Modeling Leverage With Hedge Fund Replication

There was an interesting article at the AllAboutAlpha blog a few weeks ago that discusses a recent working paper that considers a new method for measuring the systematic risk to the financial system that results from the level of hedge fund leverage. The report considers both funding leverage and instrument leverage (i.e., leverage to increase returns directly, such as buying on margin, compared to leverage that results from the product itself, such as buying an option contract). Of interest is that the study uses techniques from hedge fund replication research in order to determine the level of leverage a fund was using. Fascinating stuff for someone interested in developing hedge fund replication models. Nonetheless, given the recent issues with marketing to model when data is limited, the models developed will no doubt need to be improved a little before the Bank for International Settlements incorporates it into the next version of the Basel accord.