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Causes of Hedge Funds Collapses And Contagion To Other Financial Institutions: A
System Dynamics Approach
Mila Getmansky
Albany-MIT Fifth SD Colloquium
October 4, 2002
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OBJECTIVE
• Understand the conditions under which a hedge fund can fail
• Determine when the collapse of a hedge fund can trigger a contagion effect that leads to the failure of another institution (bank)
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HEDGE FUNDS – AN OVERVIEW
• What are hedge funds?– Unregulated investment partnerships available to wealthy
individuals and institutions (“sophisticated accredited investors”)
– Seek above-average returns using aggressive, high-risk strategies unavailable to mutual funds and other traditional money managers
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MORE ON HEDGE FUNDS
• Investing strategies include, but are not limited, to:– Short selling– Leverage– Arbitrage – Derivatives
• Compensation structure is as follows:– Percentage of assets under management (usually 1%)– Percentage of profits (usually 20%)
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WHY ARE HEDGE FUNDS INTERESTING?
• Due to their unregulated nature, hedge funds can take on huge positions, affect market dynamics and cause financial collapses:– LTCM in the 1997 Asian crisis and the 1998 Russian debt crisis
($3.6 billion bailout plan to rescue the fund)– Soros in the 1992 ERM crisis (funded a $10 billion short
position in sterling, using collateral and margins)
• Understanding the role of hedge funds in the global financial markets might help prevent future crises
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SD VERSUS TRADITIONAL APPROACH
• Not an equilibrium model (unless at steady-state); Focus is Dynamics
• Objective: understand dynamics of underlying structure of a system such as hedge fund, contagion, etc.; model the impact of different scenarios and decisions versus finding an optimal point estimate
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FUNCTIONAL DIAGRAM OF A HEDGE FUND
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GENERAL ACCOUNTING FRAMEWORK
Cash
TotalInvestments
Loans
Liabilities
Equity
Lending rate.
Loan repayments.
Liquidation ofinvestments.
New investments.
Interest payments.
Rate of return oninvestments.
Defaults.
Decr. in E. due toDefaults.
Capital gains.
Interest owed todepositors.
Incr. in E. due toInterest payments.
Withdrawals.
Incr. in L. due toDeposits.
Decr. in L. due toWithdrawals.
Deposits.
Decr. in E. due toInterest owed to
depositors.
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FLOWS: BANK LENDS TO A HEDGE FUND
• Bank lends money to a hedge fund. It earns interest.• Hedge fund borrows money from a bank. It has to pay
interest.
Bank's Cash HedgeFund's Cash
HedgeFund's TotalInvestmentsNew investmentsLending rate
Interest payments
Principalrepayment rate
Repayment rate toa bank
Rate of return oninvestments
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FLOWS: BANKS INVESTS IN A HEDGE FUND
• Bank invests in a hedge fund. It earns return on investment.
• Hedge fund receives cash invested by a bank, and usually invests right away.
Banks'sCash
HedgeFund's Cash
Return on a hedgefund investment
Investing in ahedge fund
Hedge Fund'sTotal
InvestmentsNew investments
Rate of return oninvestments
Repayment rate to a bank
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REASONS FOR A HEDGE FUND FAILURE
• Poor investment decisions
• General market conditions are weak
• Investors exiting
• Banks or other lending institutions decide not to lend (make new deposits), especially in crises times when liquidity is very much needed
• Presence of a rogue trader
• Excess of leverage
• Loss of Reputation
• Broker – trader relationships
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COST AND RISK OF LEVERAGE
Leverage Ratio
Default Risk
Cost of Capital+
Money Lent ByBanks to HF
Willingness of HFto Borrow
-
++
B1 Costof
Leverageto HF
+
Willingness ofBanks to Lend
+
+
R1 Costof
Leverageto Bank
+
-
R2 Riskto HF
B2Risk toBank
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RETURN POTENTIAL
Capital Invested ByBanks in HF
Leverage Ratio
Default Risk
Cost of Capital+
Money Lent ByBanks to HF
Willingness of HFto Borrow
-
++
B1 Costof
Leverageto HF
Willingness of Banksto Invest in HF
-
+
Equity+
-
R3 RiskyLeverage +
Potential Return
+
+
B3 ReturnPotentialDue to
Leverage
Risk Aversion
- Willingness ofBanks to Lend
+
+
R1 Costof
Leverageto Bank
+
-
R2 Riskto HF
B2Risk toBank
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REPUTATION
Capital InvestedBy Banks in HF
Leverage Ratio
Default Risk
Cost of Capital+
Money Lent ByBanks to HF
Willingness ofHF to Borrow
-
++
B1 Costof
Leverageto HF
Willingness ofBanks to Invest in
HF
-
+
Equity+-
R3 RiskyLeverage +
Losses Gains
Reputation
+
R/B5Effects ofGains onLeveragethrough
Reputation
R/B4Effects ofLosses onLeveragethrough
Reputation
PotentialReturn
+
+
B3 ReturnPotentialDue to
Leverage
Risk Aversion
- Willingness ofBanks to Lend
+
+
R1 Cost of Leverage to B
ank
CapitalInvested
+ +
++
+
-
R2 Riskto HF
B2Risk toBank
ProfitsPerceived
Profits
- +++
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ROGUE TRADER
• Losses
• Bets
• Probability of a rogue trader
• Skill
• Internal supervision
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BEHAVIOR OF A ROGUE TRADER
Net Losses
Bet
Return
Skill
ExcessPerformance
Benchmark
+
+
+
-
Probability of aRogue Trader
+
+-
R SkillMatters
BEliminateLosses orR GettingUnlucky
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BEHAVIOR OF A ROGUE TRADER
Rate of return oninvestments
Net losses(risky)Increase in net
losses (risky)
Aggressiveness of arogue trader
Maximum winningsTime toplace abet
Maximum netlosses
Probability of arogue trader-
Effect ofskill onwinnings
+
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AGGRESSIVENESS OF A ROGUE TRADER
Graph for Equity600
-3,700
-8,0000 2 4 6 8 10 12 14 16 18 20
Time (Year)
Equity : a=3_1 DollarsEquity : a=3 DollarsEquity : a=2 DollarsEquity : a=1 Dollars
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ALTERNATIVE APPROACH
Not Rogue Trader
Rogue Trader
Probability of Not Becoming a Rogue Trader
Probability of Staying a Rogue Trader
Trader a Rogue Staying ofy Probabilit-Trader a Rogue ngNot Becomi Ofy Probabilit-2Trader) a Rogue ngNot Becomi ofy Probabilit-(1* ReturnectedTrader Exp Rogue
Trader a Rogue Staying ofy Probabilit-Trader a Rogue ngNot Becomi Ofy Probabilit-2Trader) a Rogue Staying ofy Probabilit-(1* Return Expected FundHedge ReturnExpected
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ROGUE TRADER MODEL
NetLossesChange in Net
Losses
Probability ofstaying a rogue
trader
Rogue traderexpected return
Hedge fundexpected return
ExpectedReturn
-
Probability of notbecoming a rogue
trader
+
+
-
-
Skill
++
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APPETITE TO HIDE LOSSES
Losses
Bet
Return
Skill
ExcessPerformance
Benchmark
+
+
+
-
Probability ofa RogueTrader
+
+-
R SkillMatters
BEliminateLosses orR GettingUnlucky
PerceivedProfit
InternalReputation
Supervision
HiddenLosses
-
+
-
-+
R HideWhen
You Can
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PERCEIVED INTERNAL REPUTATION
Graph for Perceived Internal Reputation1
0
-10 10 20 30 40 50 60 70 80 90 100
Time (Month)
Perceived Internal Reputation : Test3 RepUnitsPerceived Internal Reputation : Test2 RepUnitsPerceived Internal Reputation : Test1 RepUnits
Test1: R=10%+RAMP(-0.5%,5)Test2: R=10%+STEP(-20%,5)+STEP(60%,50)Test3: R=10%+STEP(-30%,5)+STEP(80%,50)
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SUPERVISION
Graph for Supervision1
0.5
00 10 20 30 40 50 60 70 80 90 100
Time (Month)
Supervision : Test3 DmnlSupervision : Test2 DmnlSupervision : Test1 Dmnl
Test1: R=10%+RAMP(-0.5%,5)Test2: R=10%+STEP(-20%,5)+STEP(60%,50)Test3: R=10%+STEP(-30%,5)+STEP(80%,50)
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TRADER AND BROKER INTERACTION
Total Trades
% of TotalTrades With OneBroker
Trade AmountWith One Broker+
+
% Fees -
R1VolumeDiscountProbabilityofReplication
+
Total NetReturn
Gross Return-
+
+
-
+B1 Execution Vs. Repl
icability -
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SUMMARY AND CONCLUSIONS
• Dynamics Are Critical
• Effects Are Highly Nonlinear
• Implications for:– Credit– Liquidity– Volatility– Regulatory Environment