Thanks to reader Dan (also seen at Market Folly) for passing along this excellent note on risk management from John Paulson. It’s a must read in my opinion:
The same wise gentlemen who told me “risk arbitrage is not about making money, its about not losing money” also told me, “if you watch the downside, the upside will take care of itself”. To manage the downside, one must ﬁrst have a thorough understanding of the “risk” in risk arbitrage. Using that understanding, one must then construct a portfolio that eliminates poor quality transactions and focuses on high quality deals. To further manage risk within the portfolio, one must constantly monitor one’s positions for any changes, hedge all positions, limit position size, and broadly diversify across deals and industries. By implementing these criteria, the manager will be able to deliver the beneﬁts of this strategy: non-correlated, low volatility returns.