3.4h: factor models & hedge fund risk exposures.

What is a conditional linear factor model?

A risk model that quantifies exposures by accounting for the fact that a fund behaves differently during market turbulence compared to normal conditions.

What does the term 'conditional' signify in a risk model?

It signifies that the model's risk parameters change based on the prevailing market state, such as normal versus crisis periods.

What is the primary benefit of using a conditional factor model for hedge funds?

It helps identify actual risk exposures during crises, providing a more accurate picture of risk during market shocks to help prevent fund closures.

What does the variable Alpha (αi) represent in the conditional factor model equation?

The intercept for hedge fund i, representing the portion of return not explained by the factors.

What does the variable Beta (βi,K) represent in the model?

The exposure of hedge fund i to risk factor K during normal market periods.

What are the two possible values for the Dummy Variable (Dt) in the model?

0 for normal market periods and 1 for periods of financial crisis.

What does the term Dt * Beta (Dtβi,K) represent?

The incremental (extra) exposure to risk factor K that only occurs during financial crisis periods.

How is the Error term defined in the conditional factor model?

It is a random error with a mean of zero.

How is total factor exposure calculated during a crisis?

By adding the normal exposure (Beta) to the incremental exposure (Dt * Beta).

If a model's risk factors do not explain certain returns, what three things are those returns attributed to?

Omitted risk factors, Alpha (manager skill), or Randomness (error).

What were the six original risk factors used by Hasanhodzic and Lo (2007)?

Equity risk (SNP500), Interest rate risk (BOND), Currency risk (USD), Commodity risk (CMDTY), Credit risk (CREDIT), and Volatility risk (VIX).

Why is a stepwise regression process useful for creating linear conditional factor models?

It helps avoid multicollinearity problems by excluding risk factors that are highly correlated with one another.

In the Hasanhodzic and Lo study, which two factors were dropped due to multicollinearity?

The BOND (interest rate risk) and CMDTY (commodity risk) factors.

Which two factors were used to produce a higher adjusted R-squared in place of the dropped BOND and CMDTY factors?

CREDIT and SNP500.

What were the final four factors used for measuring risk exposures after the stepwise regression?

Equity risk (SNP500), Currency risk (USD), Credit risk (CREDIT), and Volatility risk (VIX).

From where do a hedge fund's risk factor exposures typically stem?

They stem from taking long or short positions in financial instruments that are exposed to those specific risks.

What risk factors are arbitrage strategies typically exposed to?

Credit spread risk and market volatility risk.

What is the primary risk exposure for Event-driven and L/S equity strategies?

Equity (market beta) risk.

What other terms are used interchangeably with 'conditional factor risk model'?

Factor model, linear factor model, and conditional risk model.

What are the four typical performance impacts of adding a hedge fund strategy to a conventional portfolio?

Total portfolio standard deviation decreases, Sharpe ratio increases, Sortino ratio increases, and maximum drawdown decreases.

What is the general interpretation of adding hedge fund strategies to a traditional stock and bond portfolio?

They generally increase risk-adjusted returns and provide significant diversification benefits.

What specific risk metric is used to calculate the Sharpe ratio?

Standard deviation, which penalizes both downside and upside deviations.

How does the Sortino ratio differ from the Sharpe ratio?

The Sortino ratio only considers downside deviations (variability below a target return) rather than total volatility.

Why is the Sortino ratio often considered superior for hedge fund performance measurement?

Because many hedge fund strategies exhibit significant left-tail (downside) risk, which the Sortino ratio specifically targets.

Which four strategies are most effective at generating superior risk-adjusted performance based on both Sharpe and Sortino ratios?

Systematic futures, Equity market neutral, Global macro, and Event-driven.

Which two types of fund strategies were observed to NOT significantly enhance risk-adjusted performance?

Fund-of-funds and Multi-strategy.

What are the two hedge fund strategies that result in the lowest standard deviations for an overall portfolio?

Dedicated short-biased and Bear market neutral.

Why do 'Event-driven: distressed securities' funds often fail to reduce portfolio standard deviation?

These funds tend to take long positions in securities where outcomes are binary—either mild successes or grand failures.

How is Drawdown defined in a portfolio context?

The peak-to-trough decline for a portfolio, measured as the percentage drop between a high-water mark and the subsequent low point.

Why do opportunistic strategies like Global macro and Systematic futures perform relatively well during market crises?

They have minimal exposure to credit or equity risk and benefit from being highly liquid.