Handbook of Alternative Assets Ch 3 - Intro to Hedge Fund Flashcards
Describe key elements of hedge funds that distinguish them from more traditional
funds
Hedge funds are private investment vehicles that pool the resources provided by a
narrow niche of sophisticated, high net-worth investors; cannot raise funds
through a public offering
Hedge fund portfolios are more concentrated (less diversified) than corresponding
mutual funds; do not maintain security holdings relative to a benchmark
Tend to use more derivatives; results in nonlinear cashflows that require more
sophisticated risk management
May go both long and short securities
Can invest in private securities (such as high yield and convertible bonds) that did
not go through a public offering, and thus did not receive the benefit of an SEC
review
Can use large amounts of leverage
Describe the difference between fundamental equity long/short hedge funds and
quantitative equity long/short hedge funds
Fundamental long/short hedge funds conduct traditional economic analysis on a
company’s business prospects; typically invest in one economic sector
Quantitative long/short hedge fund managers invest more broadly in the market;
base their trade selection using statistics instead of fundamental stock selection
Describe an equity long/short hedge fund
An equity long/short hedge fund combines a core group of long stock positions with
short positions
Net market exposure typically still has a long bias
Equity long/short hedge funds come in two flavors: fundamental or quantitative
Traditional metrics such as CAPM for modeling a portfolio’s expected return may
not apply, since CAPM assumes that investors hold a well-diversified portfolio.
However, equity long/short fund managers typically hold concentrated rather than
broad portfolios
Describe a market timing hedge fund, and list one difference it has from an equity
long/short hedge fund
These funds attempt to time the market so that they are fully invested during bull
markets, and strictly in cash during bear markets
Unlike equity long/short strategies, market timers use a top-down approach as
opposed to a bottom-up approach
They analyze fiscal and monetary policy as well as key macroeconomic indicators
(i.e. labor productivity, consumer confidence) to determine the health of the
economy
Describe a capital structure arbitrage trading strategy that a hedge fund invested in
distressed securities can make
Buy the senior secured debt and short the junior subordinated debt of the distressed
company
In a bankruptcy situation, the senior secured debt gets higher priority compared
with junior subordinated debt for any payouts
Thus, when the distressed situation progresses, senior secured debt should
appreciate in value relative to the junior subordinated debt
Comment on whether or not the returns of a merger arbitrage hedge fund should be
highly correlated with the returns of the general stock market
Merger arbitrage returns should not be highly correlated with the general stock market,
This is because they derive their return from the relative value of stock prices
between two companies (instead of current market conditions)
What is the overall objective of a convergence trading hedge fund?
Convergence trading hedge funds make bets that two similar securities with dissimilar
prices will converge to the same value over the investment holding period
Describe how an On-the-run and off-the-Run U.S. Treasuries (an example of a fixed
income arbitrage) trading strategy would work
This strategy buys off-the-run Treasuries, and shorts on-the-run Treasuries
On-the-run Treasuries are the most currently issued bonds by the U.S.
government, and are the most liquid
Off-the-run Treasuries are similar to the on-the-run bonds, except they were
issued at an earlier date and are less liquid
The higher liquidity of on-the-run Treasuries result in higher demand that can
increase its price well above off-the-run Treasuries
Any price difference should be eliminated by the time the bonds mature, and can
be captured as profit by the fund manager
This is because when held to maturity, the prices of on-the-run and off-the-run
bonds should converge to the same value
Describe how a yield curve arbitrage (an example of fixed income arbitrage) trading
strategy would work
This strategy trades fixed income securities that are close in maturity to take
advantage of ”kinks” in the yield curve
Kinks in the yield curve occur when the the yield is not a monotonic function of the
underlying tenor, and usually reflect an increase or decrease in liquidity demand
around a specific tenor
For example, suppose there is a kink that peaks at the two year point
The holder of the two-year Treasury bond profits by rolling down to a lower part of
the yield curve (i.e. 1-year rate 2-year rate), resulting in the bond price
appreciating
Conversely, bonds maturing in 3-5 years will roll down to a part of the yield curve
with higher rates (i.e. 2-year rate ¡ 3-year rate), resulting in price depreciation
An arbitrage trade would be to purchase the two-year Treasury bond and short a
three-year bond
Describe two risks in a yield curve arbitrage strategy
First, this arbitrage trade will not work if liquidity preferences of investors change
and the kink in the yield curve reverses itself
Second, parallel shifts in the yield curve can affect the profitability of the trade
because the two bonds have different durations
Describe how an MBS arbitrage (an example of a fixed income arbitrage) trading
strategy would work
An MBS arbitrage strategy captures pricing inefficiencies in the U.S. mortgage-backed
market
MBS trade at a credit spread over U.S. Treasuries to reflect uncertainty of cash
flows
During periods of economic stress, investors tend to seek safe, liquid investments
such as U.S. Treasuries
This may cause MBS credit spreads to temporarily increase beyond what is
economically justified
Arbitrage strategy: Buy MBS and sell U.S. Treasuries; the duration of both
instruments should be similar in order to remove interest rate risk
Strategy will make money if the credit spread between MBS and U.S. Treasuries
decline
Describe the mechanics of a convertible bond arbitrage strategy
Convertible arbitrage funds build long positions of convertible bonds, and then hedge
the equity component of the convertible option by shorting the underlying stock
This hedge ratio is known as the “delta” and is designed to measure the sensitivity
of the convertible bond value to movements in the underlying stock
If the underlying stock price increases, the call option embedded in the convertible
bonds (to buy the stock at the fixed conversion price) becomes more ITM. These
convertibles will then trade more like a stock than they do a bond, and will have a
higher delta
If the underlying stock price decreases, the embedded call option becomes more
OTM; the convertible bond will trade more like a bond (lower delta); however, they
will have higher interest rate risk (i.e. duration) that will need to be hedged
What is the difference between a market-neutral hedge fund and an equity/long short
hedge fund?
Market-neutral hedge funds also go long and short stocks in order to neutralize market
risk
However, unlike equity/long short hedge funds, market-neutral hedge funds have
no beta risk in the portfolio with respect to either the broad stock market or any
industry
For a market-neutral hedge fund, only stock selection (i.e. alpha) remains
Market-neutral funds generally hold equal dollar amount in the long and short
stock positions; they also apply no leverage because there is no market exposure
to leverage
How are statistical-arbitrage funds different from equity market-neutral hedge funds?
Statistical-arbitrage funds are similar to equity market-neutral hedge funds, except
trading decisions are driven by quantitative factor models instead of fundamental
research
Describe a global macro hedge fund strategy, which is a type of opportunistic hedge
fund strategy
Global macro hedge funds invest across broad financial markets
Make trades depending on the fund manager’s forecast of changes in interest
rates, currency movements, and other macroeconomic indicators
Having a broad investment mandate can result in a well-diversified portfolio
However, this can also result in a lack of focus that can lead to lower returns
compared with other hedge fund strategies
