Leverage and Unique Risks of Hedge Funds
There are two important points that need special mention while discussing hedge funds. One, hedge funds make extensive use of leverage. Some people believe that leverage is the major source of risk for hedge funds, while others argue that using leverage combined with risk management enhances hedge fund returns. Second, hedge funds face certain unique risks that make them more risky.
Let's discuss these two aspects in more detail:
Most hedge funds (but not all) use leverage in their trading strategies. In certain strategies such as arbitrage, leverage is essential because of the small profit margins in these arbitrage trades. Just like leverage enhances your profits, it also magnifies your losses. With a leverage of 10:1, you stand to lose as much as 10 times compared to a trade with just your own funds.
Hedge funds normally have a leverage of 2:1 to 10:1. However, some hedge funds have run leverage as high as 100:1. Within a hedge fund, there will usually be specified maximum limits for leverage, and the fund manager will be legally bound by that limit.
Hedge funds can create leverage in many forms such as:
- Borrowing external funds
- Buying on margin
- Using derivatives and other financial instruments
Apart from market risk and other trading related risks, hedge funds face the following risks that are unique to them:
Liquidity risk: Hedge funds that trade in illiquid or thin markets can cause extreme lack of liquidity for them.
Pricing risk: Hedge funds invest in very complex financial instruments and many of them are traded over-the-counter. Such products are difficult to price, which can easily go wrong.
Counterparty credit risk: Hedge funds face significant counterparty risk, which can arise from many sources such as margin trading, and mortgage trading.