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

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)

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

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%)

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

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

FUNCTIONAL DIAGRAM OF A HEDGE FUND

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.

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

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

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

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

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

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

- +++

ROGUE TRADER

• Losses

• Bets

• Probability of a rogue trader

• Skill

• Internal supervision

BEHAVIOR OF A ROGUE TRADER

Net Losses

Bet

Return

Skill

ExcessPerformance

Benchmark

+

+

+

-

Probability of aRogue Trader

+

+-

R SkillMatters

BEliminateLosses orR GettingUnlucky

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

+

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

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

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

++

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

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)

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)

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 -

SUMMARY AND CONCLUSIONS

• Dynamics Are Critical

• Effects Are Highly Nonlinear

• Implications for:– Credit– Liquidity– Volatility– Regulatory Environment