OFR Working Paper Evaluates Form PF in Gauging Risk

OFR Working Paper Evaluates Form PF in Gauging Risk

An OFR working paper published today assesses the precision of Form PF as a device for measuring the risk hedge funds pose to the financial system. It extends the approach of an earlier OFR working paper by asking how adding derivatives to a hedge fund’s portfolio affects Form PF’s effectiveness in measuring risk.

Investing in hedge funds is limited to wealthy investors who are expected to manage their own affairs and to require little protection. As a result, reporting requirements for hedge funds were limited in the past. This approach changed after the 2007-09 crisis. The Dodd-Frank Act of 2010 mandated that all funds above a certain size report their risk exposures. The paper published today reviews the legislative debate. It notes that Congress was clearly concerned about systemic risk and investor protection.

In November 2011, the Securities and Exchange Commission and Commodity Futures Trading Commission announced the rule implementing the new Form PF reporting mandate. Depending on fund size, fund advisors file either quarterly or annually. Advisors submitted their first reports in 2012.

Form PF records a range of confidential statistics about the risk profiles of fund portfolios. It also shows key counterparties and large positions. Because it is so new, we are still learning about the sorts of analyses that Form PF will make possible.

The OFR working paper does not use confidential Form PF reports. Instead, authors Mark Flood and Phillip Monin consider the form itself, which is public. They ask how precisely the statistics reported on the form reflect the actual risks in fund portfolios.

To measure this risk, the authors first simulate thousands of fund portfolios. The portfolios contain long and short positions in equities and equity options. The weights are set so all simulated portfolios appear identical on Form PF. Thus the statistics on Form PF measuring market risk are the same for all portfolios. In other words, from a risk perspective, all funds look the same to regulators. The authors then evaluate the risk in the simulated portfolios in ways other than what is reported on the form.

The analysis reveals that funds with identical Form PF filings could have vastly different risk exposures. Because Form PF allows such significant tolerance for risk exposures to differ among funds, the form does not adequately reflect these differences. This tolerance is much larger among funds with derivatives.

The analysis also confirms that requiring funds to report specific risk statistics, such as value-at-risk, has a beneficial side effect. Reporting these statistics significantly decreases the measurement tolerances in other risk dimensions. This finding suggests a way for improving risk reporting on Form PF in the future.

Stacey Schreft is Deputy Director for Research and Analysis at the Office of Financial Research