Calculating VaR for Hedge Funds

It is well known that hedge funds implement dynamic strategies; therefore, the exposure of hedge funds to various risk factors is nonlinear. In this chapter, we propose to analyze hedge fund tail event behavior conditional on nonlinearity in factor loadings. In particular, we calculate VaR for different hedge fund strategies conditional on different states of the market risk factor. Specifically, we are concentrating on dynamic risk factors that are switching from a market regime or state that we call normal to two other regimes that could be identified as “crisis” and “bubble” and that are usually characterized, respectively, by (1) largely low returns and high volatility and (2) high returns. We are proposing a factor model that allows for regime switching in expected returns and volatilities and compare the VaR determined with this methodology with the other VaR approaches like GARCH(1,1), IGARCH(1,1), and Cornish Fisher