- This article explains how hedge funds measure and manage risk when setting up investment strategies.
- It is ideal for fund managers and enthusiasts of the subject who seek to know the background of hedge funds.
- FlexFunds develops products that allow hedge funds to expand their distribution in an agile and cost-efficient way.
Hedge funds use different techniques and financial tools
Due to the fact that hedge funds specialize in obtaining positive returns regardless of the main trend of the markets in which they operate, they are forced to use very sophisticated financial tools that allow them to manage risk. Now, how do they do it?
How hedge funds measure risk
Currently, hedge funds utilize various techniques to measure the risks of operators and financial assets. Standard deviation is one of the most important ones.
The standard deviation measures the volatility of the quotations of the assets in a portfolio. It calculates how much each value deviates from the average, and these deviations are averaged out to determine the figure in question. The greater the deviation, the more dispersed or volatile the values.
In turn, hedge funds study value at risk (VaR), which consists of a statistical measure that estimates the maximum probable loss amount that an investment portfolio can experience in a given period of time.
And to reduce the maximum possible risks, considering the objectives and needs of the hedge fund, the administrators use various tools and investment methodologies:
Financial derivatives
In the first place, these investment vehicles are based on strategies with financial derivatives, such as options and futures: financial contracts that make it possible to speculate on the price movement of assets in exchange for the payment or charge of premiums or the placement of guarantees.
“The hedge funds can use derivatives to manage risk and protect themselves from losses. They can also be used to speculate on the direction of the market. For example, a hedge fund can buy an option contract that gives them the right to buy a share at a specified price. If you correctly predict the market’s direction, you will earn money with the transaction. Alternatively, they could enter into a futures contract to speculate on the price of a basic commodity”, explains Harbourfront Technologies.
Diversification
On the other hand, hedge funds use diversification as a technique to reduce risk through the purchase of a wide variety of assets, normally uncorrelated, rather than the acquisition of a few.
Diversification can be achieved by investing in different types of assets, such as shares, bonds, mutual funds, common roots, raw materials, and other financial instruments. You can also diversify by sector, company size, geographic region, currency, and other factors.
“By diversifying a portfolio and distributing investments among different asset classes, the risk of losing money in a single market sector can be reduced. It will also increase the probability that at least some of the investments will work well, even when others do not”, details the business magazine, Forbes.
To enhance diversification, hedge funds can also use products listed on the stock exchange (ETPs) as developed by FlexFunds. To know more about these financial products, do not hesitate to contact us.
Arbitration
Likewise, a large part of the hedge funds manages the risk and tries to obtain benefits from the arbitrage, strategies in which they take advantage of the price discrepancies between two or more similar financial assets, buying the undervalued one and selling the overvalued one.
The arbitrage strategy can be short or long-term and may require a significant investment in market analysis and monitoring to identify opportunities.
It is important to highlight that although hedge funds use sophisticated tools and different techniques to manage risk, losses are always possible. Investors must be aware of the risks and ensure they understand the products and investment strategies before investing in a hedge fund.
Sources:
- https://harbourfronts.com/hedge-funds-derivatives-manage-risk/
- https://www.forbes.com/sites/forbesfinancecouncil/2022/09/23/understanding-the-importance-of-investment-diversification/?sh=56e734e66a88
