Crises And Hedge Fund Risk

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Executive Summary

The authors study the effects of financial crises on hedge fund risk and show that liquidity, credit, equity market, and volatility are common risk factors during crises for various hedge fund strategies. They also apply a novel methodology to identify the presence of a common latent (idiosyncratic) risk factor exposure across all hedge fund strategies. If the latent risk factor is omitted in risk modeling, the resulting effect of financial crises on hedge fund risk is greatly underestimated. The common latent factor exposure across the whole hedge fund industry was present during the Long-Term Capital Management (LTCM) crisis of 1998 and the 2008 Global financial crisis. Other crises including the subprime mortgage crisis of 2007 affected the whole hedge fund industry only through classical systematic risk factors.

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