There are a numerous sources of risk involved in alternative strategy funds, which are described in detail below. Notably, alternative mutual fund regulations have limited some of the first and second-order risks in comparison to hedge funds.
In this section, we explain the differences between first-order risk (or directional risk) and second-order risk (such as liquidity risk, default risk, and leverage risk). Additionally, we discuss operational risk (or business risk), a third category not specifically tied to the alternative strategy fund’s strategies. First-order and second-order risks are used to classify risks related to an alternative strategy fund’s investments and trading activities. These risks directly affect the fund’s overall risk and return.
First-Order Risks
First-order risks stem from the exposure to changes in the general direction of equity, fixed income, currency, and commodity markets. The source of risk is the market itself, and this risk is systematic, meaning that it cannot be mitigated through diversification. First-order risk impacts directional strategies significantly, as they are based on the manager’s predictions about market directions, interest rates, commodity prices, and currencies. However, it doesn’t considerably affect relative value strategies or event-driven strategies.
Second-Order Risks
Second-order risks encompass liquidity, leverage, deal break, default, counterparty, trading, concentration, pricing model, and trading model risks. Unlike first-order risk, these risks are unrelated to the market and stem from other aspects of trading such as dealing, implementing arbitrage structures, and pricing illiquid or infrequently valued securities.
Here’s a detailed look at various second-order risks:
| Second-Order Risk |
Definition |
Nature of Risk |
| Liquidity risk |
The risk that the manager will be unable to unwind a position quickly and at a price close to the most recent price. |
Forced prices acceptance significantly different from the most recent prices. May take time to unwind positions at fair prices. |
| Leverage risk |
The risk of loss on a position financed with borrowed money. |
Higher leverage results in higher risk by magnifying both upside and downside returns. |
| Deal break risk |
The risk of loss from the failure of two companies to complete an announced merger. |
Merger arbitrage funds may result in losses if the expected deal fails. |
| Default risk |
The risk that the issuer of a debt security will not meet its obligations related to payment of interest or principal. |
Losses occur if an issuer defaults on these obligations. |
| Counterparty risk |
The risk that the counterparty to an over-the-counter (OTC) agreement will not fulfill its obligations. |
Losses can result if the counterparty does not fulfill its obligations. |
| Trading risk |
The risk of receiving a poor fill price based on unexpected delays in execution. |
Delays may result in worse-than-expected pricing. |
| Concentration risk |
The risk of loss from an adverse change in the price of a position with a relatively large weight in the portfolio. |
Higher concentration magnifies risk of an adverse event affecting the security. |
| Pricing model risk |
The risk that the output of a pricing model is incorrect due to incorrect assumptions. |
Incorrect assumptions can lead to erroneous valuations if not based on current market data. |
| Trading model risk |
The risk of loss related to the failure of systematic trading models in the current market environment. |
Failure in real time can lead to significant losses. |
The return on a leveraged investment can be calculated using the formula:
$$
R_{leveraged} = (1 + L) imes R_{unleveraged} - L imes C_{debt}
$$
Where:
- $R_{leveraged}$ is the return on a leveraged investment.
- $L$ is the leverage ratio (e.g., how many dollars borrowed per dollar of equity).
- $R_{unleveraged}$ is the return on an unleveraged investment.
- $C_{debt}$ is the cost of debt.
This formula helps in understanding how leverage amplification affects the overall returns, both positive and negative.
Operational Risk
Operational risk relates to the alternative strategy fund as a business entity. Often, these funds are small, newly established businesses dependent on one or more high-profile managers. While these organizations focus on leveraging the managers’ skills, they may lack the depth, talent, and planning essential for growth or survival. Operational risk arises from potential system failures, along with issues in settlement, reporting, and accounting procedures. Due diligence is crucial to mitigate operational risk.
Key Takeaways
- First-Order Risks: Involve market direction changes and are systematic in nature, affecting directional strategies significantly.
- Second-Order Risks: Encompass a range of non-market related risks including liquidity, leverage, and counterparty risks, crucial for alternative strategy funds to manage.
- Operational Risk: Stemming from the fund’s business operations often require comprehensive due diligence to manage.
Frequently Asked Questions
What are the primary sources of risk in alternative strategy funds?
The primary sources include first-order (directional) risks, second-order risks such as liquidity and leverage risks, and operational risks related to the business entity itself.
How do first-order risks differ from second-order risks?
First-order risks are related to changes in market directions and are systematic, whereas second-order risks are connected to various aspects of fund management and are not inherently market-dependent.
Why is understanding operational risk crucial for alternative strategy funds?
Operational risk can significantly impact the viability of the fund due to potential system failures and management issues. Due diligence is vital to ensure stability and reduce unpredictability.
📚✨ Quiz Time! ✨📚
## What is an example of a first-order risk in an alternative strategy fund?
- [ ] Liquidity risk
- [ ] Leverage risk
- [ ] Default risk
- [x] Exposure to changes in equity markets
> **Explanation:** First-order risks relate to market exposure such as changes in equity, fixed income, currency, and commodity markets.
## Which type of risk does leverage amplifies in an alternative strategy fund?
- [ ] Operational risk
- [x] Both upside and downside returns
- [ ] Counterparty risk
- [ ] Concentration risk
> **Explanation:** Higher leverage magnifies both upside and downside returns, increasing overall risk.
## How does liquidity risk affect an alternative strategy fund?
- [ ] It enhances the fund's profitability by securing better prices
- [x] It may force the fund to accept prices significantly different from the most recent price
- [ ] It decreases the fund's operational capabilities
- [ ] It improves model accuracy in trading
> **Explanation:** Liquidity risk can force a manager to accept less favorable prices when trying to quickly unwind positions.
## What is default risk specifically concerned with?
- [ ] Market direction changes
- [ ] Alterations in commodity prices
- [ ] Operational failures
- [x] Issuer of a debt security not meeting its obligations
> **Explanation:** Default risk concerns the issuer's inability to fulfill payments related to bonds or debt securities.
## Which risk is specific to over-the-counter agreements?
- [ ] Trading risk
- [ ] Pricing model risk
- [x] Counterparty risk
- [ ] Deal breakage risk
> **Explanation:** Counterparty risk is associated with one party in an OTC agreement failing to fulfill their obligations.
## What defines trading risk?
- [ ] Model-based valuation failures
- [ ] High leverage decisions
- [x] Receiving a poor fill price due to execution delays
- [ ] Over-reliance on high-profile managers
> **Explanation:** Trading risk involves getting a worse price than expected due to delays in executing trades.
## Which risk arises from incorrect assumptions used in pricing models?
- [ ] Leverage risk
- [ ] Counterparty risk
- [ ] Concentration risk
- [x] Pricing model risk
> **Explanation:** Pricing model risk occurs when incorrect assumptions lead to erroneous valuations.
## How does concentration risk affect an alternative strategy fund?
- [x] Loss from adverse changes in heavily weighted positions
- [ ] Increased dependency on high-profile managers
- [ ] Inaccurate model assumptions
- [ ] Unwinding illiquid positions
> **Explanation:** High concentrations in specific positions increase the portfolio's risk to adverse events.
## Which type of risk is related to operational deficiencies or failures?
- [x] Operational risk
- [ ] First-order risk
- [ ] Leverage risk
- [ ] Market risk
> **Explanation:** Operational risk is associated with failures in systems, settlement, reporting, and accounting procedures.
## What happens in trading model risk?
- [ ] Incorrect valuations due to market prices
- [ ] Fund's dependency on managers for success
- [x] Losses from systematic trading models failing in real-time
- [ ] Poor fill prices due to execution delays
> **Explanation:** Trading model risk refers to losses incurred when historical data-based trading models fail in current market environments.
## What is the definition of first-order risk?
- [x] Directional risk related to market exposure
- [ ] Risk related to defaulting debt issuers
- [ ] Operational deficiencies in fund management
- [ ] Risks from deal breaks in mergers
> **Explanation:** First-order risk focuses on market exposure, such as changes in equity, fixed income, and other market directions.
## Which risk type involves the possibility of a merger not being completed?
- [x] Deal breakage risk
- [ ] Leverage risk
- [ ] Trading risk
- [ ] Operational risk
> **Explanation:** Deal breakage risk involves the potential losses when expected mergers or deals fail to materialize.
## What risk relates to over-reliance on a pricing model?
- [ ] Trading risk
- [x] Pricing model risk
- [ ] Leverage risk
- [ ] Concentration risk
> **Explanation:** Pricing model risk arises when the underlying assumptions of a model are incorrect, leading to valuation errors.
## Operational risk in alternative strategy funds is significant due to which factor?
- [x] Dependence on specific managers and lack of organizational depth
- [ ] Changes in market direction
- [ ] Defaulting counterparties
- [ ] High leverage usage
> **Explanation:** Operational risk is significant because many alternative strategy funds are small, business-dependent entities.
## How can leverage negatively impact an alternative strategy fund?
- [ ] By causing operational failures
- [x] By magnifying both potential gains and losses
- [ ] By simplifying trading decisions
- [ ] By eliminating risks associated with liquidity
> **Explanation:** Leverage amplifies both the upside and downside potential of returns, increasing overall risk.
## Which is a characteristic of second-order risks?
- [ ] They are all market-related
- [ ] They primarily involve equity exposure
- [x] They include liquidity, leverage, and counterparty risks
- [ ] They are synonymous with operational risk
> **Explanation:** Second-order risks are non-market-related and include aspects like liquidity, leverage, and counterparty risks.
## What does concentration risk primarily affect?
- [ ] Trading model accuracy
- [ ] Systematic market exposures
- [x] The impact of adverse events on heavily weighted positions
- [ ] Leverage decisions
> **Explanation:** Concentration risk pertains to the increased threat to a portfolio from adverse changes in heavily weighted positions.
## In which scenario does default risk arise?
- [ ] Failure in executing timely trades
- [ ] Incorrect pricing models
- [x] Issuer's inability to pay interest or principal on debt securities
- [ ] Mergers not being completed
> **Explanation:** Default risk involves the risk that a debt issuer won't fulfill payment obligations on interest or principal.
## What type of strategy is most affected by first-order risks?
- [x] Directional strategies
- [ ] Relative value strategies
- [ ] Event-driven strategies
- [ ] Systematic trading models
> **Explanation:** Directional strategies, based on market direction predictions, are most susceptible to first-order risks.
## Which risk would involve the failure to meet trade execution prices?
- [x] Trading risk
- [ ] Counterparty risk
- [ ] Default risk
- [ ] Pricing model risk
> **Explanation:** Trading risk is related to poor execution prices due to unexpected delays in filling trade orders.