Are Hedge funds in trouble ?

Economist's recent article on Hedge funds has me worried and happy at the same time. The article, however, suggests that the poor performance of the Hedge fund industry is perhaps exxagerated. The industry is ripe for a shakedown and good funds (and fund of funds remain), managed by good managers and innovative strategies, will survive. This will, in turn, help consolidate the industry. This loosely translates that there will be good oppurtunites available for financial engineers in the longer run, because the emphasis would be on sound strategies and research.

From Economist:
Hedge funds are lightly regulated investment funds that take high risks to earn high returns. They come in many flavours, and have long been the bane of emerging-market governments, who claim that the funds are destabilising. Their case in point is Long-Term Capital Management, which had to be rescued in 1998 after market liquidity unexpectedly collapsed. Hedge funds subsequently struggled to gain investors' trust, but by early 2003 macro hedge funds were reviving, and even conservative Germany and Japan began to embrace them. Now the problem may be too many hedge funds—as more managers chase opportunities in each market, returns have fallen. Mutual funds that invest in hedge funds are also becoming popular, though they may be worryingly less diversified than their managers believe. In America, the Securities and Exchange Commission is contemplating tighter regulation.

Funda of week: pairs trading

Excerpt from paper by Hong and Susmel, 2003:

Pairs-trading is an old portfolio management technique based on a classic hedge:
a manager looks at stocks in pairs, buying the one she expects to perform best and selling short the one she expects to underperform. The concept has been generalized to accommodate long and short portfolios with different performance expectations. In the 1980s, hedge funds popularized pairs-trading.

The pairs-trading strategy, also known as “statistical arbitrage” and loosely based on the “Law of One Price”, is very simple: find two stocks whose prices have moved together historically. When the spread between them widens, short the winner and buy the loser. If the joint distribution of the two stocks is stationary, prices will converge and the arbitrageur will profit.

Phew.. made it

Just hit submit button for the MFE program. I had already sent in supplementary materials by mail on Friday. I submitted my essays, supplementary information, and other information via online form... and I am all done! Feels great to be done..especially when things are so busy at work.

Next up.. start prep for CFA level 1.

MFE information session

I did not get a chance to write about my visit to Berkeley and the MFE information session. Well, I got out of work at 11.00A.M. to drive upto Berkeley. After finding parking and walking up the hill to reach Haas, I realized that I was late by 10 minutes. Fortunately, the session had not started, so I proceeded to talk to some other prospective students.

The admissions director Linda Kreitzman talked about the MFE program in great detail. The session started with most of the prospectives introducing themselves. The pool was incredibly talented and highly accomplished, which made me wonder about the actual class itself. In addition, a wide range of age and industry was also represented (In fact, one person was a partner at a Big 4 firm).

The main points highlighted in the session:

• MFE faculty is composed of profesors from not just Berkeley, but also UCLA and UC Irvine.
• Curriculum is very targetted, finance-oriented. There was some discussion on differences between MBA and MFE programs.
• Internship after 75% of coursework.
• There are numerous practical finance seminars (1 or 2 per week).
• Accepted students are asked to prep themselves in advance for the program - by reading Wall Street Journal, books like "Heard on the street", take basic corporate finance courses from UC Berkeley extension, etc.

Volatility

Volatility is an important concept to understand in modern finance. Many risk management decisons, and pricing of structured products depend on the volatility of the underlying. In a sense, volatility is a measure of the speed of the markets. In engineering, it is just known as standard deviation!!

I have just started reading a good book on Option Volatility and Pricing by Sheldon Natenberg. Interesting and non-mathematical introduction to derivatives and Volatility spreads!! Very interesting...

VaR ??

Value -at-risk (VAR) is a much used term in Financial risk management. Gloriamundi has a good inrtoduction to Var.

The Orange county case provides very good insights on using VaR as a tool for risk control [Courtesy Prof. Jorion].

why MFE

As an engineering consultant, I have been working on Risk analysis problems - involving various industries - Insurance, Chemicals, Utilities, Product development, etc. I have dealt with probabilistic analyses using Monte Carlo simulations, fault trees and Markov chain models.

However, it is interesting to note that it is the financial world that is using risk management more rigorously. In fact, some major innovations are taking place in the financial sector in regards to risk management and risk transfer. For exmaple, note the convergence of Insurance and finance sectors:

One of the hottest areas of finance today, alternative risk transfer, or ART, refers to the use of various insurance products to manage market, credit, operational, legal, environmental, and other forms of risk. As the capital and insurance markets continue to converge, the number and complexity of new risk-defraying insurance products available to corporations, brokerages, money managers and other financial professionals will continue to grow.

After reading books like "When Genius Fails" and "Liar's poker", and the book on derivatives by Hull, I am hooked. I want to get into quantitative finance and financial engineering. With my background in risk analysis, and computational prowess in VBA and MATLAB, I feel like MFE is the right course for my needs. Quant finance is the future and as computational resources increase in magnitude, so will innovation in this area.

MFE program at Berkeley is very appealing to me. The reasons are:

1. The first Business school program to offer course in financial engineering.
2. 1st in rankings of FE programs (global derivatives magazine)
3. Bay area location
4. Top notch faculty and other academic resources
5. One year program with internship period