Alternative Investments and the Mismanagement of Risk

Frontmatter

1. Alternative Investments Defined

Abstract

The term alternative investments is derived from the way in which capital is employed, an approach which is not the same as in traditional investment methods. Classically a fund manager tries to obtain a maximum performance by buying a stock when it is cheap and selling it when the price has gone up. His goal is to beat the index. He is also satisfied if he has lost less value than the index, when the market has fallen.

Dimitris N. Chorafas

2. Are Alternative Investments Inherently Risky?

Abstract

The golden rule in investments is the higher the leverage, the greater the amount of risk assumed and (hopefully) profits gained.

Dimitris N. Chorafas

3. Globalisation, Legal Risk, Reputational Risk, and Technology Risk

Abstract

As Chapters 1 and 2 have documented, alternative investments involve high risk assumed by hedge funds, repackaged by aggregators, and sold by merchandisers to consumers, institutional investors, and other entities. The size of the exposure taken over by end-investors changes with every strategy — and often with every transaction.

Dimitris N. Chorafas

4. The Financial Risks Taken with Alternative Investments

Abstract

Hedge funds have strategies, and there are plenty of them. The most important, such as macromarkets, going short, market neutral, private equity, structured approaches, emerging industries, emerging countries have been introduced in Chapter 1. We will look at the way in which they are implemented in this chapter and in Chapters 5 and 6.

Dimitris N. Chorafas

5. Hedge Funds, Multimanagers, and the Macromarkets

Abstract

A brief history of hedge funds will provide a perspective to the issues discussed in this chapter. The first hedge fund was formed in 1949, by Alfred Winslow Jones who invested his own money and other assets in his dealings. Jones employed several of the current hedge fund features, such as:

• leverage;
• performance fees; and
• long/short strategies.

Dimitris N. Chorafas

6. Risk and Return with Derivatives

Abstract

This chapter addresses itself to derivatives. We consider what they are, what they do, how and where they are traded. Also, what are the risks to financial institutions, hedge funds, and other investors and what is the exposure associated with the growing use of derivatives. Finally, the chapter brings under perspective the need for regulation of derivatives trading — a subject further analysed in Chapter 9.

Dimitris N. Chorafas

7. Scrutinising Alternative Investment Strategies Intended to Give Higher Returns

Abstract

Whether we talk of alternative investments or any other business, investment strategies are made by people and, other things equal, the higher are their skills and the experience of these people the more effective the strategies will be. In 2001, a study at MIT concluded that the difference between hiring the best person and hiring an average person can be as high as 50:1. The best person will:

• have a polyvalent background;
• be innovative and imaginative;
• challenge the obvious;
• be flexible and adjustable; and
• have a deep sense of planning and control.

Dimitris N. Chorafas

8. Assessing Strategic Risks through Stress Testing

Abstract

In the background of the attention being paid by governments, economists, and financial analysts to macroeconomics lies the fact that debt, consumption, and productive power correlate. Sometimes debt is used to increase the productive capacity of a company, of an industry, or of a nation, but in other cases, money connected to leverage filters mostly into consumption and from their inflation.

• Productive investments have a longer term return.
• But debt incurred to cover shortfalls in income has only a very short-term aftermath.

Dimitris N. Chorafas

9. Highly Leveraged Institutions, Regulators, and the New Lenders of Last Resort

Abstract

Globalisation and liquidity are pillars of modern capitalism, but there are unwritten laws as well. The first law of capitalism relates to globalisation. It says money will migrate to the business environment it considers to inspire more confidence and/or where the highest return is to be had.

• The pressure is relentless on money managers to care for the assets entrusted to them, and to better their past performance.
• One of the problems is that so much money pursuing relatively few alternative investment strategies reduces the potential returns to everyone.

There is no evidence that pursuing strategies such as arbitraging the statistical difference between one convertible bond and another eliminates market inefficiencies, or provides for sustained long-term returns. But there is plenty of reason to believe that a steady pressure on the most successful companies to continue their performance, such as fast growth despite the increase in their size following years of rapid development, leads to new inefficiencies.

Dimitris N. Chorafas

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