Equity market-neutral strategy - Credit risk!

CFA Level III Portfolio Management
#1

In the EOC #7-A of the alternative investments chapter, there is a question on equity market-neutral hedge funds. We have to define what is the credit risk exposure for such a strategy.

My answer would have been none, because for me equity is not a matter of credit risk, does not matter if the position is long, or short, or neutral…

But they say “they have low credit risk because their long-short positions result in net low leverage”.

#2

You still hold long positions in specific equities so you are exposed to the credit risk of one of them defaulting

#3

Equities defaulting?

#4

equity market neutral - you have equal amounts in position of long and short positions. If you are the hedge fund manager - from your perspective - the credit risk you create for the long positions (to the parties you purchase the securities from) would be balanced against the credit risk you incur due to your short positions. So you are credit risk neutral.

That would not be the case if you were in a totally long or totally short position.

#5

Thanks Cpk123. But i totally understand that. My point is that i don’t see why we would talk about credit risk for equities, be it only long, or only short, without even any netting consideration. Credit risk is the risk of not getting paid for some payment that is due to you. Stocks are not paid back by the company to the equityholder.

#6

I think this question refers to credit risk from the perspective of the market neutral fund’s counterparties and not credit risk faced by the fund itself.

  1. equity market neutral (beta neutral) does not necessarily imply equal amounts in long/short positions (dollar neutral), although many strategies are indeed beta and dollar neutral

  2. you cannot net out credit risk for long/short positions if that risk is faced by different counterparties. long positions do not create credit risk unless leveraged (leverage is not mandatory to execute a market neutral strategy) . credit risk for short positions is borne by the prime broker mainly to the extent of short sale margin financing.

  3. both the long/short positions are typically well collateralized, net leverage is low and credit risk to counterparties is low