The Federal Reserve Bank of New York today released Measuring Risk in the Hedge Fund Sector, the latest article in its series Current Issues in Economics and Finance.
Author Tobias Adrian explains that recent high correlations among hedge fund returns—returns moving in the same direction when facing similar market conditions—could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998. Yet his comparison of the current rise in correlations with the elevation before the 1998 event reveals a key difference: The recent increase stems mainly from a decline in the volatility of returns, while the earlier rise was driven by high covariances.
Covariance measures hedge fund return comovement by capturing the extent to which the returns move together, or apart, in dollar terms. To determine more precisely how closely hedge fund returns comove relative to their overall volatility, economists divide the covariance of fund returns by the returns’ total variability; the result is correlation.
Adrian’s study concludes that despite some seeming parallels between the recent and earlier rise in correlations, the current hedge fund environment differs from the 1998 environment because volatility and covariances now are lower.
Tobias Adrian is an economist in the Capital Markets Function of the Research and Statistics Group.