A hedge fund is an unregulated investment firm, pretty much like Goldman Sachs, only hedge funds are off the public radar for the most part. There are tons of hedge funds. One of them is headquartered in the basement of the DC home of Senator Ron Wyden. Wyden is a Wall Street legislative whore disguised as a liberal Democrat. Anyway, take a look at the story below from Reuters.
(Reuters) – Nervous hedge funds managers are stress-testing their portfolios and searching for ways of protecting themselves against their worst nightmare — a potential break-up of the euro zone.
With talks on restructuring Greece’s debt mountain still deadlocked, and the exit of one of more countries from the euro seen as a small but definite possibility, funds are modeling scenarios ranging from a 50 percent slump in European stocks or a 45 percent fall in the oil price to a 30 percent rise in gold.
Managers are also trying to dig out old computer programs they once used to model the behavior of currencies such as the drachma or the deutschmark as they prepare for an event for which — even after the 2008 collapse of Lehman Brothers — they effectively have no precedent.
Many, having already trimmed risk, are piling into credit default swaps or deeply out-of-the-money options, hoping they pick a counterparty that can withstand the shock of a break-up.
“You can’t conceive what this event will be like, but it doesn’t absolve you of looking at it,” said the chief risk officer at one hedge fund firm who asked not to be named.
“People are asking the questions, ‘do I have the historical records on how things worked when there was a deutschmark?’ and ‘did I throw away those computer programs (modeling the deutschmark)?’.”
Funds are also trying to figure out how they might be affected if different asset classes that normally have a low correlation start to fall sharply at the same time.
“Anyone who’s a chief risk officer is running these scenarios — say if the euro falls 15 percent, stocks fall 25 percent, if the possibility of default increases, what if recovery rates falls, which prime brokers, administrators get hit?” said Mark Wightman, head of strategy for Asia-Pacific at specialist technology group SunGard.
“The scenarios are getting quite complicated and people are starting looking at correlations between things to understand the likely impact.”
While hedge funds, which can put on short positions, have more tools at their disposal than long-only funds to cope with market falls, their performance has been patchy.
Last year they lost just over 5 percent on average, according to Hedge Fund Research, while the S&P 500 delivered a total return of 2.1 percent. That was their second calendar year of losses in just four years after heavy losses during the credit crisis in 2008.
Many hedge funds have already cut exposure to assets seen as directly in the firing line such as the euro or European stocks, insiders say, but are finding their options limited.
“We’re all still trying to run our businesses right now. I’d like to say I’ll put everything in U.S. dollars, but you can’t,” the hedge fund chief risk officer said.
“Part of it is contingency planning — what you need to get out of first — and part is proactive — ‘I don’t need so much emphasis in a certain area right now’, such as European stocks or the euro,” he said.
“Certainly we are taking smaller positions in some of these markets.”
Some funds also rejigged their equity short positions after major differences between stronger, core economies such as Germany and weaker peripheral economies became more apparent, said one investor who spoke on condition of anonymity.
For instance, a manager who owned shares in a German bank whilst shorting a Greek bank has switched to hedging the German bank with a short position on another German bank, after the Greek bank’s shares “started to take on a life of their own” as a result of the country’s debt crisis, the investor said.
However, with uncertainty over which currencies would exist after a break-up and how they would behave, funds are still unsure how far their hedges would protect them.
“A hedge fund may have a hedging program that is very highly attuned to dealing with its positions. But the day after something happens there’s no program to deal with this and their hedge may be denominated in a new currency,” the risk officer said.
Part of the dilemma is a mistrust of value at risk (VaR), a standard measure used by banks to show estimated potential loss, expressed with a certain percentage level of confidence.
“A traditional measure of risk like VaR has nothing to say on this,” said Lance Smith, CEO at U.S.-based Imagine Software, which has been working with hedge funds to assess the impact of a euro zone break-up on their portfolios.
“A euro break-up could be a 7 standard deviation event. A 6.5 standard deviation event occurs once every 34 million years, while a 50 percent fall in the Eurostoxx would be a 21 standard deviation event. This just highlights the flaws in a standard statistical approach.”
Credit default swaps (CDS), which are meant to pay out in the event of default, currency options or deeply out-of-the-money options, are among the favored hedges, industry executives say, which has driven up option prices.
However, even here there is a concern over whether the counterparty can pay up.
“You watch the counterpart if (it’s) OTC (over-the-counter) to avoid contagion,” said Sungard’s Wightman. “Thus you do your euro trades with say Japanese, U.S., Asian or Australian institutions.”
Meanwhile, one hedge fund manager has structured a trade to buy German bunds whilst offsetting this with credit default swaps, one fund selector told Reuters.
“His base case is that if someone comes out of the euro, the German bund will be the place to be.”
(Reporting by Laurence Fletcher, editing by Sinead Cruise and Mark Potter)