Hedge Funds

Question 1

Merton model - structural model

Answer 1

Equity is viewed as a call option, debt viewed as short position on a put option on the firms assets.
Value of option to default is approximated as a call in the assets as the face value of the debt.
It’s a direct application of the Black Scholes put or call pricing model.

Question 2

Structural model - kealhover, mcquown, Vasieck model

Answer 2

Variation of Merton, allows total assets of firm to vary randomly.
Builds on Merton, adds total value of form assets and vol to estimate credit risk of debt.
Uses relationship between vol of assets and equity.
Models default using a default trigger - weighted average of a firms short term and long term debt.
Two major out puts are: probability of default, credit score.

Question 3

Reduced Form Credit Models

Answer 3

Model the debt using market based default probabilities.
Characterise defaults as exogenous events and focus on modelling the time to default and potential recovery.
Don’t rely on cap structure to predict default risk.
Looks at likelihood of default and probably theory to value the risk of default.
Jarrow-Turnbull
Duffie-Singleton

Question 6

Empirical credit model

Answer 6

Rely on historical data to create a credit score rather than trying to understand default occurs. 
Altman’s Z score.
<1.81 default group
1.81-2.99 grey zone
>2.99 non default group

Question 7

Debt

Distressed rated C or less

Answer 7

Chapter 11 - reorganise and preserve.
Chapter 7 - liquidation.
Creditors become debtors in possession. Control court process and firm Mgmt.

Question 8

Fulcrum security

DIP Loans

Answer 8

Investor buys controlling position of the company in debt issue most likely to be converted to equity.
Debtor in possession - loans made to cos in c.11. Higher coupon.

Question 9

Volatility strategies

Answer 9

Vol has negative correlation to market. Market down, vol up. Long position is short vol.
vol is NOT observable. Long vol positions are a hedge.
Vol is a beta factor. Long term - negative returns owning options, positive return being short vol.

Question 10

Vol, Greeks

Answer 10

Delta - exposure to underlying asset
Gamma - changes to exposure in delta
Vol strat May be short Theta (time decay), or vega (vol).

Question 11

Vol modelling

Answer 11

Vol is mean reverting, but has inertia - can stay high or low for some time.
Is skewed right and is kurtotic.

Question 12

Short iron butterfly

Answer 12

But strangle (out of money puts and calls) and sell straddle (with same strike)

Question 13

Tail risk

Answer 13

For distressed markets. Lowest returns over long period of time.

Question 14

VIX futures contract

Answer 14

1 is $1000

Question 15

Hedge fund replication

Answer 15

Capacity constraint - few managers can offer consistent alpha. Alpha is zero sum game.
Fund bubble

Question 16

HF replication, factor based

Answer 16

Four key issues:
Benchmark selection
Choice of factors
Length of estimation period
Number of factors
Factor based replication products (ASG global alternatives fund) found positive diversification and results.
Supported by view commonality and exposure inertia.
Uses factors to determine weights over time A can leave cash as a free variable.

Question 17

HF replication, pay off distribution approach

Answer 17

Aims to produce a return that matches a desired distribution.
Replicates end of month distribution of HF. Low correlation to benchmark and other assets.
Good for matching variance and skew, not good for benchmark mean return.

Question 18

HF replication, bottom up/algorithmic

Answer 18

Implements simplified version of an actual trading strategy. Good for merger arb, cb arb, momentum strategies.
Good for well defined, systematic trading strategies.

Question 19

FoHF construction

Answer 19

AUM weighted
Equally weighted
Equally risk weighted - weight by each strategy inversely proportional to the vol of the fund. Rebalance As vol changes.
Mean variance optimisation weighting - unconstrained optimisation. Overweight high return or low risk funds, underweight the opposite.