Managed Funds Association
Additional Comments of Managed Funds Association
for the
U.S. Securities and Exchange Commission
Roundtable on Hedge Funds
May 14 - 15, 2003
Submitted August 5, 2003 by:
John G. Gaine
President
Managed Funds Association
Via Electronic Mail: hedgefunds@sec.gov
August 5, 2003
Mr. Jonathan G. Katz
Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Re: File No. 4-476 - Additional Materials Related to "Hedge Fund Roundtable" by Managed Funds Association
Dear Mr. Katz:
Managed Funds Association ("MFA") is pleased to submit its 2003 Sound Practices for Hedge Fund Managers to the Commission in connection with the Commission's review of the hedge fund industry.
As explained in our cover letter to the Commission dated July 7, 2003, MFA organized its follow-up submission to the Hedge Fund Roundtable into three key documents. The first two documents, MFA's "White Paper on Registration of Hedge Fund Advisers Under the Investment Advisers Act of 1940" and MFA's "White Paper on Increasing Financial Eligibility Standards for Investors in Hedge Funds", were submitted with our letter dated July 7th. The enclosed document represents the third part of our submission.
The Sound Practices is the product of several months of preparation by MFA and its members. This document builds upon the sound practices that were published for the hedge fund industry in February 2000 in response to a recommendation by the President's Working Group on Financial Markets that hedge funds establish a set of sound practices for their risk management and internal controls. Recognizing the valuable guidance provided by the recommendations contained in the original publication and in light of the growth and evolution of the hedge fund industry since 2000, MFA has undertaken to update and republish the Sound Practices so that the document continues to provide useful and timely guidance to hedge fund managers and other industry participants.
In particular, MFA has expanded and updated the original recommendations to address additional topics of importance to the industry, such as responsibilities to investors, valuation practices, and business continuity and disaster recovery. In response to the hedge fund industry's growth over the past few years, MFA has also sought to make the recommendations applicable to a broader range of hedge fund managers and to take account of evolving management practices in the industry.
The Sound Practices have been developed and republished in the belief that the most effective form of oversight is self-evaluation combined with self-discipline and self-policing. MFA is hopeful that hedge funds and hedge fund managers, by evaluating the recommendations in the Sound Practices and applying those that are relevant to their particular business models, will continue to strengthen their own business practices and, in doing so, enhance investor protection while contributing to market soundness.
MFA is pleased to submit the Sound Practices to the Commission as the staff prepares its report regarding the hedge fund industry and welcomes the opportunity to discuss any of the issues raised in the Sound Practices, or any of the other materials filed by MFA as part of its submission, at your convenience.
Thank you for your consideration.
Sincerely,
/s/ John G. Gaine
John G. Gaine
President
Enclosure
Managed Funds Association
2025 M Street, NW, Suite 800, Washington, D.C. 20036
Phone: 202 367 1140 · Fax: 202 367 2140 · Web: www.mfainfo.org
2003 SOUND PRACTICES FOR HEDGE FUND MANAGERS
Copyright © 2003 by Managed Funds Association.
2003 Sound Practices for Hedge Fund Managers may be reproduced
on the condition that reproductions are not sold or otherwise reproduced for profit.
All other rights reserved.
TABLE OF CONTENTS
I. MANAGEMENT AND INTERNAL CONTROLS
II. RESPONSIBILITIES TO INVESTORS
III. VALUATION POLICIES AND PROCEDURES
V. REGULATORY AND DOCUMENTATION CONTROLS
VI. DISASTER RECOVERY AND BUSINESS CONTINUITY
APPENDIX I: Risk Monitoring
APPENDIX II: U.S. Regulatory Filings by Hedge Fund Managers
APPENDIX III: MFA's Preliminary Guidance for Hedge Funds and Hedge Fund Managers on Developing Anti-Money Laundering Programs
APPENDIX IV: Glossary
Managed Funds Association ("MFA") is pleased to publish 2003 Sound Practices for Hedge Fund Managers (the "Sound Practices") for the benefit of its members and the hedge fund industry as a whole.
The Sound Practices builds upon the sound practices that were published for the hedge fund industry in February 2000 in response to a recommendation by the President's Working Group on Financial Markets that hedge funds establish a set of sound practices for their risk management and internal controls. Since the publication of the original sound practices document, it has been widely recognized by members of the hedge fund industry as a highly useful resource for hedge fund managers. Recognizing the valuable guidance provided by the recommendations contained in the original publication and in light of the growth and evolution of the hedge fund industry since 2000, MFA has undertaken to update and republish Sound Practices so that it continues to provide useful and timely guidance to hedge fund managers and other industry participants.
In particular, MFA has expanded and updated the original recommendations to address additional topics of importance to the industry, such as responsibilities to investors, valuation practices, and business continuity and disaster recovery. In response to the hedge fund industry's growth over the past few years, MFA has also sought to make the recommendations applicable to a broader range of hedge fund managers and to take account of evolving management practices in the industry.
Capitalized terms and certain technical words and phrases used in this document are defined in the Glossary in Appendix IV.
About Managed Funds Association
Managed Funds Association ("MFA") has over 700 members who manage a significant portion of the estimated $600 billion invested in hedge fund products globally. Since its inception in 1991, MFA has provided leadership to the hedge fund and managed funds industries in government relations, communications, media relations and education for members and investors. For example, in response to the enactment of the USA PATRIOT Act, MFA recently published Preliminary Guidance for Hedge Funds and Hedge Fund Managers on Developing Anti-Money Laundering Programs (2002), which is attached as Appendix III. MFA also maintains a library of hedge fund industry materials, many of which are accessible on its web site at www.mfainfo.org. These materials include government reports on hedge funds, comment letters on proposed legislation and regulations, Congressional testimony, speeches by regulators regarding hedge funds, legislation and rules relevant to hedge funds, as well as academic and industry papers and reports on hedge funds.
Objectives of the Recommendations
Strengthen Hedge Fund Business Practices. The recommendations contained in this document (the "Recommendations") are intended to provide a framework of internal policies, practices and controls that will enhance the ability of Hedge Fund Managers to manage their operations, satisfy their responsibilities to investors and address unexpected market events or losses. MFA is hopeful that Hedge Funds and Hedge Fund Managers, by evaluating the Recommendations and applying those that are relevant to their particular business models, will continue to strengthen their own business practices and, in doing so, enhance investor protection while contributing to market soundness.
Prior to the publication of Sound Practices for Hedge Fund Managers in 2000, many recommended practices had already been adopted by a number of Hedge Fund Managers as part of the implementation of more formalized and sophisticated management policies and structures necessitated by their growth. MFA believes that the publication of the original document has effectively promoted a broader implementation of certain of the recommended practices in the industry as a whole. Other recommended practices remain aspirational and represent goals that a Hedge Fund Manager should strive to achieve or utilize as an "ideal" benchmark, depending on its size and objectives and the applicability of the practice to its particular business model and circumstances.
As the Hedge Fund industry and global financial markets continue to evolve, MFA anticipates that the Recommendations will be further adapted and refined. As noted below, the Recommendations should not be viewed as static or "one size fits all". In addition the Recommendations should not be viewed as prescriptive requirements to be applied to all Hedge Fund Managers or as a potential basis for governmental regulation or supervision of Hedge Funds or Hedge Fund Managers. Rather, the Recommendations have been developed and updated in the belief that the most effective form of oversight is self-evaluation combined with self-discipline and self-policing. As a whole the Recommendations represent a possible "ideal" set of policies and practices that can serve as an aspirational reference benchmark for Hedge Funds and Hedge Fund Managers.
One Size Does Not Fit All. It is important to recognize in evaluating the Recommendations that the strategies, investment approaches, organizational structures and extent of assets managed by individual Hedge Fund Managers vary greatly. The variations in organizational structures can be attributed partly to differences in size and partly to the different strategies used by Hedge Fund Managers, which are distinguishable both in terms of their complexity and their product focus.
The complexity of the strategy employed and the breadth of markets covered, combined with the amount of assets under management and the size of the organization, play a large part in determining the operational requirements of a Hedge Fund Manager. For example, the infrastructure needs of a Hedge Fund Manager managing several diversified macro funds with several billion dollars in net assets will be significantly greater than those of a fund manager that principally trades U.S. equities for a fund of modest size. While some Hedge Fund Managers may have different personnel performing the various practices described in the Recommendations, the personnel of other Hedge Fund Managers may reasonably perform multiple roles.
Individualized Assessment and Application of Recommendations. The Recommendations are not necessarily the only means of achieving sound practices, and they should not be viewed as prescriptive requirements to be rigidly applied by all Hedge Funds or Hedge Fund Managers. Rather, each Hedge Fund Manager should assess the Recommendations based on the size, nature and complexity of its organization, its strategies and resources, as well as the objectives of the Funds it manages, and apply them as appropriate.
In evaluating the relevance of the Recommendations and the ability to implement them, Hedge Fund Managers should recognize that, while some Recommendations can be implemented easily or unilaterally, others may require substantial planning and significant budgetary commitments, involve internal systems changes and infrastructure development, or negotiation with and cooperation by third parties. Certain Recommendations may not be relevant or appropriate to every Hedge Fund or Hedge Fund Manager, especially considering their diverse nature and structures and the individualized cost/benefit analyses applicable to them. Consequently, the Recommendations should not be construed as definitive requirements that could serve as a basis for either auditing or examining the operations of Hedge Funds or Hedge Fund Managers.
No Substitute for Professional Advice. The Recommendations are not intended to serve as or be a substitute for professional advice. Rather, the Recommendations are specifically intended to provide Hedge Fund Managers with a general description of aspirational management and business practices to consider as they develop their operations and business model. As such, the Recommendations do not seek to address specific legal requirements with which Hedge Fund Managers must comply, nor are they exhaustive or all-inclusive. Hedge Funds and Hedge Fund Managers should consult with their professional legal, accounting and tax advisors in determining the applicability of the Recommendations to their business operations and appropriate methods for their implementation.
General Considerations Relating to Hedge Funds
Hedge Fund Defined; Other Defined Terms. The term "hedge fund" is used to describe a wide range of investment vehicles, which can vary substantially in terms of size, strategy, business model and organizational structure, among other characteristics. Although there is no statutory or regulatory definition of a hedge fund, for purposes of this document, the term hedge fund ("Hedge Fund" or "Fund") refers to a fund that meets the following definition:
A privately offered, pooled investment vehicle that is not widely available to the public and the assets of which are managed by a professional investment management firm (referred to in this document as a "Hedge Fund Manager").
The term Hedge Fund, as used in these Recommendations, is not intended to capture private equity, venture capital or real estate funds.
The Nature of Hedge Funds. In assessing the appropriateness of the Recommendations for risk management and internal controls, it is important to distinguish the needs of Hedge Fund Managers from those of credit providers, such as banks and other financial institutions that seek to eliminate or minimize the risks of their businesses through hedging and other risk management methods that seek to reduce risk. Hedge Fund Managers are in the business of seeking and assuming calculated risks and do so in order to achieve the returns desired by their Hedge Fund clients.
By participating in the market as risk seekers, Hedge Fund Managers provide needed liquidity to financial markets, which helps to reduce systemic risk. In this sense Hedge Funds often act as "risk absorbers" in markets by serving as ready counterparties to those wishing to hedge risk, even when markets are volatile, and, in doing so, reduce pressure on market prices while increasing liquidity. In addition Hedge Fund Managers, through their trading based on extensive research, bring price information to the markets that translates into market price efficiencies. Without Hedge Fund Managers' research and commitment of capital, the markets might well have potentially wider price spreads, pricing inefficiencies and illiquidity. Perhaps most importantly, by standing ready to lose capital, Hedge Funds act as a buffer for other market participants in absorbing "shocks."
"...many of the things which [hedge funds] do ... tend to refine the pricing system in the United States and elsewhere, and it is that really exceptionally and increasingly sophisticated pricing system which is one of the reasons why the use of capital in this country is so efficient ... there is an economic value here which we should not merely dismiss...I do think it is important to remember that [hedge funds] - by what they do - they do make a contribution to this country." - Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve, testifying before the Committee on Banking and Financial Services, U.S. House of Representatives. October 1, 1998. |
Hedge Funds can provide investors with valuable portfolio diversification given that the performance of many Hedge Fund investments can exhibit low correlation to that of traditional investments such as stocks and bonds. Hedge Fund Managers, like other large market participants, are known to market regulators and supervisory authorities through various regulatory reports they file in connection with their trading activities (see Appendix II with respect to the United States).
Relationship of Hedge Funds and Hedge Fund Managers. The Recommendations assume that a Hedge Fund is a legal entity governed by a board of directors, managing member, general partner, trustee or similar individual or entity with the legal authority and responsibility to direct and oversee the activities of the Fund. In addition, it is assumed that the assets of each Fund are managed by an investment manager (the "Hedge Fund Manager") and that the Hedge Fund Manager is itself governed by a management committee or other body, or by selected executives, with the authority and responsibility to direct and oversee the Hedge Fund Manager's activities.
A Hedge Fund Manager is typically compensated in part based on the performance of the Hedge Fund and often is a significant investor in the Hedge Funds it manages. This structure creates a strong unity of interests between a Hedge Fund's investors and the Hedge Fund Manager.
It is important to recognize, however, that the nature and structure of Funds and their relationships with Hedge Fund Managers vary substantially and that these assumptions may not apply to all Hedge Funds. Consequently, in determining the applicability of the Recommendations to its organization, a Hedge Fund Manager should interpret and adapt the Recommendations based upon its particular structure and relationship with the Hedge Fund or Funds it manages, taking into account the assumptions upon which the Recommendations were based.
In some cases a Hedge Fund may have a formal board of directors that oversees the Fund's activities and a separate sponsor that retains the Hedge Fund Manager to exercise trading and ancillary authority pursuant to an investment management agreement. In other cases the Hedge Fund Manager conducts all material aspects of the Hedge Fund's management; for example, many U.S. Hedge Funds are organized as limited partnerships in which the Hedge Fund Manager manages the Hedge Fund as general partner in addition to being the investment manager. Certain Hedge Funds may have multiple investment managers that have authority to manage only a portion of the Hedge Fund's assets. Some Hedge Fund Managers may be primarily governed by an executive committee or supervisory board, while others may be managed by their senior investment personnel, which may be a single person in the case of smaller managers.
Risk Functions of Hedge Fund Managers. A Hedge Fund Manager is retained by a Hedge Fund in order to seek returns by assuming market risk consistent with the Hedge Fund's investment objectives. In performing this role, a Hedge Fund Manager needs to be able to identify, select and monitor the types and levels of risk associated with these returns. In this regard, a Hedge Fund Manager should generally perform the following risk functions:
1. Consistent with disclosure made to investors, the Hedge Fund Manager should determine the appropriate overall level of market risk for a particular Fund or strategy. This overall level of market risk should then be appropriately allocated, among, for example, individual portfolio managers, investment strategies or asset classes.
2. Once the market risk allocation is determined, portfolio managers should choose the market-specific risks to be assumed by the Hedge Fund consistent with the Hedge Fund Manager's risk allocation and policies.
3. The risk actually assumed by a Fund must then be analyzed and monitored as part of an established "Risk Monitoring Function". The resulting risk information should be disseminated to senior management and portfolio managers, as appropriate.
4. The Hedge Fund Manager should regularly assess whether risk levels are acceptable and consistent with established risk policies and parameters.
To summarize, a Hedge Fund Manager needs to establish the overall level of market risk to be assumed and how it will be allocated and controlled (steps 1 and 4); portfolio managers are responsible for putting the plan into action (step 2); and the Risk Monitoring Function is responsible for monitoring and analyzing the levels of risk actually assumed by the Hedge Fund in relation to the risk policies set by the Hedge Fund Manager (step 3).
As mentioned above, certain personnel may perform more than one function depending on the business model and circumstances of a particular Hedge Fund Manager. For example, a portfolio manager may also be a key member of a Hedge Fund Manager's senior management. Likewise, overlap between senior management and Risk Monitoring often occurs, e.g., it is not uncommon for a senior manager to play an active role in the Risk Monitoring Function. To the extent practicable, a Hedge Fund Manager should seek to ensure the integrity and objectivity of the Risk Monitoring Function. For example, the Risk Monitoring Function might be either structured internally to ensure that risk analysis is not inappropriately influenced by trading operations or performed through reliance upon independent external resources.
The management and monitoring of risk is a complex and technical subject that must take into account the specific considerations applicable to a particular manager's internal management structure and investment style. The Recommendations seek to address the risk functions of Hedge Fund Managers in a concise manner while acknowledging the variety of structures possible for a Hedge Fund Manager and a Hedge Fund. Appendix I, "Risk Monitoring," seeks to elaborate on certain of the issues addressed in the Recommendations with respect to Risk Monitoring; however, an exhaustive treatment of the topic is beyond the scope of this document.
Organization of the Recommendations
The Recommendations are divided into six major sections, as follows:
2003 SOUND PRACTICES RECOMMENDATIONS
I. MANAGEMENT AND INTERNAL CONTROLS
Consistent with its investment mandate, a Hedge Fund Manager should define the investment objectives and risk parameters applicable to a Hedge Fund, and the trading policies and risk limits necessary to achieve these objectives, in accordance with the investment management agreement with the Hedge Fund. Suitably qualified personnel should be retained and adequate systems established (either internally or through outsourcing) to produce periodic reporting that permits the Hedge Fund Manager to monitor trading activities and operations as well as risk levels effectively. If third-party service providers perform key business functions (such as net asset value calculation or risk monitoring), they also should be subject to appropriate controls and review processes. |
Key Management Policies of a Hedge Fund Manager
1.1 A Hedge Fund Manager should establish management policies and practices commensurate with the size, nature and complexity of the Hedge Fund Manager's trading activities and the Funds it manages.
Management policies should be established for trading activities, valuation, risk analysis, compliance and other key areas as appropriate (see specific recommendations in the sections that follow). A Hedge Fund Manager should adopt an organizational structure that facilitates effective monitoring of compliance with management policies. Policies and practices should be reviewed and updated as appropriate, e.g., when changes in structure or strategy are adopted or significant market events occur.
1.2 A Hedge Fund Manager should determine the investment, risk and trading policies to be observed with respect to each Hedge Fund it manages based on the specific investment objectives of the Hedge Fund.
A Hedge Fund Manager should allocate capital and risk (among, for example, portfolio managers, strategies and/or asset classes, as applicable) based on a Fund's performance objectives and targeted risk profile, taking into account the risk analysis produced by the Risk Monitoring Function. Allocations should be reexamined and adjusted periodically (e.g., at least once annually and following major market events). Appropriate trading and exposure limits should also be established consistent with these allocations.
1.3 A Hedge Fund Manager should impose appropriate controls over its portfolio management and trading activities to ensure that these activities are undertaken on a basis consistent with allocated investment and trading parameters and the investment objectives/strategies disclosed to a Hedge Fund's investors.
A Hedge Fund Manager's senior management should analyze and evaluate trading activities by regularly reviewing the performance of the Hedge Fund's portfolio and the associated risk levels. Internal reporting should provide the Hedge Fund Manager with information regarding the risk and performance levels of the different investment strategies employed and should identify deviations from trading parameters and risk limits.
If the Hedge Fund Manager changes or proposes to change its trading activities on behalf of a Fund in a way that differs materially from the disclosure contained in the Fund's offering documents, it should take steps to ensure that timely and appropriate disclosure is provided so that offering documents accurately reflect the Fund's trading activities.
1.4 A Hedge Fund Manager should determine the allocation of capital among portfolio managers and establish policies for the monitoring of their performance.
All portfolio managers, including external portfolio managers, should be subject to controls and review processes commensurate with the amount of assets managed and form of allocation. Where capital is invested with an external portfolio manager in a managed account, applicable trading restrictions and limits, reporting requirements and termination provisions should be clearly defined in written management agreements. The performance of all portfolio managers should be monitored on a periodic basis as appropriate, depending on the form of the allocation (e.g., monthly performance review of a passive investment in a fund vs. daily or weekly review of a significant managed account investment).
1.5 A Hedge Fund Manager should establish the criteria and methods applicable to selecting and monitoring third-party service providers that perform key business functions (e.g., those related to risk monitoring, valuation, prime brokerage or other administrative functions).
The roles, responsibilities and liability of key third-party service providers should be clearly defined in written service agreements, and the process employed for selecting service providers and monitoring their performance should be periodically reviewed.
Structure of Risk Monitoring Function
1.6 A Hedge Fund Manager should establish a Risk Monitoring Function, either internally or in reliance upon external resources. The Risk Monitoring Function should review objective risk data and prepare analysis of a Hedge Fund's performance and current risk position, the sources of its risk and resulting exposures to changes in market conditions.
The Risk Monitoring Function should report directly to senior management and possess sufficient expertise to understand a Fund's trading strategies and the nature and risks of its investments. To the extent appropriate, risk analysis with respect to a particular investment strategy should be performed independently of portfolio management personnel responsible for that strategy so that trading activities and operations may be effectively supervised and compliance with trading policies and risk limits can be controlled.
Alternatively, a Hedge Fund Manager might seek to ensure the objectivity of risk analysis by providing for an appropriate level of checks and balances with respect to risk monitoring. To the extent appropriate, the Risk Monitoring Function should produce regular risk reports that present risk measures and appropriate breakdowns by category of risk for review by appropriate members of senior management. The Risk Monitoring Function, in consultation with relevant portfolio management personnel, should conduct routine backtests of their risk measures, to ensure that their systems capture all reasonably anticipated significant exposures and that the output is consistent with the assumptions of the models.
II. RESPONSIBILITIES TO INVESTORS
A Hedge Fund Manager should work together with the Hedge Fund so that investors are provided with information regarding the Hedge Fund's investment objectives and strategies, as well as periodic summary performance information, in order to enhance the ability of investors to determine the appropriateness of an investment in the Hedge Fund. |
2.1 A Hedge Fund Manager should create a management environment that recognizes its responsibility to act in the interest of the Hedge Fund and its investors as set forth in the investment management agreement.
A Hedge Fund Manager is retained by a Hedge Fund to act as its investment manager, and, consequently, a Hedge Fund Manager has a responsibility to act in the interest of the Hedge Fund and its investors pursuant to its investment management agreement with the Hedge Fund. A Hedge Fund Manager should therefore take steps to ensure that it manages the Hedge Fund's assets in accordance with its investment management agreement with the Hedge Fund.
2.2 A Hedge Fund's prospective and existing investors should be provided with information regarding the Hedge Fund's investment objectives, the strategies to be employed by the Hedge Fund Manager and the range of permissible investments in order to enhance the ability of investors to determine the appropriateness of an investment in the Hedge Fund.
Informative disclosure regarding a Hedge Fund's investment objectives and strategies will enhance the ability of investors to form appropriate expectations as to the Hedge Fund's performance and therefore facilitate a good match between investor and investment product. A Hedge Fund Manager should therefore seek to ensure that appropriate disclosures are prepared for dissemination to investors on a timely basis (without compromising proprietary information regarding the Hedge Fund's positions). Material changes should be disclosed promptly as appropriate.
2.3 A Hedge Fund Manager should prepare certain base-line standardized performance and other relevant information for distribution to the Hedge Fund's investors based upon relevant characteristics of the Hedge Fund.
Possible disclosures include:
2.4 A Hedge Fund Manager should assess whether its operations or particular circumstances may present potential conflicts of interest and seek to ensure that any conflicts of interest that may be material are appropriately disclosed.
2.5 Appropriately qualified external auditors should be engaged to prepare annual audited financial statements with respect to any Hedge Fund with external investors. Financial statements should be delivered to investors in a timely manner.
III. VALUATION POLICIES AND PROCEDURES
A Hedge Fund Manager should determine policies for the manner and frequency of computing net asset value, or "NAV", based upon GAAP (as defined below) and its management agreement with the Hedge Fund and seek to ensure that material aspects of those policies are appropriately disclosed. Such policies should establish valuation methods that are fair, consistent and verifiable, recognizing that investors may both subscribe and redeem interests in the Hedge Fund in reliance on such values. A Hedge Fund Manager should also develop policies for the manner and frequency of computing portfolio valuation for purposes of internal risk monitoring of the portfolio. |
Fair, Consistent and Verifiable
3.1 A Hedge Fund Manager's valuation methods should be fair, consistent and verifiable.
A Hedge Fund Manager should either calculate or verify the accuracy of prices independent of the trading function to the extent practicable. To that end, a Hedge Fund Manager should seek to rely on price quotes from external sources wherever practicable and cost-effective to do so and establish policies for determining the value of assets for which appropriate external price quotes are not reasonably available (as discussed further below under Pricing Sources).
The valuation of portfolio positions for NAV purposes will be used to determine the prices at which investors subscribe to or redeem from the Fund. Accordingly, a Hedge Fund Manager should seek to utilize valuation practices that are consistent and fair to both subscribing and redeeming investors to the extent practicable and make appropriate disclosures of circumstances in which practices may necessarily deviate from this standard in a material way.
3.2 A Hedge Fund Manager's valuation policies and practices should incorporate the concept of "fair value".
For NAV purposes, a Hedge Fund Manager generally should value investments according to applicable generally accepted accounting principles (GAAP), recognizing that investors will both buy and sell shares of a Fund on the basis of NAV and that its financial statements must reflect NAV. Calculation of NAV must take into account not only the value of the financial instruments in the portfolio (sometimes referred to as "trading P&L"), but also accruals of interest, dividends and other receivables and fees, expenses and other payables.
For companies such as Hedge Funds, GAAP typically requires the use of "fair value" in determining the value of an investment or instrument. For example, under FASB Statement of Financial Accounting Standards No. 107, the "fair value" of financial assets and liabilities under U.S. GAAP is the amount at which the item could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. In circumstances where a Hedge Fund Manager believes that the application of fair value would not produce an accurate or fair valuation for a given instrument, it may employ alternative means to value an instrument as permitted by agreement. A Hedge Fund Manager should be prepared to provide explanations for exceptions made to the Fund's external auditors. In addition, the potential for this type of exception should be disclosed in the Fund's financials and offering documentation.
Pricing Policies and Procedures
3.3 A Hedge Fund Manager should establish pricing policies and practices that assure that NAV is marked at fair value.
Hedge Fund Managers should develop practices and/or systems for capturing pricing data for their positions from independent sources on a daily basis where practicable. Procedures for periodically verifying the accuracy of pricing data should also be adopted, and material discrepancies between price sources should be investigated. Where an instrument is not traded actively or where obtaining price information requires significant effort, weekly (or less frequent) pricing may be appropriate depending on the nature and the size of the position. For positions traded over-the-counter, where the only external source of fair value may be quotes from relevant market-makers (the number of which, based on the liquidity of the position, may be very limited), the number of quotes sought by Hedge Fund Manager to gain comfort with the fair value should also be considered. This may also lead to model pricing (as discussed below).
Where market prices do not exist or are not indicative of fair value, a Hedge Fund Manager should clearly establish the valuation methods to be used for NAV purposes.
3.4 A Hedge Fund Manger should choose reliable and recognized pricing sources to the extent practicable.
In general, where market prices for an instrument are readily available from organized exchanges or markets or recognized data vendors, a Hedge Fund Manager should use such market prices to compute NAV. In such circumstances fair value can be based on the official closing price of an exchange or other relevant market price as published by a recognized data vendor for that market.
Where market prices for an instrument are not readily available from such sources, a Hedge Fund Manager should determine the methods to be used in obtaining values from alternative sources. For example, reliable quotes for certain over-the-counter derivative instruments and structured or distressed securities may not be available from data vendors, either because the transactions are "one of a kind" or not actively traded. In many cases the only market for these instruments may be with the counterparty to the transaction itself. Such instruments could be valued either by obtaining a quote or estimate from the counterparty or based on a pricing model. Where a pricing model is used, a Hedge Fund Manager should be capable of justifying the model parameters used in determining the valuation.
3.5 A Hedge Fund Manager should establish practices for verifying the accuracy of prices obtained from data vendors, dealers or other sources.
For certain actively traded instruments, it may be appropriate to establish multiple feeds from data vendors in order to compare and verify their prices. With respect to less liquid instruments, dealer quotes, prices generated by models or other estimation methods used should be checked periodically against realized prices as appropriate to gauge their accuracy.
Frequency of NAV Determinations
3.6 A Hedge Fund Manager should establish policies for the frequency of determining a Hedge Fund's NAV both for purposes of disclosure and for internal risk monitoring purposes.
A Hedge Fund's official NAV, which reflects all fee and expense accruals in addition to trading profit and loss, is typically determined on an established periodic basis and is used for purposes of pricing investor subscriptions and redemptions. A Hedge Fund Manager may also prepare an estimated or indicative NAV more frequently, based upon estimates of accrued fees and expenses and trading profit and loss. A Hedge Fund Manager should determine whether indicative NAV calculations will be used solely for internal risk monitoring purposes or whether it may be disclosed to counterparties and investors (e.g., upon request or through a web site posting).
3.7 A Hedge Fund Manager should establish policies for determining when risk monitoring valuation methods may differ from NAV for operational or risk analysis reasons.
Portfolio values used to calculate NAV should also be used for risk monitoring valuation unless the Hedge Fund Manager has determined that operational or risk analysis reasons may justify a different approach. For example, in order to examine potential effects on the portfolio of changes in market conditions, the Hedge Fund Manager may permit the Risk Monitoring Function to use alternative values or make adjustments to the position values calculated in accordance with GAAP for NAV purposes. Similarly, in volatile markets, a Hedge Fund Manager may wish to discount prices for risk analysis purposes if the Risk Monitoring Function does not believe that quoted bids or offers are prices at which a trade could actually be executed.
Current market practice is to focus on three categories of risk that are measurable - "market risk," "credit risk" (including sovereign risk) and "liquidity risk". In addition a Hedge Fund Manager should seek to assess "operational risk" depending on its particular circumstances. Market risk relates to losses that could be incurred due to changes in market factors (i.e., prices, volatilities, and correlations). Credit risk relates to losses that could be incurred due to declines in the creditworthiness of entities in which the Fund invests or with which the Fund deals as a counterparty. Funding liquidity risk relates to losses that could be incurred when declines in a Fund's capital due to redemptions or other sources of funding or liquidity reduce the ability of the Fund to fund its investments. It differs from asset liquidity risk (a form of market risk), which is defined as the potential exposure to loss associated with the inability to execute transactions - particularly on the liquidation side - at prevailing prices.
While current market practice is to treat the risks separately, it is crucial for Hedge Fund Managers to recognize and evaluate the overlap that exists between and among market, credit and liquidity risks. This overlap is illustrated in the following diagram (recognizing that the relative sizes of the circles will be different for different strategies):
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For a more detailed discussion of the concepts and limitations referenced in the Recommendations in this section, please see Appendix I, "Risk Monitoring."
Encompasses interest rate risk, foreign exchange rate risk, equity price risk, and commodity price risk, as well as asset liquidity risk and the credit risk associated with investments.
4.1 A Hedge Fund Manager should evaluate market risk, not only for each Hedge Fund portfolio in aggregate, but also for relevant subcomponents of a portfolio - e.g., by strategy, by asset class, by type of instruments used, by geographic region or by industry sector, as appropriate. In addition, the market risk assumed by each individual portfolio manager should be determined. A Hedge Fund Manager should employ a consistent framework for measuring the risk of loss for a portfolio (and relevant subcomponents of the portfolio), such as a "Value at Risk" (or VAR) model. While the choice of model should be left to each Hedge Fund Manager, the Hedge Fund Manager should be aware of the structural limitations of the model selected and actively manage these limitations, including the impact of any model breakdown.
A sound market risk monitoring process should incorporate the confidence level(s) and holding period(s) deemed appropriate depending on the markets traded and the risks assumed. The holding period(s) should take into account the time necessary to liquidate and/or neutralize positions in the portfolio.
The role of the Risk Monitoring Function is to identify the factors affecting the risk and return of the Fund's investments, both within individual portfolios and across the entire range of activities of the Hedge Fund Manager. Those factors (e.g., market rates and prices, credit spreads, volatilities, correlation) should be incorporated into the risk monitoring process and, where appropriate, be included in the market risk model.
Positions managed as a separate account by external portfolio managers on behalf of the Hedge Fund should be incorporated in the routine risk assessment of the overall portfolio. Passive investments in funds managed by external portfolio managers should be monitored as appropriate.
Hedge Fund Managers should recognize that market risk measures such as VAR do not give a complete picture of risk in that they assess the risk of "standard" market movements rather than extreme events. Hedge Fund Managers should therefore complement risk modeling with relevant stress tests and backtesting, as discussed below.
4.2 A Hedge Fund Manager should perform "stress tests" to determine how potential changes in market conditions could impact the value of a Hedge Fund's portfolio.
A Hedge Fund Manager should perform stress tests by changing the parameters used in its market risk model to magnify their effects. Stress tests permit the Hedge Fund Manager to see what will happen to its market risk measures if the actual values of market factors (e.g., prices, rates, volatilities, etc.) differ from the values used as inputs in the base-case market risk model.
In addition, a Hedge Fund Manager should incorporate the impact of correlated events into stress testing, where appropriate.
A Hedge Fund Manager also should consider conducting "scenario analyses" to benchmark the risk of a Fund's current portfolio against various scenarios of market behavior (historical or prospective) that are relevant to the Hedge Fund Manager's trading activities (e.g., the October 1987 stock market event, the Asian financial crisis of 1997 or a scenario where concerns about general credit quality lead to dramatic declines in asset values combined with decreases in asset and funding liquidity).
4.3 A Hedge Fund Manager should validate its market risk models via "backtesting."
For internal control purposes, the Risk Monitoring Function should perform backtesting of its market risk models, that is, it should compare the distribution of observed changes in the value of a Hedge Fund's portfolio to the distribution of changes in value generated by its market risk model.
If the frequency of changes in the value of the portfolio exceeds the frequency generated by the market risk model (a statistical expectation based on the confidence level of the market risk model), such deviation should be scrutinized to determine its source. If appropriate after investigation, the market risk model should be modified.
Funding liquidity is critical to a Hedge Fund Manager's ability to continue trading in times of stress. Funding liquidity analysis should take into account the investment strategies employed, the terms governing the rights of investors to redeem their interests and the liquidity of assets (e.g., all things being equal, the longer the expected period necessary to liquidate assets, the greater the potential funding requirements) and the funding arrangements negotiated with counterparties such as prime brokers. Adequate funding liquidity gives a Hedge Fund Manager the ability to continue a trading strategy without being forced to liquidate assets when losses arise. |
4.4 Cash should be actively managed.
A Hedge Fund Manager should evaluate the effectiveness of the cash management process and establish policies for investing a Hedge Fund's excess cash, based on established risk parameters and taking into account the credit risk presented by the party with whom cash is invested. In establishing cash management policies, a Hedge Fund Manager should consider cash flow needs based on the risk and funding profile of the portfolio and investor subscription and redemption windows.
4.5 A Hedge Fund Manager should employ appropriate liquidity measures in order to gauge, on an ongoing basis, whether a Fund is maintaining adequate liquidity. Liquidity should be assessed relative to the size of the Fund and the risk of its portfolio and investment strategies.
A discussion of possible liquidity measures is included in Appendix I.
4.6 A Hedge Fund Manager should evaluate the stability of sources of liquidity and plan for funding needs accordingly, including a contingency plan in periods of stress.
Hedge Fund Managers should assess their Cash and Borrowing Capacity under the worst historical drawdown and stressed market conditions, taking into account potential investor redemptions and contractual arrangements that affect a Fund's liquidity (e.g., notice periods for reduction of credit lines by counterparties).
Hedge Fund Managers should periodically forecast their liquidity requirements and potential changes in liquidity measures.
Hedge Fund Managers should perform scenario tests to determine the impact of potential changes in market conditions on a Fund's liquidity. Among these scenario tests, Hedge Fund Managers should consider including the potential response to a creditor experiencing a liquidity problem during times of market stress (e.g., reluctance to release collateral).
Hedge Fund Managers should take into account in their liquidity planning redemption "windows" or other rights of investors to redeem their interests. Hedge Fund Managers should also take into account the relationship between a Fund's performance and redemptions and between a Fund's performance and the availability of credit lines.
4.7 In an effort to enhance the stability of financing and trading relationships, a Hedge Fund Manager should engage in constructive dialogue with a Hedge Fund's credit providers and counterparties to determine the extent of financial and risk information to be provided.
The extent of disclosure to be provided should be mutually agreed with such parties depending on their requirements and the extent and nature of the relationship.
A counterparty's credit department should be required to provide assurances that financial and other confidential information furnished by the Hedge Fund Manager will only be used for credit evaluation purposes and will not be made available to any member of a counterparty's trading desk or department. These assurances could be confirmed by the counterparty's credit department in a written confidentiality agreement or by providing a copy of its confidentiality policies.
4.8 A Hedge Fund Manager should understand and manage the Fund's exposure to potential defaults by trading counterparties.
A Hedge Fund Manager should identify acceptable counterparties based on an analysis of creditworthiness and set appropriate exposure limits. Where a judgment call with respect to a particular counterparty is necessary, a Hedge Fund Manager's senior management should determine whether the counterparty's creditworthiness is acceptable, e.g., based on an analysis of the costs and benefits of dealing with the counterparty to the extent practicable.
Once a trading relationship with a counterparty is established, a Hedge Fund Manager should ensure that the counterparty's creditworthiness is appropriately monitored. A Hedge Fund Manager should also seek to establish appropriate collateral arrangements with the counterparty (see Recommendation 5.8) and establish the ability to make and respond to collateral calls.
A Hedge Fund Manager should recognize that, although leverage is not an independent source of risk, leverage is important because of the magnifying effect it can have on market risk, credit risk and liquidity risk. Recognizing the impact that leverage can have on a portfolio's exposure to market risk, credit risk, and liquidity risk, a Hedge Fund Manager should assess the degree to which a Hedge Fund is able to modify its risk-based leverage in periods of stress or increased market risk. |
4.9 A Hedge Fund Manager should develop and monitor several measures of leverage, recognizing that leverage, appropriately defined, can magnify the effect of changes in market, credit or liquidity risk factors on the value of the portfolio and can adversely impact a Hedge Fund's liquidity.
A Hedge Fund Manager should recognize that leverage is not an independent source of risk; rather, it is a factor that influences the rapidity with which changes in market risk, credit risk or liquidity risk factors impact the value of a Fund's portfolio. A Hedge Fund Manager should seek to assess leverage while taking into account the limitations inherent in different leverage measures, as noted below and discussed in further detail in Appendix I.
Risk-Based Leverage
A Hedge Fund Manager should track a Fund's leverage using "risk-based leverage" measures reflecting the relationship between the riskiness of a Fund's portfolio and the capacity of the Fund to absorb the impact of that risk. Risk-based leverage measures that could perform this function are described in Appendix I. Some of the liquidity measures discussed in Appendix I can also be viewed as risk-based leverage measures.
The Hedge Fund Manager must be aware of limitations of the models used and must guard against placing too much reliance on mathematical measures of leverage alone. For example, market risk measures such as VAR are incomplete measures of market risk because they focus on "standard" market movements rather than extreme events. Consequently, the Hedge Fund Manager should consider assessing the impact of extreme events by comparing a market risk measure derived from analysis of extreme event scenarios (or stress tests) to the Fund's capital. In addition, it is essential that the Hedge Fund Manager use judgment based on business experience in calculating and assessing quantitative measures of leverage.
A crucial factor influencing the Fund's ability to absorb the impact of extreme market events is the degree to which the Fund can modify its risk-based leverage, especially during periods of market stress. A Hedge Fund Manager should therefore assess its ability to reduce risk-based leverage by modifying (upward or downward) traditional leverage or by reducing the level of risk that is being accepted (e.g., by changing strategy or the types of assets being held in the portfolio).
Accounting-Based Leverage
A Hedge Fund Manager may consider tracking certain traditional accounting-based measures of leverage as part of its financial reporting or in connection with the analysis and interpretation of certain risk-based leverage measures or funding liquidity. However, a Hedge Fund Manager should recognize that although such measures can provide useful information if they are understood fully and interpreted correctly, they have a number of weaknesses, particularly as stand-alone measures of leverage, as discussed in greater detail in Appendix I.
4.10 Hedge Fund Managers should seek to limit the Fund's exposure to potential operational risks, including data entry errors, fraud, system failures and errors in valuation or risk measurement models.
Hedge Fund Managers should consider measures to limit or mitigate operational risk, including:
V. REGULATORY AND DOCUMENTATION CONTROLS
A Hedge Fund Manager should seek to actively monitor and manage its regulatory responsibilities to ensure compliance with all applicable rules and regulations. A Hedge Fund Manager also should pursue a consistent and methodical approach to documenting transactions in order to enhance the legal certainty of its positions. |
Compliance with Applicable Rules and Regulations
5.1 A Hedge Fund Manager should create a management environment that provides for compliance with all rules and regulations applicable to its business operations.
Hedge Funds and Hedge Fund Managers are required to comply with a wide variety of rules and regulations and furnish significant information and reports to regulators in connection with their trading activities. See Appendix II for a list of some of the reporting requirements and other regulations applicable to Hedge Funds and their activities in the United States.
A Hedge Fund Manager should take steps, in reliance upon its internal and external resources (including prime brokers, administrators, attorneys and accountants), to ensure that its personnel are cognizant of and comply with the rules and regulations applicable to its business operations, as well as those of the Hedge Funds it manages. For example, a Hedge Fund Manager should seek to ensure compliance with rules and regulations applicable to private offerings and sales practices, anti-money laundering, soft dollar practices, insider trading and market manipulation, among others.
5.2 A Hedge Fund Manager should identify all actual and potential required regulatory filings and clearly allocate responsibility for such filings to appropriate personnel or service providers who will supervise and ensure timely compliance with applicable regulations and filing requirements.
5.3 Taking into account the size and complexity of the Hedge Fund Manager's operations, a Hedge Fund Manager should establish written compliance policies that address, where applicable, trading rules and restrictions, confidentiality requirements, policies designed to ensure compliance with applicable securities, commodities and related laws (e.g., prohibitions on insider trading and other forms of market manipulation, measures to prevent the flow of non-public information from one function to another, personal trading policies).
Compliance policies should be regularly updated and internal controls should be established to monitor compliance with such policies. All employees should be required to attest in writing upon hiring and on an annual basis to their understanding and acceptance of relevant compliance policies.
5.4 A Hedge Fund Manager should be aware of the anti-money laundering regulations to which it and the Hedge Funds it manages are subject and ensure that appropriate investor identification procedures are performed where required.
Hedge Fund Managers may wish to consult MFA's Preliminary Guidance for Hedge Funds and Hedge Fund Managers on Developing Anti-Money Laundering Programs, attached as Appendix III, for practical guidance in this evolving area.
5.5 A Hedge Fund Manager should establish transaction execution and documentation management practices that seek to ensure timely execution of necessary transaction documents and enforceability of transactions.
To the extent practicable, a Hedge Fund Manager may wish to implement the following practices:
5.6 A Hedge Fund Manager should track the status of documentation and the negotiation of key provisions and terms such as termination events (including use of a database if needed) to seek to ensure consistency and standardization across Funds and counterparties to the extent appropriate.
5.7 A Hedge Fund Manager should seek consistent bilateral terms with counterparties to the extent practicable in order to enhance stability during periods of market stress or declining asset levels.
For example, a Hedge Fund Manager may seek to negotiate standardized events of default and other termination or collateral events to achieve consistency in documentation with different counterparties to the extent practicable. A Hedge Fund Manager may also endeavor to avoid including provisions that permit counterparties to terminate or make demands for collateral solely at their discretion or based upon highly subjective determinations.
5.8 A Hedge Fund Manager should seek to negotiate bilateral collateral agreements that require each party to furnish collateral, taking into account the relative creditworthiness of the parties.
To the extent feasible, a Hedge Fund Manager should seek to establish collateral arrangements either internally or through reliance on external resources that permit the Hedge Fund Manager to effectively and regularly make calls for deliveries and returns of collateral from counterparties when permitted.
5.9 A Hedge Fund Manager should consider providing input to the Risk Monitoring Function for use in stress/scenario testing as well as liquidity analyses based on legal or contractual relationships.
For example, in performing stress tests or scenario analyses, the Risk Monitoring Function may wish to take into account the legal or contractual sales restrictions applicable to certain investments. The contractual rights of counterparties to terminate or otherwise unwind trading relationships or increase margin/collateral requirements upon the occurrence of certain events (such as declines in NAV) may also need to be considered.
5.10 A Hedge Fund Manager should have appropriate documentation and approval processes for retaining external traders as well as administrators, prime brokers or other third-party service providers.
VI. DISASTER RECOVERY AND BUSINESS CONTINUITY
While the need to establish a functional disaster recovery and business continuity plan ("BCP") is not unique to Hedge Funds, it is particularly important for a Hedge Fund Manager because the inability to carry out routine trading and risk monitoring functions (even on a very short-term basis) as a result of a disruption could result in large financial losses. |
6.1 A Hedge Fund Manager should establish a business continuity plan that includes practices to ensure, to the greatest extent practicable, that appropriate personnel will have the ability to monitor a Hedge Fund's existing portfolio positions and execute transactions where necessary in the event of a market emergency or other severe market disruption.
A Hedge Fund Manager should establish a written business continuity and disaster recovery plan that outlines practices to be followed in an emergency or significant market disruption. Hedge Fund Managers should consider addressing the following items as applicable to its operations:
The plan should be updated as necessary to respond to material changes in a fund's operations. It is also recommended that the Hedge Fund Manager test its plan for effectiveness.
6.2 A Hedge Fund Manager should establish contingency plans for responding to failure of a third party administrator, credit provider or other party that would affect the market, credit, or liquidity risk of a Fund.
Contingency planning should address responses to a failure of a third party on a Fund's ability to meet its obligation, including transfers of activity to back-up clearing systems, credit providers and other service providers and back-up providers.
APPENDIX I
RISK MONITORING PRACTICES FOR HEDGE FUND MANAGERS
The objective of this appendix is to elaborate upon the discussion of risk monitoring practices contained in the Recommendations. In so doing, this appendix describes the general array of risk management techniques and methodologies currently available, in addition to addressing the specific techniques and methodologies that should be considered as part of sound risk monitoring practices for Hedge Fund Managers. The latter discussion includes further explanations of valuation, liquidity and leverage from the perspective of Hedge Fund Managers.
This appendix begins by providing an overview of the risks faced by a Hedge Fund Manager in Section 1.1 The descriptions of the practices for monitoring Market Risk (Section 2), Funding Liquidity Risk (Section 3) and Leverage (Section 4) form the core of this appendix and address the following key issues:
This appendix concludes with a description of practices for monitoring Counterparty Credit Risk (Section 5). Because Hedge Funds generally deal with counterparties having high credit quality, the credit risk of counterparties may be of less concern to Hedge Fund Managers than the other sources of risk but should nonetheless by appropriately monitored.
1. Overview: The Risks Faced by a Hedge Fund Manager
Effective risk management requires that the Hedge Fund Manager recognize and understand the source of the returns the Fund is earning - i.e., the risks to which the Fund is exposed. Consequently, one of the primary responsibilities of the Risk Monitoring Function is to identify and quantify the sources of risk.
While observers often distinguish four broad types of risk - Market Risk, Credit Risk, Liquidity Risk and Operational Risk2 - it is important to recognize that these risks are interrelated. Indeed, Hedge Fund Managers should recognize that "market risk" incorporates elements of credit risk and liquidity risk. Defined most narrowly, market risk focuses on the impact of changes in the prices of (or rates for) securities and derivatives, the volatilities of those prices, and the correlations between pairs of prices on the value of the portfolio. However, elements of liquidity risk and credit risk have a similar focus; for example:
Because these three risks all focus explicitly on changes in the value of an asset or the portfolio, Hedge Fund Managers should integrate the monitoring and management of them (i.e., view them as a group, rather than individually). Hence, in Section 2 of this appendix, "market risk" will encompass the credit risk associated with assets held in the portfolio and asset (or market) liquidity risk, as well as the more commonly cited market risk factors: interest rate risk, foreign exchange rate risk, equity price risk and commodity price risk.
In addition to having an impact on the value of securities or derivatives held by the Hedge Fund, changes in funding liquidity can impact on the Hedge Fund Managers' ability to finance its positions. Section 3 will indicate why this risk is of greater concern to Hedge Fund Managers than to other entities and will describe the techniques that should be used by Hedge Fund Managers to monitor funding liquidity risk.
The Hedge Fund Manager must also consider "leverage." However, leverage is not an independent source of risk; rather, it is a factor that influences the rapidity with which changes in market risk, credit risk or liquidity risk factors change the value of the portfolio. Indeed, it is essential to consider what leverage means - or doesn't mean - in the context of a Hedge Fund:
Stylized Portfolios In Sections 2, 3 and 4, a collection of stylized portfolios and balance sheets are used to illustrate and compare the measures of market risk, funding liquidity risk and leverage that are discussed in the Recommendations and this appendix. As described below, these simple portfolios are composed of various combinations of three hypothetical securities (which are denoted as Asset 1, Asset 2 and Asset 3) and two derivative contracts. Two of the securities are lower risk assets, with annualized volatility of 30% and 25%, respectively. The third asset is a higher risk asset with annual volatility of 60%. The two derivatives are simple futures contracts on the two low risk securities; therefore they have the same volatility as those securities. Each portfolio is part of a simple balance sheet. It is assumed that $100 of investor equity funds each strategy. To calculate all of the various risk measures, the stylized balance sheets also indicate a cash position, a futures margin position, and a liability account that reflects any financing transactions. The required futures margin is 10% in cash, which is not counted as liquidity. In addition, up to 50% of Assets 1, 2, or 3 can be borrowed, and 50% of the proceeds from a short sale are available to finance investments. For each portfolio various measures of market risk, liquidity and leverage have been calculated. Note that not all the risk measures are relevant for every portfolio.
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As noted above, for Hedge Fund Managers, changes in credit quality that affect the value of the portfolio through a change in the price of securities owned are incorporated into "market risk." However, Hedge Fund Managers are also exposed to counterparty credit risk. Changes in the credit quality of counterparties can impose costs on the Hedge Fund either in the form of an increase in expected losses due to counterparty failure to perform or by forcing the Hedge Fund Manager to find alternative counterparties.
Operational risks faced by Hedge Fund Managers are much the same as those faced by other financial institutions - data entry errors, fraud, system failures and errors in valuation or risk measurement models. The appropriate techniques and practices to deal with these risks are, likewise, the same techniques and practices used by other entities. As noted in the Recommendations, these include random spot checks, maintenance of a single, centralized data set, contingency plans for responding to failures in the Hedge Fund Manager's systems or for responding to the failure of a third party service provider.
Encompassing the credit risk associated with securities and derivatives in the portfolio and asset liquidity risk, as well as interest rate risk, foreign exchange rate risk, equity price risk, and commodity price risk.
A Hedge Fund Manager should employ a consistent framework for measuring the risk of loss for a portfolio (and relevant subcomponents of the portfolio). In order that the Hedge Fund Manager be able to manage the risks that the Hedge Fund faces, the Risk Monitoring Function needs to produce some useful measures and analyses of risk. While the choice of framework or model for measuring risk should be left to each Hedge Fund Manager, the Hedge Fund Manager should be aware of the structural limitations of the model selected and actively manage these limitations, including the impact of any model breakdown.
For example, measuring the degree to which the portfolio is diversified (e.g., the percentages of the portfolio allocated to different asset classes or to different geographical regions) may be useful, but it is important for the Hedge Fund Manager to recognize and understand the correlations between positions. For complex portfolios, many summary measures of market risk do not reflect such correlations.
One model that is intended to provide a summary market risk measure that incorporates correlations between positions is Value-at-Risk (VAR). VAR measures the maximum change in the value of the portfolio that would be expected at a specified confidence level over a specified holding period. For example, if the 95% confidence level, one-day VAR for a portfolio is $500,000, one would expect to gain or lose more than $500,000 in only 5 of every 100 trading days on average. One of the roles of the Risk Monitoring Function is to identify the factors affecting the risk and return of the Fund's investments, both within individual portfolios and across the entire range of activities of the Hedge Fund Manager. Those factors should be incorporated into the risk monitoring process and, where appropriate, be included in the market risk model. Factors that are commonly incorporated in a market risk model include:
The Risk Monitoring Function may also consider incorporating "asset liquidity" (i.e., the potential exposure to loss attributable to changes in the liquidity of the market in which the asset is traded) as an additional factor. Measures of asset liquidity that may be considered include:
Parameter Selection
In order to calculate a VAR measure, a number of parameters must be input; these parameters describe the positions in the portfolio and the underlying markets. In addition, users of VAR must select across three methodologies that have become standard forms of VAR over the past several years:
Variance/Covariance. Under this method, which is probably the most widely used VAR methodology, the program draws volatility (Variance) and correlation (Covariance) information from data histories, for each position in the portfolio, and calculates the volatility estimate under the assumption that the returns for the overall portfolio will assume a normal distribution. It is the least process intensive and perhaps the easiest of the VAR methodologies.
Historical Volatility. Under this approach, the VAR portfolio actually is repriced each day over the data history, a daily P/L calculation is derived and ranked in ascending order. The risk estimate is then set at the level consistent with the confidence interval selected for the analysis. Historical Volatility is very process intensive, but is considered by many to be the most effective form of VAR.
Monte Carlo Simulation. Under the Monte Carlo approach, the portfolio is repriced across large numbers of random observations that are consistent with the volatility history of the underlying instruments. Like historical VAR, these observations are then ranked in ascending order, and the risk estimate is set at a level consisted with the applicable confidence interval. Historical Monte Carlo VAR is typically only used for very complex portfolios, featuring abundant nonlinearities.
Each method, if applied accurately and in a manner consistent with the Risk and Capital allocation policies of the Hedge Fund, can be an effective, if imperfect, means of estimating exposure.
In addition to the selection of VAR methodology, for a given portfolio, the parameters most likely to have a significant impact on the VAR value are the time horizon or holding period (the period of time that would be necessary for the portfolio to be liquidated or neutralized), the confidence level (the probability that the change in the value of the portfolio would exceed the VAR), and the variance-covariance data (which reflects the volatility of the individual market factors and the correlation between pairs of factors). These parameters are explained further below.
Time Horizon
The time horizon or holding period used in the VAR calculation is intended to reflect the time period necessary to liquidate (or neutralize) the positions in the portfolio. In practice, if the Hedge Fund has positions in thinly traded or illiquid instruments, it is difficult to determine the correct liquidation/neutralization period for the portfolio. Consequently, good practice is to use standard holding periods - e.g., one day, three days, 5 days, and 10 days in the base-case VAR calculation and then employ stress tests to determine the degree of holding period risk in the portfolio.
Confidence Level
There is no mathematical formula that defines the appropriate confidence level; the appropriate confidence level is determined by the business circumstances of the entity. Different types of businesses should and do use different confidence levels. The appropriate confidence level for a specific Hedge Fund will be a business decision that is determined by the specific circumstances of the Fund; and senior management of the Hedge Fund Manager should be actively involved in this determination.
Variance-Covariance Data3
While the measure of the riskiness of individual market factors (i.e., the variances of the market factors) is important, the question of the degree of correlation (i.e., covariance) between pairs of market factors is critical, because correlation has such a large impact on the VAR calculation. A number of VAR models use historic correlations. However, since historic correlations are unstable (especially during periods of market stress), the Hedge Fund Manager should employ scenario analyses and stress testing (see below) to ascertain the impact of inaccurate correlation assumptions.
Beyond a Single VAR Number
Scenario Analysis, Stress Testing and Backtesting
Hedge Fund Managers must recognize that a single VAR number is not sufficient to capture all risks faced by the Hedge Fund and that successful risk management requires the Risk Monitoring Function to analyze both the sensitivity of the VAR to alternative market conditions and the reliability of the VAR calculations.
Scenario Analysis
By their nature, VAR calculations are based on "typical" market days. Periods of market stress or crisis - the very times of greatest concern - will not be well represented in the data for a typical period; so the resulting VAR number will underestimate the risks of severe markets. To address this limitation, the Hedge Fund Manager should perform scenario analyses regularly, to assess the VAR for the current portfolio in periods of market stress.
In creating scenario analyses, a Hedge Fund Manager should use both historical stress periods - e.g., October 19, 1987 when the equity markets "crashed," February 4, 1994 when the US Federal Reserve changed direction and started increasing US interest rates, December 20, 1994 when the Mexican Peso was devalued - as well as hypothetical periods, designed perhaps to put the most pressure on the current portfolio.
Stress Testing
Hedge Fund Managers should stress test the VAR number by changing the parameters of the VAR model. Stress tests permit the Hedge Fund Manager to see what will happen to the VAR number if the actual values of market factors (i.e., prices, rates, volatilities, etc.) differ from the values used as inputs in the base-case VAR calculation.
Among the potential changes in market conditions that should be considered in stress testing are:
If the portfolio contains options or instruments with options characteristics, additional changes that should be considered as part of stress testing are:
Hedge Fund Managers also should consider including the effects of changes in the liquidity of various assets in their stress testing. For example, Hedge Fund Managers could examine the effects of changing the holding period. A horizon of several days may reveal strings of losses (or gains) that, while individually consistent with the one-day predicted distributions, in total add up to a significant deviation from the market risk model's predicted distribution.
Rather than changing the holding period to reflect the illiquidity of securities or derivatives, the Hedge Fund Manager could gauge the impact of illiquidity by inputting changes for the appropriate market risk factors that are reflective of multiple-day market price movements (as opposed to single day changes).
If specific asset liquidity factors are incorporated in the market risk model (see above), these asset liquidity factors can be "stressed" to examine the impact of (1) changes in the value that could be lost if the position in question were to be liquidated and/or neutralized completely during the standard holding period, or (2) changes in the number of days required to liquidate and/or neutralize the position in question.
Of particular concern to Hedge Fund Managers are "breakdowns" in the correlations reflected in current market data. In times of market crisis, the correlations between asset prices or rates can change dramatically and unexpectedly, with the result that positions that were thought to be diversifying - or even hedging - end up compounding risk. While it remains difficult to hedge correlation risk, stress tests to evaluate the impact of correlation changes permit the Hedge Fund Manager to help ensure that, when the Hedge Fund Manager selects the assets to be included in the portfolio, the Fund is accepting the desired level of correlation risk (and is being compensated for bearing that risk).
Illustrative Risk Measures Table 2 contains several illustrative VAR measures for each of the nine stylized portfolios introduced earlier:
Table 2 provides confirmation of some general propositions regarding the VAR measures:
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Back Testing
Perhaps even more important than analyzing the sensitivity of the VAR number is "back testing" the VAR to see how it performed. By comparing actual changes in the value of the portfolio to the changes generated by the VAR calculation, the Hedge Fund Manager can gain insight into whether the VAR model is accurately measuring a Fund's risk.
In back testing, one expects that the portfolio will lose more than the VAR from time to time. For example, a 95% one-day VAR should be exceeded 5 days in every 100 trading days on average. When the actual changes in the value of the portfolio exceed VAR, the Hedge Fund Manager should determine the source of the discrepancy, i.e., whether the VAR measure is flawed or whether this loss is simply one which was expected given the confidence level employed. Other potential sources of deviations include:
Relating Earnings and Risk
It was noted at the outset that effective risk management requires the Hedge Fund Manager to recognize and understand the risks the Fund faces. That, in turn, requires the Hedge Fund Manager to understand the various sources of the Fund's earnings, both the size of the earnings and their volatility.
One way that Hedge Fund Managers can accomplish this attribution is by decomposing the daily value changes by market factors. The objective is to determine if the actual changes were what would have been predicted, given the now known changes in the market factors. If the observed change in the value of the portfolio differs significantly from the change that would be expected, given the composition of the portfolio and the observed changes in the market factors, the differences should be reconciled.
Such a source-of-return and source-of-risk attribution process sets the stage for linking performance measurement with risk measurement. The Sharpe Ratio is widely used by investors to measure a portfolio's risk-adjusted performance over a specific period.4 The numerator of the Sharpe Ratio is a measure of portfolio return during the period; the denominator is a measure of the risk incurred in achieving the return. (For example, over the past decade the Sharpe Ratio for the S&P 500 has been approximately 1.2.) Investors prefer higher Sharpe Ratios, since a higher Sharpe ratio indicates that the portfolio earned superior returns relative to the level of risk incurred.
There are a number of ways in which return and risk could be calculated. Below is the Sharpe Ratio for an arbitrary portfolio - designated as Portfolio j - calculated using the most common conventions for measuring return and risk. The numerator is the return earned on the portfolio (Rj) in excess of the risk-free rate of return (Rf), i.e., the interest rate earned on risk-free securities such as U.S. Treasury securities, over the same period. The denominator - the risk incurred - is measured as the standard deviation of the portfolio's daily return ( σj ).
| R j - R f | ||
| (Sharpe Ratio) | = | --------- |
| σ j |
While Value at Risk and the Sharpe Ratio contain some similar information, the two measures are different tools, designed for different purposes. VAR is primarily a risk measurement tool. The Sharpe Ratio is a summary measure, combining both risk and return information. Moreover, while VAR is a risk measure and the denominator of the Sharpe Ratio contains a risk measure, these two risk measures are quite different. The risk measure used in the denominator of the Sharpe Ratio is a historical measure; it characterizes the actual volatility of the return over some historical period. In contrast, VAR is intended to be a prospective measure of risk.
3. Funding Liquidity Risk
While other entities face funding liquidity risk, this risk is a more central concern to Hedge Fund Managers than others, because funding liquidity problems can rapidly increase a Hedge Fund's risk of failure. As is described in the following box, a lack of funding liquidity can contribute to a crisis situation for the Hedge Fund.
Liquidity Crisis Cycle Hedge Fund Managers should be concerned about a confluence of risks - i.e., market or credit risk events affecting illiquid positions that are leveraged. Such a confluence of events could require the Hedge Fund to liquidate positions into a market that cascades in price because of a high volume of liquidation orders. Such a situation could be decomposed into three stages: 1. A loss that acts as the triggering event. 2. A need to liquidate positions in a disorderly manner to raise cash, because of this loss. The liquidation may be required either because the Fund must post margin with its counterparties or because of redemptions by investors due to the loss. 3. A further drop in the Fund's net asset value as the market reacts to actions by the Fund. Obviously, attempts by the Fund to sell in too great a quantity or too quickly for the market liquidity to bear can cause a further drop in prices, precipitating a further decline in the Fund's net asset value, and leading in turn to yet a further need to liquidate to satisfy margin calls or redemptions. This downward spiral can be exacerbated if other market participants have information about the Fund's positions. The point of no return comes when the effect of liquidation has a greater impact on the value of the remaining Fund position than the amount of cash raised from the liquidation. If this happens, the Fund is caught in an accelerating, downward spiral; and eventually it will not be able to satisfy the demands of its creditors or investors. Once the losses move beyond a critical point, it becomes a self-sustaining crisis that feeds off of the need for liquidity, a need imposed by the demands of the Fund's creditors and investors. |
Because of its importance, Hedge Fund Managers should focus significant attention and resources on measuring and managing funding liquidity risk. There exist a range of measures Hedge Fund Managers can use to track funding liquidity risk. Hedge Fund Managers should monitor the liquidity available in the Fund by tracking its cash position (i.e., cash and short-term securities issued by high-credit-quality entities) and its borrowing capacity (e.g., access to borrowings under margin rules or credit lines).
Beyond measures of available liquidity, Hedge Fund Managers should also monitor measures of relative liquidity. Hedge Fund Managers should relate the measures of liquidity (Cash or Cash + Borrowing Capacity) to the need for that liquidity. The following measures are indicators of a Fund's potential need for liquidity:
Illustrative Liquidity Measures Table 3 contains the results of calculating five of the liquidity measures discussed in this section for each of the nine stylized portfolios. Available liquidity is measured by cash that is not committed as margin, and by cash plus the "borrowing capacity" of the assets. For the three cash market assets, it is assumed that 50% of the value of a long position can be borrowed (i.e., assume current Regulation T margin requirements if the three assets were equities). For simplicity, short positions in the assets are assumed to have a 50% margin requirement, in effect, allowing 50% of short trades to be used to fund long positions, or for cash. Several features of funding liquidity risk measurement are evidenced by the stylized portfolios.
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Additional insight about funding liquidity can be gained by looking at the variability in the relative liquidity measure over time. A relative liquidity measure that varies over time is evidence consistent with "effective liquidity" - i.e., the assets are liquid and the manager is willing to take advantage of that liquidity.
Beyond simply monitoring liquidity, Hedge Fund Managers should manage liquidity in several dimensions. Foremost is the use of the Hedge Fund Manager's experience and judgment to maintain liquidity levels that are adequate given the risk of loss and/or the likelihood of investor redemptions. Also, Hedge Fund Managers should strengthen lines of communication with their credit providers, providing them with summary measures of the Fund's risk and liquidity consistent with the nature of the relationship. Hedge Fund Managers should actively manage (or monitor) the cash in margin accounts. Similarly, Managers should negotiate haircuts, the speed at which prime brokers can dictate an increase in margin rates and two-way collateral agreements, where appropriate, to further reduce the likelihood of running out of liquidity.
4. Leverage
As the Recommendations made clear, leverage is not a concept that can be uniquely defined, nor is it an independently useful measure of risk. Nevertheless, leverage is important to Hedge Fund Managers because of the impact it can have on the three major quantifiable sources of risk: market risk, credit risk, and liquidity risk.
That leverage is not a uniquely defined concept is evidenced by the variety of "leverage" measures used in banking and finance. These measures, which are described in more detail below, may be accounting-based (also referred to as "asset-based") or risk-based. The accounting-based measures attempt to capture the traditional notion of leverage as "investing borrowed funds." Using borrowed money (or its equivalent) enables an investor to increase the assets controlled for a given level of equity capital. Accounting-based measures of leverage relate some measure of asset value to equity. Both returns and risk, relative to equity, are magnified through the use of traditional, accounting-based leverage. The risk-based measures of leverage capture another aspect associated with leverage, namely, the risk of insolvency due to changes in the value of the portfolio. The risk-based measures relate a measure of a Fund's market risk to its equity (or liquidity). Although useful in this capacity, as described below, risk-based leverage measures do not convey any information about the role borrowed money plays in the risk of insolvency.
No single measure captures all of the elements that market participants, regulators, or market observers attribute to the concept of leverage. Indeed, examples will be presented in which a risk-reducing transaction increases some leverage measures while decreasing others. This leads to the observation that leverage is not an independently useful concept, but must be evaluated in the context of the quantifiable exposures of market, credit and liquidity.
While continuing to track and use accounting-based measures of leverage, Hedge Fund Managers should focus their attention on measures of leverage that relate the riskiness of the portfolio to the capacity of the Fund to absorb that risk - i.e., the measures must include elements of market risk (including the credit risk associated with assets in the portfolio) and funding liquidity risk. Hedge Fund Managers should focus on such measures because traditional accounting-based leverage by itself does not necessarily convey risk of insolvency. To say that one Fund is levered 2-to-1 while another is not levered does not necessarily mean that the levered Fund is more risky or more likely to encounter liquidity problems. If the levered Fund is invested in government securities while the Fund that is not levered is invested in equities, accounting-based leverage would lead to erroneous conclusions about the riskiness of the two Funds. In this sense, accounting-based measures of leverage are arguably deficient since they convey the least information about the nature and risk of the assets in a portfolio.
Risk-based measures (see below) present a measure of market risk (usually VAR) relative to a measure of the resources available to absorb risk (cash or equity). However, in doing so, risk-based measures effectively condense several dimensions of risk into a single number. The result of this compression is that some of the detail is lost; the specific effect of leverage is intertwined with dimensions of market, credit and liquidity risk. To illustrate, consider two Funds with identical risk-based leverage. One Fund employs 2-to-1 accounting leverage while investing in "low risk" strategies (e.g., long/short strategies) using borrowed funds, while the other Fund uses no accounting leverage but employs "high risk" strategies (e.g., macro directional) and large cash reserves. One is "high risk" and "high cash" and the other is "low risk" and "low cash/high borrowing," yet each achieves the same risk-based leverage. This comparison highlights the second reason why leverage measures are not independently useful: more comprehensive measures blend the effect of multiple risk dimensions. To assess the contribution of leverage requires additional information.
Accounting-Based Leverage Measures
There exist a number of accounting-based measures of leverage. In addition to the pragmatic recognition that counterparties and credit providers routinely request these measures, a more compelling rationale for calculating these measures is that they can contribute to an understanding of leverage measures that incorporate risk. This is particularly true when accounting and risk-based leverage are tracked over time.
Certain accounting measures can also provide information regarding how much direct or indirect credit in the form of repurchase agreements, short sales, or derivatives are employed by a Fund. However, it must be recognized that even these accounting-based measures have serious weaknesses, discussed below, particularly as stand-alone measures of leverage.
The most widely used and generally accepted accounting-based measures of leverage are those that relate items from a Fund's balance sheet:
This straightforward measure is easily calculated from published financial statements; however, it fails to incorporate two important elements of a Fund's effective leverage.
While this measure requires more detailed information about the positions in a Fund's portfolio, it does provide a partial solution to the shortcomings of the Gross Balance Sheet Assets to Equity measure by including offsets and direct hedges as reflected in matched book assets. However, important elements of the Fund's effective leverage are still not incorporated:
Other accounting-based measures have been proposed to capture off-balance-sheet transactions (e.g., forward contracts, swaps and other derivatives). For example:
Gross Accounting Leverage incorporates the gross amount of off-balance-sheet derivatives. Such a measure cannot reliably indicate the effective amount of leverage obtained from off-balance sheet transactions because offsetting exposures are not netted. An active derivative user that uses offsetting transactions rather than closeouts to reduce or eliminate positions will accumulate a substantial number of transactions even though the risk of the related positions and their effective leverage may be quite low.
Risk-Based Leverage Measures
Risk-based leverage measures reflect the relation between the riskiness of a Fund's portfolio and the capacity of the Fund to absorb the impact of that risk. While not the only measure that could be used, the Hedge Fund's equity provides a useful measure of "capacity." There are, however, different measures of market risk that could be used as the "riskiness" measure:
This is a measure of actual performance volatility over a given horizon relative to equity. While useful, it is subject to criticism. Since it is a retrospective measure, it is less useful if the composition of the portfolio changes or if future market conditions are not like historical conditions. Moreover, it does not isolate the effect of financing on the risk of the fund since it includes financed assets.
This measure gives a picture of the Fund's capacity to absorb "typical" market movements. The criticism of such a measure is that it does not reflect the risk of the Fund's portfolio in extreme markets.
To assess the impact of extreme events, the leverage measure could be calculated using a market risk measure derived from analysis of extreme event scenarios (or stress tests). This measure gives senior management information about the Hedge Fund's ability to absorb extreme market events.
Illustrative Leverage Measures Table 4 contains the results of calculating all of the accounting-based leverage measures and two of the risk-based leverage measures discussed in this section. Note that "Net balance sheet leverage" and "Net accounting leverage" are only relevant for Portfolios 8 and 9, because these portfolios are the only ones in which the long and short positions can be netted under accounting rules. Leverage can be interpreted in several ways: as the use of borrowed money to fund larger asset positions than would otherwise be achievable, and as the use of economic leverage to increase effect of a given change in market prices on the value of Fund's equity. The illustrative portfolios demonstrate several common features of accounting-based and risk-based leverage.
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While the preceding leverage measures are the ones most commonly used by Hedge Fund Managers, other measures may be used to analyze leverage. Indeed, because of the interrelation between market risk, funding liquidity risk and leverage, measures of funding liquidity risk described in Section 4 - particularly Cash + Borrowing Capacity relative to VAR - also provide the Hedge Fund Manager with insights about a Fund's leverage.
Dynamic Measures of Leverage
A crucial factor influencing a Fund's ability to absorb the impact of extreme market events is the degree to which a Fund can modify its risk-based leverage, especially during periods of market stress.
Treating equity as constant, there are two ways a Hedge Fund Manager could reduce risk-based leverage:
1. If a Hedge Fund Manager wishes to continue an existing investment strategy, risk-based leverage could be reduced by reducing traditional leverage resulting from either on- or off-balance-sheet transactions.
2. A Hedge Fund Manager could reduce risk-based leverage by reducing the level of risk that is being accepted (e.g., by changing strategy or the types of assets being held in the portfolio). To track the degree to which the Fund is able to modify its risk-based leverage, the Hedge Fund Manager should track variations in the Fund's market risk measure (e.g., VAR) over time.
The following two measures could be used to track the relationship over time between measures of market risk and actions taken by the Hedge Fund Manager to adjust leverage. Both of these measures consider a short time interval (1 day, 2 days,..., 1 week) ; and, both assume that equity is constant.
A decline in a portfolio's market risk measure (e.g., VAR) in a period following an increase in that market risk measure in the preceding period could be evidence of the Hedge Fund Manager's ability to de-lever the portfolio during a period of market stress. (The market risk measure could be VAR or the observed volatility of the value of the portfolio during the relevant period.)
All other things equal, if a Hedge Fund Manager is able to reduce the portfolio's accounting-based leverage, the result would be an increase in cash or in borrowing capacity. Therefore, an increase in Cash + Borrowing Capacity in a period following an increase in the market risk measure for the portfolio (e.g., VAR) could be evidence of the Hedge Fund Manager's reacting to market stress by reducing leverage.
5. Counterparty Credit Risk
Hedge Fund Managers enter into transactions with a variety of counterparties including banks, securities firms, exchanges, and other financial institutions. The risk of loss to the Fund as a result of the failure of a counterparty to perform as expected constitutes counterparty credit risk.
Credit risk is present to some extent in almost any dealing with a third party, including the settlement of securities and derivatives transactions, repurchase agreements, collateral arrangements, and margin accounts. It is also present in open derivatives positions where the exposure of one counterparty to another will change over the life of the contract as the contract's value fluctuates. Hedge Fund Managers should be aware of, and track, concentrations of credit risk with particular counterparties, and where applicable, different regions of the world.
The willingness of the Hedge Fund Manager to enter into a transaction with a specific counterparty should depend on the loss the Hedge Fund would suffer were the counterparty to default. That, in turn, depends on the magnitude of the Hedge Fund's exposure to the counterparty and the likelihood of default, i.e., the counterparty's creditworthiness.
An assessment of exposure to a particular counterparty should include analysis of the following elements of exposure:
