate returns are

highly predictable,it is noteasyto profit from these predictions.Thehigh transactions

costsassociated widi realestate transactions,die inabilitytoshort sellproperties,andothermarket frictions makeitdifficult toprofit from predictionsin the real estatemarket

Anotherreason autocorrelations are an important proxyforestimatingliquidity isrelated

tothecalculationofahedgefund’snet asset value (NAV)*Amarketpriceisdifficult to

determine for assets that are notfrequentlytraded.Thisilliquidityallowsa hedgefund

manager considerablediscretion in determining theportfolio’s valueat theendof eachmondi,which isused tocalculate thefund’sNAV.Hedgefundmanagers havean incentive

tosmooth their returns over timehecause dieircompensationcontracts arebasedon

performance.Smoothingreturns over timealsodecreasesdie volatility of diefund,whichin turn increasesthe Sharpe ratio

When hedge funds smoothreturns over time,diesmoothing processcreates serial

correlation LjungandBox2proposedthefollowingstatistic as asummarymeasureof theoverall statistical significance of theautocorrelations:

each otherout,andfundswith largepositive ornegativeautocorrelation coefficients will

result inlarge Q-statistics

Figure5contrastsserial autocorrelations and Q-statistics for the monthlyreturnsofa

sample ofmutualfundsand hedgefunds.Thefigurereportsnumberofmonths, T, mean,

fit,standard deviation, cr ,autocorrelations pj to p6,and/ÿ-valuesfor theQ-statisticcalculated using thesumof the squared firstsix autocorrelations.Thestatisticsfortwo

mutual funds and twohedgefundsarereportedinPanels A and B,respectively.The results

suggjestdiatserialautocorrelationsareverylowformutual funds,and the Q-statisticsate

notsignificantat the 5% level*Conversely,Panel B reflectshighserialautocorrelationsforhedgefunds, with Q-statisticsthat aresignificantat the5%level

1 Samuelson, P 1965 ‘‘Proof ThatProperly AnticipatedPricesFluctuate Randomly.”Induslriat

ManagementReview, vof* 6, no 2 (Spring): 41—49.

2 Ljung, G., and G, Box 1978, “On a Measure of Lack of Fit in Time Series Models,”

Bwmetrika, Vol 65, No 2, 299-315,

©2013Kaplan,Inc.

Page 1 56

Crass Reference to GARPAssigned Reading-Lo

Figure5:Autocorrelation % ofMonthlyReturns forMutual andHedge Funds

Large mutual fundstypicallyinvest inhighlyliquid securities.Therefore, itis notsurprising

thatdie serial autocorrelationsfor mutual fundsarelow In addition,SECregulations,

detailedprospectuses,and dailyNAVcalculationspreventprice manipulationorsmoothing

ofreturns.Conversely, the hedge fund sample revealssignificantautocorrelations and

Q-statistics thatare reflectiveof potential returnsmoothingandilliquidityof theunderlying

securities.Thus, theresultssuggest autocorrelations,and Q-statistics provide valuahle risk

metricsfor liquidityexposuresinhedgefunds

Other IssuestoConsider

Riskpreferencesareimportant from both die manager’s andinvestor s perspective

Hedge fund managersareoften compensated with nonlinearpayoffs basedonfixedand

performanceincentives.Thus, thereis an incentive forexcessiverisk-takingon die partof

the manager Inaddition, the behaviorof investors also influences hedgefond managers

Hedgefund investments are sometimesreferredto as“hot money,” which may encourage

hedgefondmanagers tobe moreaggressivein takingon risks Furthermore,lock-up periods

areoften imposed to prevent investorsfrom panicking and runningin periods ofpoor

performance.Risk management toolsshouldalsoconsider theserisk preferencesof both

managersandinvestors.

Operacionnlrisks refertoorganizationalcharacteristics,suchas back-officeoperations,legal

infrastructure,accounting practices, personnel, trading,andmanagementpractices These

risks,while difficultto quantify,shouldnotbe ignored

Institutionalinvestors,suchas pension funds, mayfind that hedge fundsaregoodfits

for their optimalriskportfolios.However, fiduciary responsibilitiesrequirebetter risk

measurementsthat reflect risk transparencyof thehedgefunds.Forexample, plansponsors

managepensionfundassets to minimizethe riskofdefaultingon the plan's liabilities

However, acompletelyimmunized portfolio againstdefaultsisoften toocostlytoobtain

Thus, managersmaintain a“surplus1’ ofassets toliabilitiestohelp control tills risk It is not

clear how muchsurplus thereshould be and whatis anacceptable level ofdefaultriskfor

differenttimehorizons, suchas one,five,or twentyyears Better risk measurements that

capture these dynamicaspectsof pensionfundsate requiredforfinding theoptimal risk

exposure for pensionportfoliosthatinclude hedgefunds

Topic 63

Cross Reference to GARP AssignedReading-Lo

KEY CONCEPTS

AIM63.1Theinvestment perspectivesof hedge fundmanagersareverydifferent than those ofinstitutionalinvestors Thisdifferenceislargelydue to the lackof positiontransparency

andrisk transparency.Thus, majordifferencesare reflectedin thefollowingcharacteristics:accountability, tradingstrategies,performanceobjectives,riskmanagement, regulatory

environment,andintellectualproperty.

AIM63.2

Ifreturns followalognormal returndistribution, thenhedgefond managers maybeable to

createalphareturnsby truncating downsiderisks

AIM63.3ThefollowingarelimitationsofVaRas ariskmeasurefor hedge funds:

* Hedge funds areexposed to awide variety of risks that VaRcannotmeasure

* VaRdoes not captureuniquerisksfor varyingeconomicconditions

* VaRisdifficultto estimatebecause of uncertainty relatedtotailevents.

* VaRis an unconditionalmeasureofrisk, buL hedgefundsuseconditional strategies.AIM63.4

Survivorshipbiasrefers to theexclusionof data from inactive fundsin hedgefonddata andanalysis

AIM63.5

Standardriskmeasurement cools donot accurately reflect the risks ofcertain hedge fond

strategies thatare not required toreveal positionsorstrategies For example,shorting

out-of-the-moneyputoptionsordelta-hedgingstrategiescan createimpressive, butmisleadingperformance results usingtraditional risk measures

AIM63.6

“Phase-locking1’ behavior refersto the phenomenonwherean event causes assetsthatnormallyhave zerocorrelation tobecomehighly correlated.Asymmetric correlation refers

toanothertypeof nonlinear riskinwhich correlation coefficients approachonewhen die

U.S.market Isin adownmarket.

AIM63.7The Q-statisdcIsanabsolutemeasureofcorrelations,becauseitsumsthe squared

autocorrelations.Q-statisticsand serial autocorrelationsarevery usefulinmeasuring the

liquidity risk fora hedgefond

©2013Kaplan,Inc.

Page1 58

Topic 63 Cross Reference to GARPAssignedReading-Lo

C areequallyconcerned with riskmanagementandreturnperformance

D have little intellectual property asdiefondtypicallyrelieson oneindividual

Constructingoptimal hedgiefund portfolios basedonanalysis of onlyactivehedge

funds resultsin;

A riskier portfolios

B survivorship bias

C excess returns oralpha

D lower Sharperados.

Creatingsyntheticputopdonsondeepout-of-the-money Europeansecuritiesis a

strategyreferred to as:

A. market-neutral

B synthetic-hedging

C. delta-hedging.

D along/shortstrategy.

Whichof thefollowingstatementsdoesnotaccuratelydescribea limitationof using

VaRas a riskmeasureforhedgiefunds? VaRis:

A purelyastatisticalmeasureof risk that doesnot captureunique risks associated

with different underlyingeconomic structures.

B difficultto estimateduetothe uncertainty of tail exposure fordifferent

economic structures.

C a conditionalmeasureofrisk.

D notabletoaddress the widespectrumof risks that hedge fundscover.

A useful measure for assessingliquidityriskforhedgiefundsisdieQ-statLstic

Whichof thefollowingstatements is trueregardingthe statistical significance of the

Q-statLsticmeasure?

A. Smaller indicate chatautocorrelationsare more startsdcallysignificant

B Wewill be 99%confident thatwe can rejectthenullhypothesis ofno

correlation when the test statisdchasaÿ-valueof0.1,

C Thenull hypothesis of posidveautocorrelationscan berejectedwhen each

laggedautocorrelationiscloseto zero.

D Larger/ÿvaluesindicatechatautocorrelationsare morestatisticallysignificant

Cross Reference to GARP AssignedReading-Lo

CONCEPT CHECKER ANSWERS

1 L C Hedgefund managers enjoy considerablefreedomfrom regulations andcomplianceissues

comparedto pension plan sponsorsand other fiduciaries.Theyare not as concerned with risk

management, and there is little risk transparency as the fund returnperformanceis the major objective The fundtypicallyrelies on thegeneralpartner who protects proprietary strategies.

2 B Survivorship bias occurs when funds arc ranked based on historical realized returns of only

the currently active funds,excluding underperforminginactive funds TheSharperatios, or excess returns per unit of risk will be biasedupwardfor thesampleoffundsselected from

onlv surviving funds.

3 G Delta-hedgingis a well-known strategy that createssyntheticpur options ondeep

out-of-the-moneyEuropean securities,

4 C VaR is an unconditionaltmeasure of risk,referringto the unconditionalunderlying

distribution It docs not capture risks associated withhedgefunds that are often activelymanagedbased on conditional measures.

5 A The Q-statLstic reflects the absolutemagnitudesof the correlations, because it sums the

squaredautocorrelations Thus, the signs do not cancel each other out, and funds with large positive or negative autocorrelation coefficients will result in largeQ-staristics Fund managers have an incentive forsmoothingthe returns ofilliquid funds.Thissmoothing

process results in serialautocorrelations.As with most statistics, the smaller the for the statistic, the greater our confidence in die inference madebyrejecting the null

hypothesis

©2013Kaplan,Inc.

Page 160

The fbllowbig i-s i review of (he Risk Mali jÿeiuenL mJ Invesuitem Management principles designed to address

the ATM sniemenLS SCL forth byGART®.This topicis also covered in:

Topic 64

EXAM FOCUS

This topicfocuseson the roleof due diligencein thedelegated investment decision-making

process* Specifically, investors in hedge funds not only delegate decision-making to fund

managers,hut theyalsooften dosowith littleinformation about diefundorfundmanagers

The markeris non-transparent,and thus investorsmuse trustmanagers.However, somehedge

fund managersfail co reportor mislead investorsregardingpast regulatoryor legal prohlems

Past problems, and more importantly, crying to hide past legal and regulatory problems

from investors, is a leading indicatoroffuture operational risk Issues.Institutionalinvestors

sometimes hire third-partydue diligencefirms togadier andverify information about fund

managers.In the process, these firms uncoveroperationalriskfactors Therefore,duediligence

isimportantfor identifying inadequateorfailedinternalprocesses withinhedgefunds

Investors in hedge funds delegateinvestmentdecision-making LO fundmanagers.Auditing

isexpensiveand marketsaregenerallyopaque Itis aclassic principal-agent relationship

where thebehavior oftheagents, the hedgefund managers,isdifficult toobserve.Assuch,

theintegrityof managersiscritical

Operational riskisdefined by the BaselCommittee onBankingSupervision1as “the risk

of direct orindirectloss resultingfrom inadequateorfailed internal processes, people,and

systems orfromexterna!events."TheBasel Committee distinguishes operational risk from

market risk andinsolvencyrisk Severalacademic studiesfind thatoperationalrisk has

resultedin morehedgefund failures than hadinvestmentdecisions andothertypesof risk

DUE DILIGENCE IN THE INVESTMENT DECISION-MAKING PROCESS

AIM64.1:Explainthe roleof third pattyduediligencefirmsinthe delegated

investmentdecision-making process

Hedge fundinvestors are“sophisticated" and supposedly do not need dieprotectionof

regulationsthatguardmutual fundinvestors.Therefore,with theexceptionofabrief

periodin 2006, U.S.domiciled hedgefundshavegenerally notbeen required toregister

wirh the LSecuridesandExchangeCommission (SEC).If theyregister, theygenerally doso

voluntarily

“WorkingPaper on the Regulatory Treatment of Operation al Risk," Basel Committee on Bank

Supervision,Working Paper# fl, September 2001.

1.

Cross Reference to GASP Assigned Reading-Brown at al.

Professors Note: ThePrivateFundInvestmentAdvisers RegistrationActof

2010 wiltrequirehedgefundiwith morethan$100million in atsets under

management to register with theSECas investmentadvisors

Public dataservices,suchastheLipperTASS database and theCenterfor InternationalSecurities andDerivativesMarkets(CISDM)hedgefund datahase, alsorelyonhedgefunds

tovoluntarily provide information regardingfees, performance, theuseofleverage,and

hedgefund style

As aresult, thereislitde publicly available information regardingthestrategies,performance, risk,organizationalstructure,andpersonnelof hedgefunds.Thefundofferingmemorandaisviewedby potentialinvestors butis notavailabletothegeneral

public

Severalinstitutions havedevelopedinresponse to the lackofinformation and transparency

regarding the character andactionsof hedgefund managers.Theseincludethefollowing;

* Third-partydue diligence firms

* Independentauditors

• Regulators

* Informal networksofinvestors transferring information viaword-of-mouth

Informationisgenerated by theseoutsideentities thateidierincreases ordiminishes theperceived trustworthinessofahedge fundmanager

Third-party due diligence firmsarehiredbyhedgefund investors togather andverifyinformationabout thehedgefund.Funds-of-hedge-fundsaretypicalclients; however,

investmentbanksorwealthyindividualsmayalsohire these firms.Theclientisgenerallyinterestedin investing in thehedge fundbutwouldlikemoreinformadon thanisprovided

by the fundin theprospectusand related documents

The typical reportprovided bythethird-partyduediligence firmranges from 1 00 to 200

pages hut maybe severalhundred pages inlength.Alongwith the verificationoffund

informationregarding performance,fees,personnel, andstyle, redflagsareraisedbydiefirm regardingpotentialoperational risk factors Togather information andidentify

concerns,die firm will do thefollowing

• Thoroughlyreviewoffering documentsand marketingmaterials provided by the fluid

manager

* Examineforms filledout in theduediligenceprocessbyfundmanagers

* Interviewfund managers

• Attempttoverify theauditreportwith the fundsauditor

* Verify operationalcontrols,assetsunder management,and performancefigureswith the

fundadministrator

* Performa backgroundcheckon managers and other key hedgefundstaff

Oneof thegoalsof diediird- partyduediligenceprocessis toidentify imperfect orfailedinternal processes.The firm identifiesdiscrepanciesandmisstatementsmade by fund

managersregardingperformance and controlprocesses by cross-checking information withmultiplesources.

©2013Kaplan,Inc.

Page 162

Topic 64 Cross Reference to GARP Assigned Reading—Brown etaJ.

Incontrast to theTASSandCISDMdatabases, whichfocusprimarilyonquantitative

factors suchasfees, assets, returns,and leverage, thedue diligence reportalsoreveals

qualitativefactorssuchas:

* Themethodbywhichasset/portfolio valuesaredetermined

* Howandbywhom theday-to-day accountingof thehindisaccomplished

* Substantiationof dieaccuracyof the data provided bythefund

* Howcontrol processesareperformed

Operationalissues,whichare notevidentin publichedge funddata,could potentially be

revealedin third-partyduediligence reports.

HEDGE FUND REPORTING ISSUES

AIM64.2:Explainhowpastregulatory and legal problemswithhedgefund

reporting relates to expectedfutureoperational events.

Inastudyof444duediligencereportscompiled bya third-party duediligencefirm,

Brown, Goetzmann, Liang,andSchwarz2find that4l% of the fundsstudiedhave had

someform ofregulatoryorlegal problem.Thisisinterestingin that it is morethan twice

die percentageof funds self-reportinga problem in astudy of the2006Form ADVflings

byBrown, Fraser,andLiang.3

Professor'sNote: TheForm ADVistheuniform form used by investment

advisorsto register with theSECandstate securitiesregulators. Theform

requiresthefundtoprovide informationabout theinvestmentadvisor's

business, ownership,clients,employees, businesspractices, affiliations,and

anydisciplinaryeventsoftheadvisororthefirm's employees.Firmsmight be

disinclined toprovide informationaboutregulatoryor legalproblemsina

publiclyavailable medium,suchas SECregistrationforms. Somemanagers

whoarelesstrustworthy mayeven misrepresenttheextentofpastproblemsor

deny them altogether Thethird-partyduediligencereportshoulduncoversuch

discrepancies.

Thethird-party due diligencefirm in theBrownetal.study compared self-reported

statementsregardingpastregulatory and/or legal problemsto third-party records(such

as audit reports or discussionswithprime brokers)and noted whether there were

discrepancies.In addition, Brownetal.separated problemfunds(those funds dial have had

legal and/orregulatory problems) from non-problem funds and analyzed the characteristics

of thetwogroups

2. StephenBrown, William Goetzmann, Bing Liang,ChristopherSchwarz, “Trust and

Delegation,”May28, 2010.

3 StephenBrown, Thomas Fraser and Bing Liang, 2008,HedgeFund DueDiligence:A Source of

Alphain aHedgeFund PortfolioStrategy,”Journal ofInvestmentManagement,6,23-33

Topic 64

Cross Reference to CARP Assigned Reading-Brown at d.

Basedon univariate tests, common characteristicsofproblem fundsincludethefollowing:

* Generallymoreilliquidwith longer lock-upandredemption periods

* Lesslikelyto useindependent pricingprocedures forasset/portfolio values (perhapsin

partdueto dieilliquidityofassets).

* Lesslikely dian uon-prohlemfundstohaveaBig4auditor

• More likelytoswitch datavendors

* Similarsignaturesetupsfor transferring funds buLahigherlevelof verification problemsrelativetonon-problem funds

• Generally largerthannon-problemfunds This may simply indicate that there are more

opportunitiestosuelargerfunds than smallerfunds

• Generallyhave poorer operational controls than non-problemfunds

Infurther analysis,Brownetal.uses alogistic modelto examinethe relationshipbetween pastlegalor regulatoryproblemsand theoperationalriskof the fund.Thefindingssupport

the univariate results and indicate that funds with pastlegal/regulatory problems generallyhave poor operationalcontrols

In addition,a lackofhonestyfrom fund managersregardingpastlegalandregulatory

problemsis aleadingindicatorof operational problemsin the future.The failureto usea

Big4orwell-knownaccountingfirmisalsoanindicatorof future operational problems.Theauthorsconclude that information verification, suchas thatprovided by diird-party

due diligencefirms,isimportant inlightly regulatedindustries, suchasthehedgefundindustry

Brownet al,also deriveadirect measureofoperational risk, referredto as thetu-score.

Again, supporting the aboveunivariateresults,they find that:

* Funds widi better pastperformancehaveloweroperational risk

* Funds with highqualitymanagershaveloweroperational risk

* Funds withlongerlock-upandredemption periods have higheroperationalrisk

* Smaller or newerfundsgenerallyhavehigher operationalrisk

* Fundswith smoothedreturnshave higher operational riskTheauthorsfind diat hedge fundswithexposuretooperational risk,as measured by the

w-score,haveanincreased chanceoffuturepoor performance.Ato-scorehigher than diemedianscore,fora given time period,is anindicadonofhigh operadonalrisk

INDENTIFYING INADEQUATE OR FAILED PROCESSES

AIM64.3: Explain the roleof the duediligence processinsuccessfullyidentifying inadequateorfoiled internalprocess.

The hedgefundindustryis notedfor itslackoftransparency. Hedge fundmanagersare reluctant to revealdetailsabout thefund,especially if theyengageinproprietarytrading

strategies Fund managersarenotrequired to registerwiththeSEC,thoughsomefundsdo

sovoluntarily.Evenfund information reported in publicdatabases,such asLip perTASS

andCISDM,ofteninclude unverified,voluntarily providedinformation aboutspecificfunds

©2013 Kaplan,Inc.

Page164

Cress Reference to CARP AssignedReading—Brown etaJ

In thisenvironment, theduediligenceprocessiscriticallyimportant Duediligence

identifies inadequateorfailed internal processesby uncovering and verifying information

Asnoted,third-partyduediligencefirmsgatherandverify information about thefundfrom

a numherofsources,including theoffering documentsof die fund,marketingmaterials,

interviewswithfund managers, forms filledout byfund managers,background checksof

key employees,andinterviewswith prime brokersand administrators,

Firmswho use oneof theBig 4accounting firmsaresubjecttoduediligencein thesense

that diese firms typically pre-screen managersforvariousoperational riskfactors before

cakingthefundon as aclient.Oneofthe redflagsin theBernieMadoffPonzischeme

wasthe lackofaknown auditing firm MadofPsfirm,which had billionsofdollars under

management,wasaudited byFriehlingandHorowitz, a three-personaccountingfirm

operatingoutofastrip mall

Byverifyingand cross-checkinginformation across sources,dieduediligenceprocess

can uncoverfailuresin die internalprocessesof thefund,whichin turnlead toincreased

operational risk,

Professor’sNote: One wouldassumethat would-be investorsengagein due

diligenceto uncover riskfactorsand either avoid the riskorprice the riskinto

theexpected return However, Brown etal.find, surprisingly, thatinvestors

appeartochase past returnsregardlessoftheoperationalrisk characteristics

duediligence reportsexaminedin theBrown etaLstudy, theflow of capital

into someproblem hedgefunds wasunabated Infact, thestudyfindsthat

therewerehigherinvestorflows after the due diligencereport, indicating

thatinvestors arecomfortableinvestingin thesefunds despitetheexposure to

operationalrisks uncovered by third-party due diligenceproviders.

©

Cross Reference to GARP Assigned Reading—Brown et al.

KEY CONCEPTS

AIM 64.1Investors delegate investmentdecision-makingauthoritytomanagersofmutual funds

and hedgefunds.The behavioroffundmanagers, atleast with respect tohedgefunds, is

generallyunobservableto investors In thisprincipal-agent relationshipthatexistsbetween

investorsand managers, trust isessential

Operationalrisk,asdefined bythe BaselCommittee on BankingSupervision,is risk

of director indirect lossresulting from inadequateorfailed internalprocesses,people, and

systems orfrom externalevents.”Operational risk has resultedin morehedgefundfailuresthan other typesofrisk,accordingtoseveralstudies

Third-party due diligencefirms collect andverifyinformationabouLhedgefundmanagers.Typicalclients includefunds-of-hedgefunds,aswellas institutions andwealthy individuals

Third-party duediligencefirmsexamineandcross-validateinformationfromofferingandmarketingdocuments, interviewswith fund managers, forms filledoutby managers,

interviewswithauditorsandfund administrators regarding audited information,performancefigures,assetsunder management,andoperationalcontrols.Theyalsoperform

backgroundcheckson the managers and key employees of thefund

AIM64.2Past regulatoryandleg4problems, and perhaps moreimportantlyalack of honesty from

managersregarding theseproblems,is aleadingindicatoroffutureoperational problems

Funds diat havelegalandregulatory problems,referred to asproblem funds,aregenerally

moreilliquid,are lesslikelytouseindependent pricing procedures, arelesslikelyto have

aBig 4 auditor,are morelikelytoswitchdatavendorsinaddition tohavingverificationproblemswith respect tosignatures for fund transfers,arelarger than non-problem funds,and generally have pooreroperational controlsinplace

AIM64.3The duediligence processplaysanimportantrole inidentifyinginadequateor foiledinternal processes Thehedgefundindustryis non-transparent,andmanagersarereluctant

toreveal information, especially if theyfollowa proprietarytradingstrategy Thedue

diligenceprocess is critical in uncovering andverifyinginformation about funds andfundmanagers

©2015 Kaplan,Inc.

Page ]66

Topic 64 Cross Reference to GARP Assigned Reading—Brown et al.

CONCEPT CHECKERS

Akey goalof thethird-partyduediligenceprocessis to:

A generate truthfuloffering andmarketing documents forthehedgefund

B provideanindependent auditingreport thatinvestors can trust.

C identifyimperfectorfailed internal processesof the fund

D* perform backgroundchecksonmanagers and keyemployees

Afundwith pastlegal orregulatory problemsis:

A morelikelytochooseaBig4auditing firm

B lesslikelytoswitchdatavendors

C generally largerthannon-problem funds

D* generallymoreliquid

Theduediligenceprocessidentifies inadequate internal processesby:

A. verifyinginformation about the fund

B analyzingdatafrom publicsources,such asthe LipperTASSandCISDM

databases

C. takingon the roleof auditortoidentify problemsbefore theauditor does

D registering die fund with die Securities and ExchangeCommission as an

investmentadvisor*

1.

2

3

4 Athird-partyduediligencereport reveals bodi quantitativeandqualitativefactors

regardingdie potentialoperational risk inhedgefund activities.Examples of

qualitativefactors thatareevaluatedin thedue diligenceprocessincludeall of the

followingexcept;

A. substantiationof die accuracy of die dataprovided bythe fund

B how the dailyaccountingof the fundisaccomplished

C themethod by which portfolio valuesaredetermined

D* howhedgefundleveragechangesover time.

Given dierecentfinancialfailures, investors have placedgreateremphasison

determining thelegitimacyoffund reportedreturns.An operationalrisk measure,

knownasthein-score, can be appliedin these situationssince it isbaseddirecdyon

data pulled fromadue diligencereport Whichof the followingstatements most

accuratelydescribesthe validationof theu measure? Exposureto the risk that this

score measureswouldlead to;

A anincreased likelihoodof gpod performancethat canbeexplained bymarket

risk and operational riskexposure

B adecreased likelihoodof lowerperformance thatcannotbeexplained bymarket

riskoroperational risk exposure

C adecreasedlikelihoodofpoorperformance thatcan he explained by operational

Crass Reference to GASP AssignedReading-Brown et al.

CONCEPT CHECKER ANSWERS

1 „ C Thethird-partyduediligenceprocess involvescollectingandverifyinginformation to

identityimperfectorfailedinternal processes.Performing backgroundchecks on managers andkey employeesis part of that process Duediligencefirms alsoverify auditingreports and cross-check information that is inmarketingdocuments.

2 C Problemfunds[withlegaland/orregulatoryissues), arcgenerally largerthan non-pro hlcm

funds.Theyarc lesslikelyto use a Big 4auditingfirm, morelikelyto switch data vendors, and arcgenerallylessliquidwith longer lock-upandredemption periodsthannon-problemfunds

3 A Information isgatheredand verified in the duediligenceprocess in an attempt toidentify

inadequateorfailedinternal processes.

4 D Hedgefund leverage is revealed in TASS and CISDM databasesandis measured using a

quantitativeapproach Examplesofqualitativefactors revealedby third-partyduediligence

reportsinclude:the methodbywhich asset/portfoliovalues arc determined, how andby

whom theday-to-dayaccounting of the fund isaccomplished,suhstandation of the accuracy

of the dataprovided bythe fund, and how control processes arcperformed

5 D The uvseone can be validated as a measure ofopcradonalriskbyusing a univariate test to

show that exposure tooperational riskwouldmostlikelylead to poorperformance.This poor performance would not beeasilyexplained byexposure to market risk.

©2013Kaplan*Inc.

Page 1613

The liollituvuig is a review ul the Risk Management and Investment Management principles designed in add™**

the AIM statements set forth by GART® This Lopic is also covered in:

Topic65

EXAM FOCUS

Bernard Madoff ran a securities advisory firm that managed $17 billion in assets. In

December 2008, Madoff confessed tofamilymembers char the businesswas “a giant Ponzi

scheme" andwasarrestedtirenextday ThistopicexploresthehusinesslinesofBernardMadoff

Investment Securities, LLC (BMIS) There were many red flag£ that should have alerted

investorsandregulators to thefraud thatwas being perpetrated hyMadoff Itis importantto

understandthese red dagsbodrfromanoperational standpointandfroman investment point

ofview.In the end,investorscould onlysee die returnsand ignored the redflags, leadingto

thelossof billions ofdollarsofsavingsfromwealthy individuals, pension funds,hedgefunds,

banks,and charitable organizations

In December 2008,the world witnessed thecollapseof perhapsthe largestPonzischemein

history Bernard Madoff had runasuccessful wealth managementbusinessformorechan

17years TheinvestmentstrategyemployedbyBernard MadofflnvestmentSecurities,

LLC (BMIS) wasconsideredoneof themostsuccessfulin the world The strategy,called

a'split-strikeconversionstrategy”byMadoff,allegedly generated stablereturns between

8% and 12% year after year Itwasdeemedaprivilege to investwith Madoff, and those

whowereallowed inweregenerallysuccessful and socially connected.Notonlydid wealthy

individualsloseinthecollapseof BMIS,but also charitableorganizations, pension funds,

celehrities,hedgefunds, fundsof hedgefunds,andbanks

In hindsight,itseems impossiblethat sucha massivefraud couldhave gone undetectedfor

so many years Fromregulatorsto investors, no oneseemed toasktherightquestions Due

diligence, agiveninthehedgefund industry,wasmissing.Madoffwas so well respected

in the industry that peopledidnordarequestionorcriticize him for fear ofjeopardizing

their own careers.The investigationisongoing, and the potentialloss is enormous. Madoff

himself has speculated that lossescould reach$50 billion,fargreater chan ocher hedgefund

failures

BERNARD MADOFF INVESTMENT SECURITIES

AIM65.1:Describe Bernard MadofflnvestmentSecurities (BMIS) anditsbusiness

lines

BMIS, foundedin I960, wasinitiallyabrokerage business Thefirm quotedbid and

askpricesandexecutedover-the-counter (OTC)tradesfor clients Thefirmwas anearly

adopter oftechnology, focusingonelectronic trading earlyon.Madoff discovereda New

York Stock Exchange(NYSE) rule (Rule390) that allowed for the tradingofNYSE stocks

awayfrom the floor of the exchange (i.e., away from specialistson thefloor).Membersof

theNYSEcould not make marketsinexchangestocks

Topic 65

Cross Reference to GASP Assigned Reading-Gregpriou and Lhabitant

As a resultof die discovery ofRule390,Madoff enlistedas a member of theailing

CincinnatiStock Exchange(CSE)and upgraded thecomputer systems so that theCSE

became the first all-electronictradingsystem in diecountry Madoffs firm mademoneyoff thespread,whichwas in fractionspre-2000(l/8th, If4th, andso on) rather dianin

pennies BMLSbegan making marketsinNYSE-listedstocks and placed ordersfor firmsaway from theNYSE BMIS paidfirms$Q.01 per shareto executeorders, and thefirmquickly garneredalarge share of theNYSE tradingvolume—more than 5% by 1989and

approximately10%by200N However,paying firms for their businesswas a controversialpracdce

Madoffwas a key figureindeveloping die NASDAQstock market Hewas a memberof die

boardof governorsand ultimately was chairman of the NASDAQboard of directors

By the late1980s,margins in thebrokerage businesswereshrinking, andcompetitionwas

ontherise Acdiat point, Madoff createda separatefinancial advisory firmlocatedin the

samebuildingashis brokerage business.AlthoughsomesayMadoff ran ahedgefund,hedidnot Hisfirm managed several discretionaryaccounts (23 in 2008,accordingto its

FormADV).By2008,funds under management totaledapproximately$17billion, andequitycapitalamounted to$700 million Feeder funds accounted for diemajority of thediscretionaryaccounts.Feeder fundsopened brokerageaccountswith BMLSand gaveBMISfull authorityto tradetheir accounts.The feederfunds attractedinvestorsworldwide.This

meant thatdie uldmace investors were not customersofBMLS,butof dieindividual feederfunds

Professor'sNote:Thefactthat thefinalinvestors were notdirectBMIS

customers, hutinsteadcustomersofthevariousfeederfunds, is very important

to the overallstory. Thepeopleandfirmsproviding moneytoMadoff'sfirm

couldperform duediligenceon thefeeder fundin which they invested, but not

on BMIS BMIS wouldnotallowinvestors to visit, ask questions, orengagewithMadoffl Investorshadto trustthatfeederfunds wereperformingthecritical duediligencetask in theirplace.

BMIS INVESTMENT STRATEGY

AIM65-2: Explain whit is asplit-strikeconversionstrategy

Madoff calledhis proprietaryinvestmentstrategyasplit-strikeconversion strategy.The

strategy wasfairlysimple and isusually referredto as a collaror a bullspreadbyoptiontraders It issometimescalleda vacationtradebecause the position could beignored until

near the expirationdateof theoptions

AccordingcoMadoff, thefirm activelytradeda portfolioof stocks and options TheportfoliowassimilartotheS&P100.Thestrategyinvolved the following:

1. Takealongposition inaportfolio ofstocks The portfoliomust behighly correlated to the

S&P 100.

2. Writeout-of-the-moneycalloptionsontheS&P100.The notionalprincipalof the calls

must be closeinvalue todieequity portfolio

©2013Kaplan,Inc.

Page 170

Cross Reference to GARPAssignedReading—GregoriouandLbabitant

3 Bayout-of-the-moneyput optionson die S&P 100.Again, die notional principalof the

putoptioncontracts mustapproximatelymirrorthe valueof theequity portfolio

Aftera point, gains in die stockportfolioareoffsetbythe increasing liabilityof the short

call position,therebycreatingaceiling.Afloor iscreated by the longput position.Beyonda

certain point, lossesin die stock portfolioareoffsetbygainsin thelongputoptions

AJM65.3: Describe thereturnsreportedonMadoffs feederfundfi.

Madoff claimed that the portfoliowas incashmostof the dmeand thatthesplit-strike

conversion strategywas implementedover shorttimehorizons, usuallyless than30 days

He promisedconsistentpositive returnsrangingbetween8%and12%as aresultof the

strategy.The feederfundsdid indeed post incrediblystable, posidvereturns over the17

years Oneof the red flags, however,was that Madoffneverhad adownyeanInfact,more

than 95% of die months posted positivereturns over the lifeof theinvesunentadvisory

business.Whilereturns arehigherbutsimilar to theS&P100,volatilitywas markedly lower

inthe feeder funds

AIM65.4:Explain how thesecuritiesfraudatEMISwascaught.

Surprisingly,Madoffwas notcaught, but instead confessed tofamily members thathis

investment advisorybusinesswas“agiantPonzischeme.” This confession occurredon

December 10, 2008 His sons turned himin diateveningto U.S.authorities,and hewas

arrestedthefollowing day Madoffwaschargedwithsecuritiesfraud.Thefamilyassets were

frozen,anda receiver wasappointed for BMIS Theoutrageofinvestorswholosteverything

will not soon beforgotten

Professor’sNote;Madoffdidnot confessoutofthegoodnessofhis heart

The marketwas in a tailspin, andinvestors werescared Investors were

withdrawingfundsat a ratethatBMIScouldnot keep up with.Madoffwas

trying to raiseadditionalcapitalhut couldnotdo itfastenough.Atthat point,

he admittedto hitsons , wife,and brother thatit was “alla biglie.”Had the

market downturn notaccelerated, the schememighthave gone on longer.Itis

abit like thesubprime mortgagecrisis ; it can keepgoingaslongas assetprices

areincreasing Oncepricesstart tofall, itall unravels

OPERATIONALANR INVESTMENT RED FLAGS

AIM65-5: Describe theoperationalredflags at BMISconflictingwith the

investmentprofessionsstandard practices.

Therewereseveral redflags thatshouldhavealertedinvestorsand regulatorsco the

prohlemsat BMLS.Operational red flags included the following:

• BMISprovidedvirtually allinvestment services toitself In mostfunds,diere areseveral

serviceproviders, includingabroker to executetrades,anadministrator cocalculatethe

andan investmentmanager tomanageassets BMIShandled all ofthesefunctions

Topic 65

Cross Reference to GARP Assigned Reading-Gregoriou and Lhabitant

in-house.Itisobviouslyeasier tomanipulateperformancenumbersif thereis no third

partyoversight.Assetsmay bemisappropriatedaswell without properoversightThefirmwasalsoabrokerdealerand market makerinsomestrategies, creatinganotherconflictofinterest.

* Obtcureauditingfirm.BMISmanaged$17billion in assets, yetemployedaperson auditingfirm operatingina500-square-foot office Feederfond*weregenerally

three-auditedbylarge-namefirmssuch as KPMG.Thislikelygaveinvestors a seuseof security

However, diese firms hadtorely onthe auditsof odierfirms,namely Friehfing and

Horowitz,MadofFs auditingfirm.Whydidn'tthesebigfirms verifythelegitimacyofFriehlingandHorowitz?

* Familymembersin key positions.Madoff,hishrother,hissons,hisniece,andhis nephewheldkeypositionsin the firm Again, like in-houseservicesanda no-nameauditor,

itraises thequestionof independenceandproperoversight to protect investors. Inaddition,filingsreportdiatone tofive peoplemanaged theinvestmentadvisoryfunctions,animpossibilitygiven $17billionofassets under management*

* Feestructure.Madoff didnotchargemanagementor performancefees,onlyabrokerage

commission waschargedoneachtrade Assuch, feeder firmswereable tochargelarge

managementandperformance foes.Given thesuccessof diestrategy, itshouldhaveraised redflagsto investorsanddiefeeder fundsbecauseit doesnotmakesense thatBMISwould bewillingtogive upmillionsofdollarsof profitsinlostfees.It did,perhaps, keep feeder funds satisfied andlookingthe otherway (Le.,ignoring the red

flags)

• Nomentionof Madoffallowed andalackof operationaltransparency Feederfundswere

generally prohibitedfrom mentioning eidier Madoffor BMIS in marketingmaterials

and privateplacementmemoranda.Madoffdidnot reveal thedollaramountofassets

undermanagementeither,whichis rare in anindustrythat likesto bragaboutsuccesses Also, investorswere oftennot permittedto visit BMIS,and MadofF refused to answer

questionsaboutinvestmentstrategies.On-siteduediligencevisits weregenerallydenied

* Papertickets BMIS used paperticketshymail rather thanallowingclients electronic

access todieiraccounts.This practice, combined withno third party investment service

providers/oversight, allowed for end-of-die-day manufacturing of rickets that matchedreportedinvestmentresults

AIM65.6: Describeinvestment tedflagsthat demonstratedinconsistenciesin

BMIS’investment style

Notonlywere there clear operational red flags that shouldhavealertedinvestorshut there

were investmentredflagsaswell.Investmentred flags included die following:

• Black-boxstrategy.Asplit-strikestrategy can he profitablein the long runhutwill

include downmonths,whichwassomethingmissingfromMadoffsperformance.The

consistency of theperformanceshould have heen suspicious to investors.Investorshavetriedto rationalize thetoo-good-to-be-trueperformancebysuggesting excellent stock

©2013 Kaplan,Inc.

Page 172

Cross Reference to GARPAssignedReading—Gregoriou and Lhabitant

pickingbyMadoff subsidizingstrategy returns (to smoodireturns)with market-making

profit,or usingleverageto increase returns.Somehavesuggested frontrunning,anillegal

practicein the UnitedStates However, nothingexplains the performance besidesablack

box

* Questionablestyleexposure.MadofFs split-strikeconversionstrategy,as hedescribesit,

requiresalongput, shortcall, andlong index position.However,style analysisused to

explain MadofPsreturnsfindsthat he hadtobedoingtheoppositeof what he claimed

Quantitative analysisof the strategyshouldhave raisedtedflags

* Illogicalform13Ffilings BMIS13Ffilingsshowed small investmentsinsmall firms

(non-S&P 100companies).Madoffsaidheconverted tocashatthe endof each quarter

toavoid public analysisof hisstrategy.However,given thehugeamountofassets under

management,enormousamountsofmoneywouldhavetohe moved eachquarter.It

simplydoes notmakesense.

* ImpossiblestrategyusingS&P100options MadofFsaid the firm usedS&P100options

rathertitanS&P500options to execute the strategy.This wouldhavebeen prohibitively

expensive becausetheyarelesswidelyusedthanS&P500derivatives Hehad$17

billionofcapital undermanagement.Tradeswouldhaveresultedinsharpmovements

in the options.Madoflfsaid he usedOTCmarketsbyway ofexplanation.Thisis not

possihlebecausecounterpartieswouldhave heen losingyearafteryear,creditexposures

for these firmswere toohigh,andsomecounterparties would havehedged,and thereis

noevidenceof this No counterpartiesliaveheen confirmed, suggestingMadoff was not

doing what hesaid

Professor'sNote: There were some who did take noteofthe redflags Aformer

money manager namedHarryMarkopolostried manytimes over theyears

to alert theSEC. He wasdismissedby regulators. Somebanks also refused

to do business with BMIS beeauseofconcerns. Even basedsolely on public

Goetzmann, Liangand Schwarz(2008) would have identifiedBMIS as a

problem fund. Butgreed overruled goodsense. In theend,it is apainfullesson

in duediligence. Investorscannot letreturnsblind them toeverythingelse

Cross Reference to GARP AssignedReading-Gregprioa and Lhabitant

KEY CONCEPTS

AIM65.1Bernard Madoffrail a investment advisorybusinessfor more dim17 years Itall fellapart inDecember2008when Madoff confessed to family membersthat die business

was agiant Ponzisclieme

Foundedin i960,Bernard Madoff InvestmentSecurities, LLC wasinitiallya brokeragebusiness

Madoffwas anearlyadopterof electronictradingand useddieailingCinciimadStockExchange(CSE) toexploitRule390 Therule allowed for tradingof NYSE stocksawayfrom die exchange.He upgradeddie computer systems, and theCSE became the first all-electronic trading exchange.

Dueto increasedcompetitionand fallingmarginsin thebrokeragebusiness,Madoffstartedan investmentadvisorybusiness that lasted for17years.By2008, the businesswas

managing$17 billioninassets.

Madoffwas akeyfigureindeveloping theNASDAQ stock market andwas at onepointchairmanof the NASDAQboard ofdirectors.

AIM65.2Madoffreferred tohisinvestmentstrategyas asplit-strikeconversionstrategy.The strategy

involved thefollowing:

* Takealongpositionin aportfolioof stocks.Theportfoliomust hehighlycorrelated to

theS&P100

* Writeout-of-die-moneycall optionson theS&P 100.The notional principalof the calls

musthe closeinvalueto the equityportfolio

* Buy out-of-the-moneyputoptionsontheS&P100.The notional principal of theputs

mustapproximatelymirror thevalueof the equityportfolio

AIM65.3

Feederfunds reported extremelyconsistentpositive returnsranging between 8% and12%,

year after year Negativereturns were reported in a mere5% of months Returnswere not

thatfar off from theS&P100onaverage, butvolatilitywas markedly lower

AIM65.4

Asthe market downturn accelerated,investorsstartedwithdrawing fundsat arapidpace In

December 2008,Madoff confessed tofamily members diat hisinvestmentadvisorybusiness

was '‘agiantPonzischeme.'"Regulators,who had been warnedof prohlemsandredHagsat

BMIS,did notdiscover die scheme

* BMISprovided virtuallyallinvestment services toitself

• Obscureauditingfirm

* Questionablestyleexposure

• Illogical form13Ffilings

* Impossiblestrategy usingS&P 1 00options

Topic 65

Cross Reference to GASP AssignedReading—Gregoriou and Lhabitant

CONCEPT CHECKERS

Bernard MadoffInvestmentSecurities, LLC (BMIS) started business in I960:

A as an investmentadvisory business

B doingelectronictrading ondieCincinnatiStockExchange,

C as abrokeragebusiness

D as aderivativesclearinghouse

Which statement about MadofFssplit-strikeconversionstrategyis incorrect?

A Partof thestrategyinvolvessellinganout-of-the-money calloption

B Eventually, gainson dieportfoliowill besupplemented by gainsondielong,

out-of-the-moneycall option position

C. Afloor valueiscreated by the purchase ofanout-of-the-money putoption

D Alongpositionin aportfolioof stockshighly correlated totheS&P 1 00 is

required

Whencomparingthe feeder fundreturnsfor MadofPsstrategywith dieS&P 100,

the reportedreturnsoffeeder fundswere:

A. much higherthan the S&P 100with higher volatility than theS&P 100.

B much higherthan theS&P 100withmuchlowervolatilitythan dieS&P 1 00.

C muchlower dian theS&P100butwith volatility thatapproximatesdiatof

3-monthTreasurybills

D, about thesame astheS&P100butwith much lower volatility dian theS&P

100.

1.

2.

3

4 Thesecuritiesfraudwascaughtat BMIS when:

A HarryMarkopolossent a17-pageletterto theSECdetailing the redflag?at

BMIS.

B Madoffssons,finally givingunderdie pressureof lying for their father forso

many years, called the authorities

C. theSEC,after years of investigation, compiled enoughevidencetoindictMadoff

D MadofFconfessedto hisfamilythat his investmentadvisory businesswas agiant

Ponzi scheme,

Thefeestructure at BMIS was awarningno investorsbecause Madoff’s firm:

A cliarged such high performance fees

B only cliargedabrokeragecommission on trades,

C, cliargedsuchhighasset management fees

D did notchargefees ofanysort,relyingonlyon returnsfrom theinvestment strategy’

5

©2013Kaplan,Inc.

Page 376

Topic 65 Cross Reference to GARPAssignedReading-Gregoriou and Inhabitant

CONCEPT CHECKER ANSWERS

1 C BMIS began as abrokeragebusiness and then movedinto electronic trading via the

Cincinnati StockExchange They ultimatelystarted an investmentadvisorybusiness that

eventuallycaused the firm’s demise.

2 B The strategy requiressellinga call andbuyinga put There is nosupplementto the gains on

dieportfolio,just aceilingand floor created from the option positions.

3 D Reeder hindsreported returns between 8% and 12% The returns arc similar to the S&P 100

but with markedlylowervolatility.Fundsshowed positive returns in 95% of the months over

several years This consistency of positive returns should have been aredflagfor investors.

4 D Madnft’did not getcaught,butconfessedin the wake of arapidly decliningstock market.

In December 2003, Madnft’ told his sons, wife, and brother that the wealth management

business was a giant Ponzi scheme.

5 B Madnft did notchargeeither management orperformancefees,onlyabrokeragecommission

on trades This is suspicious in that his firm waswillingtoforgomillions of dollars of fees If

the strategy was sogockf,he would have charged for it

The following i* a review of die Current Issues in Financial Markets principles designed to address the AIM statements set fotlh bvGARP®.This topic is also covered in:

In this topic, we look at the factors leading up to the economic crisis during the period

2002-2007,and the dinee keyfactors thatcontributed to theglobal natureof thecrisis*We

also lookatspecificwaysrisks can be transmittedfrom die financial sector tosovereignsandfrom sovereigns to the financial sector.It is crucial to understand that the fiscal soundness

of sovereign governments is an important prerequisite for the efficient functioningof thefinancialsystem, while a well-functioninggloballinancialsystem isequally important to the

financial healdiof sovereigns.It iskey to recognize that certain bufFers are necessary inorder

to maintainsovereign risk-freestatus,where thecreditworthinessofa sovereignis paramount

in maintainingor reinstatinginvestorconfidence

ECONOMIC CRISIS CONDITIONS

AIM 66.1:Explain three keyinitial conditions thathelped spread of theeconomiccrisis globally amongsovereigns

Thereare threekeyinitial conditions thatcontributedto theglobaleconomiccrisis.The

crisisoriginated in the financialsectorbut rapidly spread tosovereigns, where sovereignsolvency wasoneof themajorconcerns.

First,thebankingsystemsofmost major developedeconomies had insufficientcapitalatthe

outsetof thecrisis.Theveryliquid marketplace prior to thecrisisallowed manyfinancial

institutions totakeincreasinglylargerisks with minimalimposedlimits.As a result, those

insdtudonshad inadequatecapital andwereoverly leveragedwithlargematurity andcurrencymismatches These risks left theinsdtudonsexposed to the liquiditycruncheffects

of the crisis as well as thenegadvefeedbackeffects between banksandsovereigns

Second,majorsovereignsdid notbuildup sufficient financialcushions duringdie boomperiodprior to thecrisis.The credit boom period, which lasted from 2002 to 2007,led

to anunsustainablerise inrevenues that created an environmentoffalseconfidence thatleft sovereigns ill prepared tofaceeconomicshocks While sovereigngovernmentsquicklyprovidedfundstorecapitalize their financialsystemsand toenable discretionary fiscalstimulus,theylacked thedepthofreserves tofullyfund all of theirlong-term obligations

Third, the veryhighlevelofintegration in Lheglobalfinancialsystemamongsovereignsand financial institutionsexacerbated thecrisis.While the levelofinterconnectednessin

©2013Kaplan,Inc.

Page178

Topic 66 Cross Reference to GARPAssigned Reading-Cam ana and Avdjiev

global marketsgreatly aids globalfinancial integration, riskscanbecome pronouncedinthe

absenceofsufficientcapital, liquidity,or resilience,

FINANCIAL SECTORAND SOVEREIGN RISKS

AIM66.2: Describe three waysinwhich the financialsectorrisksatetransmitted

to sovereigns

Despiteseemingly prudentfiscal andfinancial policies by Europeansovereigngovernments

priortothe financial crisis,die risksfrom the financialsector materiallyaffectedsovereign

governments.Therearethreeprimary waysinwhich riskfrom the financialsector canlie

transmitted tosovereigns,

First,credit booms providea one-timeabnormal boost to governmentfiscalbalances over

regular cyclical economicexpansions.Thismay not onlyhideweaknessesof the underlying

financialsystem,butcanalso makeagovernment’sfiscal positionseem stronger than it

actuallyis.Asa result, governmentsmaycondnuespending that would proveunsustainable

inthelonger term.

Second,lendingconstraintsdue toweak financialinstitution balance sheets resultin

macroeconomic coststhat could further weaken fiscalaccounts.In theabsenceofadequate

capitalandliquiditybuffersof financialinstitutions,creditconstraints cantighten beyond

adeclinein borrowerquality, cuttingoff thesupplyof credit.As aresult,economicactivity

andtax revenueswoulddecline andgovernmentexpenditures wouldrise,leading tohigher

publicsectordeficits and reducing the creditworthiness of thesovereign(as recentlyseen in

Spain),

Third,whensignificantfinancialinstitutions are onthe brinkofbankruptcy,sovereigns

may beforced toprovide them with financialsupport(i.e.,bailout funds) throughliquidity

assistance, directcapital injections,asset purchases,ordebtguarantees inorder to provide

overallmacroeconomicstability, These actionsincreaseboth the explicit and implicit

obligationsof thesovereign,as were prominendy observed inIreland during2008-20 1 1 ,

Topic 6f>

Cross Reference to CARP Assigned Reading-Caruana andAvdjiev

AJM66.3: Describe fivewaysin which sovereign risksaretransmittedto thefinancialsector.

Rather thanweaknessesin the financialsectoraffectingsovereigns, sovereignriskcanalsoaffect the financialsector.ForthisAIM, welookatfivewaysinwhich sovereign riskscan be

transmittedto the financialsector.

sovereign risk through their holdings ofsovereign bonds Financialinstitutions,

includingbanks, exhibita stronghome biasinholdingdomesticsovereignbondportfolios.In theEuropean Union (EU),banks heldan estimated85%ofdomestic

governmentbonds,and financial institutions incountrieswith higher public debt tend

toholdagreater percentageofdomesticgovernment bonds.Financial institutions,

especially thoseactiveinternationally,arealso vulnerabletoforeignsovereign riskthrough theirholdingsofforeign governmentboud portfolios

2. Fundingconditions:Banksfrequently usesovereignsecurities ascollateralinwholesale

funding, repos,andcoveredbond markets.As sovereign riskincreases,the availability ofeligiblecollateral declines,reducingbanks’fundingcapacity Itwasestimatedthat 30%(and up to 50%) of bank bond spreadsin 2010 representedsovereign risk

3 Sovereign capacity to assist.Sovereignsthatare perceived by financial marketsasweakerhaveareducedcapacitytoprovideassistance tobanksunder pressure,increasingbanks’

creditrisk.As recentlyasdie secondquarterof2011 , banks receiveda two tofive notchupgrade by ratingagenciesbasedonperceived sovereignsupport.Thischangedin the

secondhalf of2011 ,where the declinein sovereigncreditworthiness in Greece,Italy,

Portugal,and Spain led to adropin theirratings

4 Crowdingoutprivatesectordebt.Sincebankscompetewith governments forfunding,

sovereigndebt maycrowdout privatesectordebt byincreasingthecostand reducing

theavailability of bankfunding.Thisisespecially pronouncedfor sovereignsatriskoflosingtheir risk-free rating

5 Fiscal consolidation:Alossof market confidenceinsovereign debtmaylead tofiscalconsolidation Tndieshort term,die risksareweaker aggregatedemand andeconomic

activity that pressure creditqualityand bankprofitability.The benefits, however,includelong-term (and potentiallyshort-term) fiscal consolidation

EU BANKSAND SOVEREIGNS DURING 2002-2007

AIM66.4:Summarizetheactivityof banksand sovereignsin theEuropean Union

duringthe2002—2007 period leadinguptotheeconomic crisis

Duringthe 2002-2007 periodpreceding theeconomic crisis,dierewaslittle indication thatmarket participantswere awareoftheunderlyingeconomicand financial risks Sovereigndebt-to-GDP ratios of EuropeanUnion countries werewithin sustainablelevels,bond yields

werelow,and sovereign ratings remained high Bank profitability continued to increaseeachyear, and bank ratingsalsoremainedhigh, despite ongoingincreases in leverage.Infact,

the global integration of the financialsystemsustainedhighlevelsofleverageas thesystem

©2013Kaplan,Inc.

Page ISO