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Hedge Fund · Topic lesson

Portfolio Risk

How a fund measures and limits risk across the book: portfolio volatility, contribution to risk, beta hedging, Sharpe ratios and leverage, and drawdown limits.

5 chapters About 51 minutes0 of 5 complete
Start chapter 1

Picking good stocks is half the job; the other half is combining them so the fund survives its bad weeks. Interviewers test whether you can put numbers on a book's risk: how positions combine, which one drives the total, how to remove the market, how much leverage a strategy deserves, and how big the book can be before a bad week ends it.

  • Combine. Portfolio volatility depends on correlation.
  • Attribute. Each position's contribution to risk, against its share of the capital.
  • Hedge. Index futures remove the market beta.
  • Lever. The Sharpe ratio says which strategy deserves the leverage.
  • Limit. A drawdown limit caps how big the book can be.
The rule that solves every question

Work in variances and in dollars of risk, never in averages of volatility or dollars of capital. Volatilities combine through their squares and the correlation; market exposure is beta × dollars; and the limit that matters is the loss the fund can take.

From positions to a book that survives

Each step points to the chapter that practices it.

  1. 1
    Combine the positions

    Variance, correlation, diversification.

    Chapter 1
  2. 2
    Find what drives the risk

    Contribution to risk against capital.

    Chapter 2
  3. 3
    Remove the market

    Index futures sized by beta-dollars.

    Chapter 3
  4. 4
    Choose the leverage

    Sharpe ratio, and the cost of borrowing.

    Chapter 4
  5. 5
    Respect the limit

    Cushion, stress and maximum gross.

    Chapter 5

Chapters

1

Two-asset portfolio volatility

11 min

Risk does not add. How much of two positions' risk survives the combination depends on one number: the correlation.

  • Calculate the volatility of a two-asset portfolio
  • Measure the diversification benefit against the no-diversification case
  • Back out the correlation from a portfolio's realized volatility
  • Show what happens to portfolio risk as the correlation changes
2

Contribution to risk versus capital

11 min

Half the capital is not half the risk. Which position really drives the book's volatility, and what an equal split of risk looks like.

  • Split portfolio volatility into each position's contribution
  • Compare each position's share of the risk with its share of the capital
  • Find the risk-parity weights for two assets
  • Compare the volatility of the current book with the risk-parity book
3

Hedging the market with index futures

9 min

A long book carries market beta. Short index futures to remove it, or to keep just the amount you want.

  • Calculate a book's beta-dollars and what a market move does to it
  • Work out how many index futures to short for a target beta
  • Split a market move into the book, the futures and the hedged result
  • Back out the beta a hedge assumed
4

Sharpe ratio and leverage

10 min

Return per unit of risk, and the dial that trades one for the other. Free borrowing would leave the Sharpe untouched; real borrowing wears it down.

  • Calculate a Sharpe ratio
  • Lever a strategy and find its return, volatility and Sharpe
  • Find the leverage for a target volatility, and what it delivers
  • Say why allocators compare Sharpe ratios before returns
5

Sizing under a drawdown limit

10 min

Every fund has a loss at which its capital gets cut. Work back from it to the most the book can run, and see why a loss shrinks the book.

  • Size a book's maximum gross exposure from a drawdown limit
  • Work out the gain needed to recover from a drawdown
  • Back out the stress a book is sized for today
  • Show how much smaller a book must be after a loss