Framework for risk management of Hedge fund

Abstract

This paper analyzes two different approaches to capture the nonlinearities of hedge fund returns. One approach
provides an adequate framework used for style analysis of hedge funds’ dynamic strategies. The other one uses
the contractual relationships hedge funds have with their investors and prime brokers to explain the nonlinearities
in their returns. The effects of those relationships are captured by hedge funds’ short positions of two options:
funding option and redemption option. This paper also suggests a guideline in risk management process for
hedge funds’ managers. They can obtain the optimal leverage level to gain maximum returns without making
unencumbered cash level too low. Implication of this analysis for investors and policy makers are also presented.