Hedge Fund Flashcards
2 types of funds that constitute a large part of the hedge fund universe.
Event-driven and relative value hedge funds
market neutral hedge fund
relative value hedge funds
The event-driven category of hedge funds includes ….
- activist hedge funds
- distressed securities funds
- merger arbitrage funds
- special situation funds
- multi-strategy funds
2 event driven funds that have the major asset allocation
special situation funds
multi-strategy funds
What do event- driven hedge funds do?
Speculate on security price movements during the anticipation and realization of business, legal, or financial events.
What are the events that event-driven funds speculate on ?
- mergers and acquisitions,
- spin-offs
- tracking stocks
- accounting write-offs,
- reorganizations
- bankruptcies,
- share buybacks,
- special dividends,
- and any other corporate events that are generally associated with substantial market price reactions in the securities related to those events.
The most common strategy for an event-driven fund is
to enter positions in one or more corporate securities during a period of potential change.
What is an event return or event risk premiums?
- A risk premium is the return in excess of the risk-free rate of return an investment is expected to yield;
- an asset’s risk premium is a form of compensation for investors who tolerate the extra risk, compared to that of a risk-free asset, in a given investment. For example, high-quality corporate bonds issued by established corporations earning large profits typically have very little risk of default. Therefore, such bonds pay a lower interest rate, or yield, than bonds issued by less-established companies with uncertain profitability and relatively higher default risk.
What is an activist investment strategy about?
(1) identify corporations with management teams that are not maximizing shareholder value,
(2) establish investment positions that can benefit from particular changes in corporate governance, such as the replacement of the existing management team
(3) execute changes to corporate governance policies that will benefit the shareholders’ interests.
Shareholder activism efforts include…
casting votes, introducing shareholder resolutions, and undertaking legal actions.
Proxy battle is
is a fight between the firm’s current management and one or more shareholder activists to obtain proxies from shareholders. Proxy battles can be very expensive. The firm’s current board of directors gen- erally uses the corporation’s financial resources to wage the battle; thus shareholder activists pay not only for their side of the battle, but also their pro rata share of the other side.
Types of Shareholder Activists
- Financial versus social activists
- Activists versus pacifists
- Initiators versus followers
- Friendly versus hostile activists
- Active versus passive activists
A free rider is
A person or entity who allows others to pay initial costs and then benefits from those expenditures.
the most popular activist agenda
Interlocking boards and exorbitant CEO compensation are typical conflicts of interest that are near the top of the activist agenda.
Interlocking boards
Interlocking boards occur when board members, especially managers, from multiple firms simultaneously serve on each other’s boards and may lead to a reduced responsiveness to the interests of shareholders.
stock buybacks
A company buys back outstanding shares for a number of reasons.
1) reduce cost of capital,
2) benefit from temporary undervaluation of the stock,
3) consolidate ownership,
4) inflate important financial metrics 5) free up profits to pay executive bonuses.
Why under-leveraged companies can be targets of shareholder activism or targets for acquisition?
Despite the risks, leverage can provide benefits to shareholders by forcing a firm’s management to deploy the capital wisely and oversee the firm more closely. Conversely, managers of firms with limited leverage and excess cash may be less disciplined, have greater conflicts of interest with shareholders, and ultimately subject the firm to greater losses.
Merger Arbitrage
a hedge fund strategy that involves simultaneously purchasing and selling the stocks of two merging companies to create “riskless” profits. A merger arbitrageur reviews the probability of a merger not closing on time or at all.Because of uncertainty, the stock price of the target company typically sells at a price below the acquisition price. The arbitrageur purchases the stock before the acquisition, expecting to make a profit when the merger or acquisition completes.
also known as risk arbitrage (“merge-arb”), is a subset of event-driven investing or trading, which involves exploiting market inefficiencies before or after a merger or acquisition. A regular portfolio manager often focuses on the profitability of the merged entity.
By contrast, merger arbitrageurs focus on the probability of the deal being approved and how long it will take to finalize the deal. Since there is a probability the deal may not be approved, merger arbitrage carries some risk.
exchange offer
This traditional merger arbitrage strategy seeks to capture the price spread between the ratio-adjusted spreads of the current market prices of the merger partners and the spreads that will be realized upon successful completion of the merger. If arbitrageurs believe that the target firm is overvalued relative to the probability that the merger will succeed, the arbitrageur can short the target and buy the acquirer.
Is there a correlation b/n stock market and merger arbitrage ?
the merger arbitrage strategy shows some correlation with the overall stock market and tends to perform poorly during market declines.
Cash and stock merger
In a cash merger, the acquiring company purchases the target company’s shares for cash. Alternatively, a stock-for-stock merger involves the exchange of the acquiring company’s stock for the target company’s stock.
risks of merger arbitrage
- regulatory
- financial
- bidding war risk
- deal failure
Role of merger arbitrageurs
1) They specialize in assessing these risks and maintaining a portfolio diversified across several industries.
2) Conduct substantial research on the companies involved in the merger. They review current and prior financial statements, SEC EDGAR filings, proxy statements, management structures, cost savings from redundant operations, strategic reasons for the merger, regulatory issues, press releases, the financial resources of the acquirer, and the competitive position of the combined company within the industry in which it competes.
SEC EDGAR
EDGAR is the Electronic Data Gathering, Analysis, and Retrieval system used at the U.S. Securities and Exchange Commission (SEC). EDGAR is the primary system for submissions by companies and others who are required by law to file information with the SEC.
A bidding contest
When two or more firms compete to acquire the same target.
A risk premium
is the return in excess of the risk-free rate of return an investment is expected to yield; an asset’s risk premium is a form of compensation for investors who tolerate the extra risk, compared to that of a risk-free asset, in a given investment.
Regulatory risk
is the term used to describe the risk of uncertain outcomes stemming from decisions that will be made by regulators.
Various U.S. and foreign regulatory agencies may not allow a proposed merger to take place for a variety of reasons; one common reason for the denial of a merger is that it could reduce competition in the given market.
Regulators can also disallow deals for nationalistic or tax-related reasons.
Financing risk
is the economic dispersion caused by the failure or potential failure of an entity, such as an acquiring firm, to secure the funding necessary to consummate the deal.
Merger spread
refer to the difference between two prices, rates or yields. In one of the most common definitions, the spread is the gap between the bid and the ask prices of a security or asset, like a stock, bond or commodity.
A large spread exists when a market is not being actively traded and it has low volume—meaning, the number of contracts being traded is fewer than usual.
viable
жизнеспособный
fate of the equity in the pre-bankrupt firm during the reorganization process
typically canceled and becomes worthless, as shares in the newly reorganized firm are offered to subordinated debt holders or sold to new investors.
In the United States, what happens to firms declaring bankruptcy
Their operations will be liquidated or reorganized. European firms typically face liquidation when they are deemed unable to meet their debt obligations.
company liquidation process
(Chapter 7 in the U.S. bankruptcy laws), all of the assets of the firm are sold and the cash proceeds are distributed to creditors.
The goal of a firm reorganization process (Chapter 11 in the U.S. bankruptcy laws)
stabilize the operations and finances of the company in a way that allows the firm to continue operations after the bankruptcy process has been completed.
litigate
участвовать в судебном разбирательстве
divest of
избавиться от
company’s fortunes
судьба шансы
what is an investor’s naked option position
when the investor is short an option position and does not have a hedged position, such as owning the underlying asset when short a call and being short the underlying asset when short a put.
Capital structure arbitrage
investors typically buy the more senior claim and sell short the more junior claim. The key to traditional capital structure arbitrage profitability is when the more senior security improves more, or deteriorates less, than the junior security.
Financial market segmentation is
When two or more markets use different valuations for similar assets due to the lack of participants who trade in both markets or who perform arbitrage between the markets.
How can hedge fund profit from the financial market segmentation?
by exploiting perceived mispricing due to financial market segmentation between the stock, bond, stock option, and credit derivatives markets.
Role of CDSs in capital structure arbitrage ?
provide cost-effective vehicles for hedging credit risk in corporate debt. Credit default protection is bought and sold in the over-the-counter market, further increasing opportunities to exploit certain aspects of financial market segmentation.
CDS
A credit default swap (CDS) is a financial derivative or contract that allows an investor to “swap” or offset his or her credit risk with that of another investor. For example, if a lender is worried that a borrower is going to default on a loan, the lender could use a CDS to offset or swap that risk. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults. Most CDS will require an ongoing premium payment to maintain the contract, which is like an insurance policy.
offset (-ing)
компенсировать (-ия)
convergence is
the return of prices or rates to relative values that are deemed normal.
relative value hedge fund strategy
attempt to capture alpha through predicting changes in relationships between prices or rates. Relative value fund managers take long and short positions that are relatively equal in size, volatility, and other risk exposures. Ideally, the combined positions have little net market risk, but can profit from short positions in relatively overvalued securities and long positions in relatively undervalued securities.
market condition for the relative value hedging
Relative value funds tend to profit during market conditions when valuations converge to their equilibrium values.
risk of the relative value hedging strategy
Since returns to these convergence strategies are typically very small, managers have to employ a significant amount of leverage to generate acceptable returns for these strategies. Therefore, relative value funds can experience substantial losses during times of market crisis, as leveraged funds may be forced to liquidate positions and wind down leverage at times when prices are in drastic decline.
