Collateral Management for Hedge Funds

Let's return to the world of prime brokerage and hedge funds.  One of the advantages that hedge funds have is the ability to use leverage to enhance their returns.  Prime brokers are the main source of financing.  Hedge funds may finance trades on margin.  In securities trading, margin is the amount of money borrowed from the broker to buy the position using another position as collateral.  The hedge fund finances the remaining through the margin deposit.  The deposit is compared against the maintenance margin requirement constantly.  If it is below the requirement level, then a margin call to collect the difference is issued by the broker.  At this time the broker does not care how the call is collected.  It can ask for cash or may sell the fund's other holdings.  Here, it is important for the hedge fund to have a good relationship with the broker.  The broker will have more patience on margin calls in this case.

For commodity futures, the idea is the same except the margin rate is much lower.  The initial futures margin is around 5 - 15% of the value of the contact.  This is compared against the margin maintenance.  If it is below the maintenance level, then a call will be made to bring the balance to the initial margin.  The maintenance margin is usually lower than the initial margin to allow for some price fluctuation.

Another method of financing is the repurchase agreement (repo).  This is merely selling the security while agreeing to buy it back at a future date and price.  The difference in prices (called the spread) is the interest rate.  Hedge funds will take the borrowed cash and invest it.  Hopefully, they will earn returns higher than the interest paid.

Both repos and margining will be under the collateral management desk of the prime broker.

Hedge funds have multiple holdings in their portfolios.  Prime brokers calculate how much leverage to give them by using proprietary formulas based on the riskiness of the portfolio.  The methodologies include running it through stress tests, scenario analysis and mapping it against various risk factors.  The large prime brokers are able to do this across securities, derivatives, commodities, etc.  This takes a sophisticated and powerful technology system that consolidates data and gives funds one-stop shopping for reporting.  This is called portfolio margining.