A hedge fund can borrow in order to enhance its overall returns. Borrowing, or using leverage, is a source of both volatility risk and financing availability risk. If investments are wise, leverage typically amplifies returns and helps reduce the costs of borrowing. The two most widely used measurements of leverage are gross exposure and net exposure. Although these indicators have little meaning for funds following different strategies, they provide a relative and reliable measurement when applied to the same strategy. For strategies with a low level of non-systematic risk, statistical indicators such as Value-at-Risk (VaR) are better measurements of volatility risk.
For strategies with a high level of non-systematic risks, such as arbitrage on companies undergoing restructuring, the different quantitative approaches are supplemented by qualitative methodologies. The latter focus on strategy diversification, positions, allocation control, use of stop-loss orders, etc. A manager that uses leverage is exposed to the risk of having to return upon demand any borrowing to the brokers. The availability of financing is measured by the quality of the relationship between the manager and its main broker. This is generally positively correlated to the size of the funds. The impact of requirements by the main broker to return borrowing is clearly linked to the liquidity of the investments undertaken by the fund.
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