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Measuring Loss Potential of Hedge Fund Strategies

Author

Listed:
  • Marcos Mailoc López de Prado

    (UBS)

  • Achim Peijan

    (UBS)

Abstract

We measure the loss potential of Hedge Funds by combining three market risk measures: VaR, Draw-Down and Time Under-The-Water. Calculations are carried out considering three different frameworks regarding Hedge Fund returns: i) Normality and time-independence, ii) Non-normality and time- independence and iii) Non-normality and time-dependence. In the case of Hedge Funds, our results clearly state that market risk may be substantially underestimated by those models which assume Normality or, even considering Non-Normality, neglect to model time- dependence. Moreover, VaR is an incomplete measure of market risk whenever the Normality assumption does not hold. In this case, VaR results must be compared with Draw-Down and Time Under-The-Water measures in order to accurately assess about Hedge Funds loss potential.

Suggested Citation

  • Marcos Mailoc López de Prado & Achim Peijan, 2005. "Measuring Loss Potential of Hedge Fund Strategies," Finance 0503010, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpfi:0503010
    Note: Type of Document - pdf; pages: 25. Journal of Alternative Investments, Vol. 7, No. 1, pp. 7-31, Summer 2004
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    File URL: https://econwpa.ub.uni-muenchen.de/econ-wp/fin/papers/0503/0503010.pdf
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    References listed on IDEAS

    as
    1. Hamilton, James D, 1991. "A Quasi-Bayesian Approach to Estimating Parameters for Mixtures of Normal Distributions," Journal of Business & Economic Statistics, American Statistical Association, vol. 9(1), pages 27-39, January.
    2. Gaurav Amin & Harry. M Kat, 2002. "Generalization of the Sharpe Ratio and the Arbitrage-Free Pricing of Higher Moments," ICMA Centre Discussion Papers in Finance icma-dp2002-15, Henley Business School, University of Reading.
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    Cited by:

    1. Sevinc Cukurova & Jose M. Marin, 2011. "On the economics of hedge fund drawdown status: Performance, insurance selling and darwinian selection," Working Papers 2011-04, Instituto Madrileño de Estudios Avanzados (IMDEA) Ciencias Sociales.
    2. Zabarankin, Michael & Pavlikov, Konstantin & Uryasev, Stan, 2014. "Capital Asset Pricing Model (CAPM) with drawdown measure," European Journal of Operational Research, Elsevier, vol. 234(2), pages 508-517.

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    More about this item

    Keywords

    Hedge Fund; Value-at-Risk; risk; performance; drawdown; under- the-water; normal returns; non-normal returns; time-dependence; ARMA; Monte Carlo; skewness; kurtosis; mixture of gaussian distributions; survival probability; styles; investment strategies;
    All these keywords.

    JEL classification:

    • G0 - Financial Economics - - General
    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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