LOS b: Evaluate the use of maximum drawdown and value-at-risk as tools for measuring risks of hedge funds.

Q1. Which of the following most accurately describes the distribution of hedge fund returns? Hedge fund returns:

A)   have fat tails in the distribution.

B)   are lognormally distributed.

C)   are normally distributed.

Q2. Which of the following most accurately describes the maximum drawdown measure of risk? Maximum drawdown is the:

A)   ratio of the portfolio’s expected return to some measure of risk.

B)   largest percentage decrease in value from peak to valley.

C)   ratio of excess return to risk using the minimum acceptable portfolio return.

Q3. Which of the following least accurately describes shortcomings of the VaR measure of risk? VaR typically:

A)   does not provide the probability of a loss.

B)   assumes that component risks are additive.

C)   assumes that the left hand side returns are normally distributed.

LOS b: Evaluate the use of maximum drawdown and value-at-risk as tools for measuring risks of hedge funds. fficeffice" />

Q1. Which of the following most accurately describes the distribution of hedge fund returns? Hedge fund returns:

A)   have fat tails in the distribution.

B)   are lognormally distributed.

C)   are normally distributed.

Correct answer is A)

Investors should be concerned about hedge fund risk because hedge fund returns have fat tails on the left hand side of their distribution. In other words, the probability of large losses is greater than that expected from a normal distribution. For this reason, it is imperative that investors evaluate a downside measure of risk, such as maximum drawdown and/or value at risk.

Q2. Which of the following most accurately describes the maximum drawdown measure of risk? Maximum drawdown is the:

A)   ratio of the portfolio’s expected return to some measure of risk.

B)   largest percentage decrease in value from peak to valley.

C)   ratio of excess return to risk using the minimum acceptable portfolio return.

Correct answer is B)

Drawdown is the percentage decrease in investment value from its peak to its valley. Maximum drawdown is just the largest drawdown that has ever occurred for a fund within a specified time period. The maximum drawdown is quoted so that investors can have an idea of the largest loss they can expect from a hedge fund investment. It measures left tail risk. For example, a maximum drawdown of 15% would imply less risk than a maximum drawdown of 25%.

Q3. Which of the following least accurately describes shortcomings of the VaR measure of risk? VaR typically:

A)   does not provide the probability of a loss.

B)   assumes that component risks are additive.

C)   assumes that the left hand side returns are normally distributed.

Correct answer is A)

Value at Risk (VaR) does provide both the amount of an expected largest loss as well as its probability. For example, the VaR could be stated as “there is a 95% chance that a fund will not lose more than 11.4% of its value over the next quarter.” However, the measure is not frequently used for hedge funds and has several shortcomings. First, given that VaR is usually estimated using historical data, it is not indicative of future risk when a fund changes their investment strategy over time. Second, VaR is usually calculated under the assumption that the left hand side returns are normally distributed, and hedge fund returns are rarely normally distributed. Third, VaR is often computed assuming that component risks are additive, when in fact they are often multiplicative.

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