Hedge Fund Flashcards
1
Q
2 types of funds that constitute a large part of the hedge fund universe.
A
Event-driven and relative value hedge funds
2
Q
market neutral hedge fund
A
relative value hedge funds
3
Q
The event-driven category of hedge funds includes ….
A
- activist hedge funds
- distressed securities funds
- merger arbitrage funds
- special situation funds
- multi-strategy funds
4
Q
2 event driven funds that have the major asset allocation
A
special situation funds
multi-strategy funds
5
Q
What do event- driven hedge funds do?
A
Speculate on security price movements during the anticipation and realization of business, legal, or financial events.
6
Q
What are the events that event-driven funds speculate on ?
A
- 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.
7
Q
The most common strategy for an event-driven fund is
A
to enter positions in one or more corporate securities during a period of potential change.
8
Q
What is an event return or event risk premiums?
A
- 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.
9
Q
What is an activist investment strategy about?
A
(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.
10
Q
Shareholder activism efforts include…
A
casting votes, introducing shareholder resolutions, and undertaking legal actions.
11
Q
Proxy battle is
A
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.
12
Q
Types of Shareholder Activists
A
- Financial versus social activists
- Activists versus pacifists
- Initiators versus followers
- Friendly versus hostile activists
- Active versus passive activists
13
Q
A free rider is
A
A person or entity who allows others to pay initial costs and then benefits from those expenditures.
14
Q
the most popular activist agenda
A
Interlocking boards and exorbitant CEO compensation are typical conflicts of interest that are near the top of the activist agenda.
15
Q
Interlocking boards
A
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.
16
Q
stock buybacks
A
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.
17
Q
Why under-leveraged companies can be targets of shareholder activism or targets for acquisition?
A
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.
18
Q
Merger Arbitrage
A
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.
19
Q
exchange offer
A
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.
20
Q
Is there a correlation b/n stock market and merger arbitrage ?
A
the merger arbitrage strategy shows some correlation with the overall stock market and tends to perform poorly during market declines.
21
Q
Cash and stock merger
A
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.
22
Q
risks of merger arbitrage
A
- regulatory
- financial
- bidding war risk
- deal failure
23
Q
Role of merger arbitrageurs
A
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.
24
Q
SEC EDGAR
A
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.
25
A bidding contest
When two or more firms compete to acquire the same target.
26
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.
27
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.
28
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.
29
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.
30
viable
жизнеспособный
31
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.
32
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.
33
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.
34
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.
35
litigate
участвовать в судебном разбирательстве
36
divest of
избавиться от
37
company's fortunes
судьба шансы
38
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.
39
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.
40
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.
41
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.
42
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.
43
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.
44
offset (-ing)
компенсировать (-ия)
45
convergence is
the return of prices or rates to relative values that are deemed normal.
46
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.
47
market condition for the relative value hedging
Relative value funds tend to profit during market conditions when valuations converge to their equilibrium values.
48
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.
49
relative value hedge fund include styles :
convertible bond arbitrage, fixed-income arbitrage, and multi-strategy funds.
50
Multistrategy Funds
fund that increase capacity by mixing different strategies mainly : equity securities, especially firms which are generating spin-offs, engaged in merger and acquisition activities, or emerging from bankruptcy.
51
Capacity of the multi-strategy fund vs fixed -income and convertible bond arbitrage and single strategy fund?
2:1 ratio
| $440 bn is multi-strategy vs $220 bn of the other 3 combined
52
Convertible bonds
hybrid corporate securities, mixing fixed-income and equity characteristics into one security; a combination of an unsecured corporate bond and a call option on the issuer’s stock.
53
Call options (vs put...)
are financial contracts that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity or other asset or instrument at a specified price within a specific time period. The stock, bond, or commodity is called the underlying asset. A call buyer profits when the underlying asset increases in price.
54
asset distribution hierarchy of the convertible bonds vs equity securities vs senior and collateralized debt at the bankruptcy procedure
1. Senior and collaborated debt
2. Convertible bond
3. Equity securities
55
Convertible bond arbitrage
trade is to purchase a convertible bond that is believed to be undervalued and to hedge it using a short position in the underlying equity.
56
Convertible bond arbitrage (incl. reverse trade)
trade is to purchase a convertible bond that is believed to be undervalued and to hedge it using a short position in the underlying equity.
57
Convertible bond value
is calculated by valuing each component (straight debt and the equity call option), and then summing their values.
58
Moneyness is
The extent to which an option is in-the-money, at-the-money, or out- of-the-money. In the case of a convertible bond, moneyness indicates the relationship between the strike price implied by the conversion option and the price of the underlying stock.
59
A conversion premium is
an amount by which the price of a convertible security exceeds the current market value of the common stock into which it may be converted.
60
Coupon income
or a coupon rate is the yield (annual payment) paid by a fixed-income security issuer on its issue date relative to the bond's face or par value. The coupon rate, or coupon payment. This yield changes as the value of the bond changes, thus giving the bond's yield to maturity.
Also referred as a coupon payment, "coupon rate," "coupon percent rate" and "nominal yield")
61
Principal of a bond is
the amount of money the issuer of the bond is borrowing and will repay to the bondholder in full upon the bond's maturity. A bond's principal is also known as its par value or face value
62
Busted convertibles are
Bonds with very high conversion premiums,
because when the stock option is far out-of-the-money, the convertible bond’s value is primarily derived from its coupon income and principal payments.
63
Equity-like convertibles are
Bonds with very low conversion premiums have stock options that are deep in-the-money, where the convertible bond price and the conversion value are very close. The further in-the-money that the option is the more the convertible bond behaves like the underlying stock and it is referred to price very closely. Interest rates and credit spreads matter less on equity-sensitive convertibles.
64
Hybrid convertibles are
Convertible bonds with moderately sized conversion ratios have stock options closer to being at- the-money and are called hybrids. Hybrid convertibles are usually the most attractive bonds for use in convertible arbitrage strategies, due to their asymmetric payoff profile.
65
Traditional convertible arbitrage strategy’s return basis
varies directly with the level of volatility experienced in the underlying asset.
66
implied volatility of an option or an option-like position, such as a convertible bond, is
the standard deviation of returns that is viewed as being consistent with an observed market price for the option.
67
A complexity premium is
a higher expected return offered by a security that compensates an investor for analyzing and managing a position that requires significant time and expertise.
68
gamma delta theta
???
69
components of convertible arbitrage returns
1) income from coupon interest paid on the bond
- dividends due on the short stock position
+ earns a rebate on the cash proceeds from the short sale of the stock.
- costs to financing the position such as the cost to borrow the stock or pay the interest on leveraged positions, those costs are deducted from the arbitrage profits.
2)the gain on stock trading and the possible gain or loss on the eventual sale of the convertible bond. In the traditional convertible arbitrage trade of being long the convertible bond, the larger and more frequent the stock price moves, the greater the potential profits from gamma trading.
70
idiosyncratic risk
factors that affect an asset such as the stock and its underlying company at the microeconomic level. It has little or no correlation with risks that reflect larger macroeconomic forces, such as market risk. Microeconomic factors are those that affect a limited or small portion of the entire economy, and macro forces are those impacting larger segments or the entire economy.
71
Fixed-income arbitrage
involves taking simultaneous long and short positions in fixed- income securities with the expectation that the security prices will converge toward a similar valuation standard over the investment holding period. The arbitrage is often performed on a pair of securities with a long position in one security offset by a short position in the other security. However, the arbitrage can involve any numbers of longs and shorts.
72
A yield curve is
the relationship between the yields of various securities, usually depicted on the vertical axis, and the term to maturity, usually depicted on the horizontal axis.
73
fixed -income arbitrage market categories (4)
1) sovereign debt,
2) corporate debt,
3) asset- backed securities
4) mortgage-backed securities (MBS).
74
Carry trades
attempt to earn profits from “carrying” or maintaining long positions in higher- yielding assets and short positions in lower-yielding assets without suffering from adverse price movements.
75
Sovereign Debt
is debt issued by national governments which possesses distinct credit risks from corporate debt because governments can choose to default on their obligations, even when they are technically able to meet them.
76
treasury bills/notes/bonds
- T-bills maturing in less than a year; pays no interest but is sold at a discount to its par value or face value.
- T-note exists in maturity term of 3,5,7,and 10y
- T-bond's maturity is over 10y
77
on-the-run and off-the-run bills/bonds
liquid/illiquid
78
The recovery rate of a bond
is the portion of face value that is ultimately received by an investor in the bond at the end of the bankruptcy proceedings. Securities with higher seniority in bankruptcy generally experience higher recovery rates and are worth more than junior securities
79
Relative-value arbitrage
is an investment strategy that seeks to take advantage of price differentials between related financial instruments, such as stocks and bonds, by simultaneously buying and selling the different securities—thereby allowing investors to potentially profit from the “relative value” of the two .
80
Divergence between/with
расхождение
81
what type of activists are called free riders
active followers.
82
Shareholder Activism Agendas
1. CEO, Compensations, Board of Directors
2. Capital Structure , Dividend Policy Issues
3. Mergers and Divestitures
83
Divestiture
изъятие активов
84
Activism agenda (CEO, Compensations, Board of Directors)
centers on the senior management team, the level and terms of compensation for the CEO, and the relationship between the CEO and the Board of Directors.
85
The top of the activist agenda
interlocking boars and exorbitant CEO compensation are typical conflicts of interest .
Activists believe that total compensation should be incentive-based and appropriate relative to the value generated in the firm by the management team. Large non-incentive-based compensation schemes can exacerbate agency conflicts and costs.
86
CEO may effectively controls the board of directors in one of two forms
1. CEO might also be the chairman of the board of directors. In such a position, the CEO-chairman controls both the company’s operations and the board of directors, with limited checks and balances.
2. The board of directors can become too comfortable or friendly with the CEO. This can lead to excessive pay packages for the CEO.
87
exacerbate (sb./sth.) verb
усугублять что-л. v
88
one common reason for the denial of a merger by the US and foreign governing regulatory agencies
due to the antitrust concern, when the event could reduce competition in the given market.
89
Why returns of the merger arbitrage funds are called risk premium?
The returns of these funds can be seen as risk premiums for bearing event risk, or superior returns from identifying mispriced stocks.
90
A key skill of merger arbitrage managers is
to determine the likely outcome of antitrust deliberations before the governing bodies make their rulings. In deals where antitrust issues are a concern, the spreads between the prices of the target and acquiring firm may start out wide and then narrow substantially if and when the deal is cleared by regulators.
91
A bidding contest is
when two or more firms compete to acquire the same target.
92
Bidding war risk in merger arbitrage process
Risks from defensive actions taken by the management of the target company,
93
What may the wide arbitrage spread be signaling of ?
the market is not confident in the ability of the acquiring firm to fund the purchase of the target firm. The merger spread is likely to tighten substantially if the financing is arranged successfully, perhaps through a bank loan, a bond issue, or asset sales.
94
reasons for bankruptcy
too much debt on the balance sheet, poor operating performance, accounting irregularities, or competitive pressures.
95
Similarities and differences b/n strategies of distressed debt hedge fund and private equity funs?
The key difference is that private equity investors take a long-term view on the value and reorganization potential of the corporation, whereas hedge funds typically take a shorter-term trading view on distressed firms.
96
Hierarchy of the claims payouts upon bankruptcy
1. senior claims (wages, holders of senior, secured, and collateralized debt)
2. junior, subordinated, and convertible bond holders
* **Junior debt holders do not receive a full recovery during the bankruptcy proceedings, but may receive equity in the firm if it is reorganized.
3.preferred stock and equity holders (often receive little or no value during the bankruptcy reorganization process)
97
collateralized debt obligations (CDO)
- Collateralized debt obligations (CDOs) are structured investment products that contain various assets and loan products.
- If the loans within a CDO are mortgage loans, the product is often referred to as a mortgage-backed security (MBS).
- The credit products are repackaged and grouped into tranches based on the credit risk appetite for the investors buying the CDO.
98
other term for distressed securities
non-investment-grade securities
99
naked option position is
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.
100
distressed short-selling strategy is analogous to what strategy
naked option position
101
The recovery rate of a bond is
the portion of face value that is ultimately received by an investor in the bond at the end of the bankruptcy proceedings. Securities with higher seniority in bankruptcy generally experience higher recovery rates and are worth more than junior securities.
102
offsetting
компенсация
103
traditional capital structure arbitrage trade strategy
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.
104
role of the Derivative securities in the capital structure arbitrage trade
Derivative securities can expand the opportunities available for capital structure arbitrage and make strategies more versatile and riskier.
105
CDS
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.
A credit default swap is the most common form of credit derivative and may involve municipal bonds, emerging market bonds, mortgage-backed securities or corporate bonds.
106
Realized volatility is
the actual observed volatility or standard deviation of returns experienced by an asset, in this case, the underlying stock.
107
A delta-neutral position is
a hedged position where the value-weighted sum of all deltas of all positions equals zero.
108
The long gamma nature of the convertible bond ensures
that the hedged position will make money if the underlying asset rises or falls in value quickly. This profit is generated by the unlimited upside and limited downside nature of a long position in an option.
109
The theta of the long option position indicates
that as time passes, the hedged position loses value in the absence of underlying asset changes.
110
The traditional convertible arbitrage strategy’s return varies directly with
the level of volatility experienced in the underlying asset.
111
carry trades
Carry trades attempt to earn profits from “carrying” or maintaining long positions in higher- yielding assets and short positions in lower-yielding assets without suffering from adverse price movements.
112
Sovereign Debt risks
1. governments issued the debt can choose to default on their obligations, even when they are technically able to meet them.
2. most national governments can use monetary policy to alter the value of their currency and thereby change the inflation-adjusted value of their outstanding obligations
113
Sovereign Debt risks
1. governments the debt is issued by can choose to default on their obligations, even when they are technically able to meet them.
2. most national governments can use monetary policy to alter the value of their currency and thereby change the inflation-adjusted value of their outstanding obligations
114
yield curve
process of holding a bond as its yield moves up or down the yield curve due to the passage of time
115
yield curve arbitrage.
involves trading among maturity ranges of fixed-income securities, especially those that are relatively close to maturity
116
A parallel shift in the yield curve
is when yields of all maturities shift up or down by equal amounts. However, a hedge that is duration-neutral does not necessarily provide perfect interest rateimmunization.
117
Rolling down the yield curve is
the process of experiencing decreasing yields to maturity as an asset’s maturity declines through time in an upward-sloping yield curve environment.
118
Interest rate immunization is
the process of eliminating all interest rate risk exposures.
119
Relative value multi-strategy (RVMS) funds combine an array of relative value strategies, such as
convertible arbitrage, volatility arbitrage, or fixed-income arbitrage and diversify their positions across these strategy types.
120
ABS vs MBS
Mortgage-Backed Securities (MBS): An Overview. ... MBS are created from the pooling of mortgages that are sold to interested investors, whereas ABS is created from the pooling of non-mortgage assets. These securities are usually backed by credit card receivables, home equity loans, student loans, and auto loans.
