Causes of Hedge Funds Collapses And Contagion To Other Financial Institutions: A System Dynamics Approach

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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
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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.

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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.

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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
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RETURN POTENTIAL
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REPUTATION
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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
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BEHAVIOR OF A ROGUE TRADER
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AGGRESSIVENESS OF A ROGUE TRADER
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ALTERNATIVE APPROACH
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ROGUE TRADER MODEL
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APPETITE TO HIDE LOSSES
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PERCEIVED INTERNAL REPUTATION
Test1 R10RAMP(-0.5,5) Test2
R10STEP(-20,5)STEP(60,50) Test3
R10STEP(-30,5)STEP(80,50)
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SUPERVISION
Test1 R10RAMP(-0.5,5) Test2
R10STEP(-20,5)STEP(60,50) Test3
R10STEP(-30,5)STEP(80,50)
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TRADER AND BROKER INTERACTION
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SUMMARY AND CONCLUSIONS

• Dynamics Are Critical
• Effects Are Highly Nonlinear
• Implications for
• Credit
• Liquidity
• Volatility
• Regulatory Environment