Chapter 3: Hedging strategies (C9693391)

Last modified: 3166d ago
Word count: 1,805 words

Legend: Key principles // Storyline


Hedge funds are distinct from other funds because of their low level of regulation. Because of the low level of regulation, if you cannot afford to lose the money, you should not be looking at hedge funds.

The low regulation is because the product is not offered to the public, but by regulation, is restricted to "accredited investors" with high net worth (usually $1m+), generating a certain income ($200k for singles, $300 for couples). The fund manager is usually the general partner, and investors are limited partners. As an incentive, the manager usually invests their own money. There are also self-made further rules, including:

  • High minimum investments
  • High fees (2% of asset for management fee, and 20% performance fee if it exceeds a hurdle rate, both paid annually, known as 2/20)
  • Restrictions on exit periods (known as a "lock up" period), and infrequent redemptions (at set points during a year)

Other characteristics of hedge funds include:

  • Hedge funds create a diversified portfolio of shorts and longs, with horizons of 1-18 months, but usually 3 months
  • Day trade is a SMALL part of a hedge fund strategy; they essentially don't do it, because only brokers win in those scenarios. It's the 90/90/90 rule, 90% will lose 90% of their money within 90 days, known as "blowing up". This strategy is only used when volatility picks up, where there are wild swings, setting targets and stops appropriately
  • They use around 5 times leverage, up to 8 in FOREX. The ability to ramp up due to CFD doesn't mean you have to
  • They may be registered in an offshore jurisdiction to reduce tax liability

The classical definition however, is their ability to hedge against market risk, making money even if the market is falling, thereby protecting the capital of their investors - avoiding loss, which is priority. Since market risk is hedged out, strategies a hedge fund uses, should thus be market neutral. Some strategies a hedge fund use are directional, where market trends or anomalies are exploited, and thus is less of a true "hedge".

Frequently asked questions
What is a hedge fund?
Clasically, it's what is known as an "absolute return" fund, meaning it makes returns, whether the market is rising or falling, because it hedges against market risk. Nowadays, it's just a fund that is only offered to "accredited investors".

What makes an investor accredited?
They have a high net worth ($1m+), and generate a certain income ($200k for singles, $300 for couples).

How do you exactly hedge?
The classical example is a long-short equity hedge. It's where you short say the index, and you long a stock. This means that if the entire stock market drops, although you lose money on your long stock position, you gain this back on your short index position. So it eliminates market risk, and focuses only on your stock-picking ability.

So, how much do these hedge funds cost?
They usually use a 2/20 fee structure, which is yearly, they charge 2% of assets for management, and 20% performance if the amount they make exceeds a certain hurdle. There's also a big problem relating to "lock up", where you can only take your money out at certain periods, and only after a certain time.

I heard that brokers sometimes refer to customers as "muppets"... Why is this?
Because many people want to "get rich quick", doing things professionals don't do. The primary strategy of professionals is not to day trade, it's not to leverage at the maximum amount.

1 Relative value arbitrage

Involves taking advantage of price discrepency due to mispricing of securities compared to related securities, the underlying security, or the market overall.

Fixed income arbitrage

Fixed income arbitrage involves exploiting inefficiencies in pricing bonds (i.e. instruments yielding a fixed stream of income).

Long/short equity

Involves buying long one equity which they deem undervalued, and short selling another equity they deem overvalued within the same sector, industry, market capitalization, and country; thereby hedging against broader market factors.

Rather than using the equity market, the bond market, or even CFD's can also be used. For example, buying long share CFD's, and short selling the S&P/ASX 200.

Frequently asked questions
How does long/short equity differ from directional stock picking?
Because the long/short strategy is driven by arbitrage different in two stocks, that should be equally priced, but aren't. However, over time, there wil be convergence. On the other hand, with stock picking, you are presuming that one stock will move in one direction, and the other in the other direction.

Convertible arbitrage

Convertible arbitrage involves long buying convertible securites, and short selling the issuer's stock. This thus assumes the convertible security is underpriced, and the issuer's stock is overpriced.

Statistical arbitrage

Statistical arbitrage is a heavily computational approach, which involves data mining, statistical methods, and other mathematical modelling techniques, as well as automated trading systems.

Volatility arbitrage

Exploit change in implied volatility instead of the change in price

Regulatory arbitrage

Taking advantage of regulatory differences between two or more markets

Currency arbitrage

Currency arbitrage is taking advantage of different spread offered by brokers of a particular currency pair, to take advantage of this disparity.

2 Event-driven

Situations where opportunity is associated with a corporate event, such as consolidations, acquisitions, recapitalizations, bankruptcies, and liquidations. Hedge funds have the expertise and resources to analyze corporate transactional events, for investment opportunity. Examples of other events include predicting final approval of new pharmaceutical drugs.

Distressed securities

Securities or bonds of companies already in default, under bankruptcy protection, in distress, or heading toward such condition, are significant risk, and may render them worthless, often carrying ratings of CCC or below. They therefore trade at significant discount to their intrinsic value. This allows purchase of the debt at deep discount, and has high return if the company/country doesn't go bankrupt or default.

Risk/merger arbitrage

Take advantage of market discrepency between acquisition price and stock price, which factors in risk. The risk is that the merger or acquisition will not proceed, so research and analysis will be done to determine if the event will take place. The risks are caused by failure to satisfy conditions of the merger, failure to obtain requisite shareholder approval, failure to receive antitrust or other regulatory clearance, and reduced interest between the parties. It involves short selling the acquirer, and buying the target.

Special situations

Events that impact company stock value, including restructuring of a company, spin-offs, share buy backs, security issuance/repurchase, or asset sales. It is very risky and challenging.

Activist strategy

Take large positions, and uses ownership to participate in management. Push for corporate change, demanding for board shuffles or corporate restructuring.

3 Directional trading

Although not a true hedge, because of the unregulated nature of these funds, high risk directional trading can be used with high leverage, including:

  • Short selling, which is the selling of borrowed securities. Essentially, they are purchased, and then sold back to the broker. Thus, if the price drops, the buyer is able to sell back to the broker at a lower price, thereby gaining a profit. There is also a fee involved with the loan. Remember also that shorting goes against the upward market trend
  • CFD (contract for difference), which is where the seller will pay the buyer the difference between the current value of an asset, and its value at contract time

In all scenarios, the trader is "puntng", namely picking particular stocks/assets that they expect to rise or fall.

Global macro

Taking sizable positions in shares, bonds, currency, commodities, options, futures, forwards, and so forth, in anticipation of global macroeconomic events. The timing of such strategy is important, as it is a type of directional investment strategy. It has the highest risk/return profile.

Insurance strategy

As insurance, namely, purchasing a put option on an existing long position; or purchasing a call option on an existing short position.

Other examples include, selling stock index futures, equity index option, on an existing long position. Apart from stock, this can also be applied with debt, and bonds.

Another example is hedging debt with CDS (credit default swap).

Stock picking

An example is buying long Microsoft stock, and short selling Apple stock. With this position:

  • If the entire computing industry falls, there is no net effect on this position, as Microsoft will decrease, but Apple will increase
  • If the entire computing industry improves, there is no net effect on this position, as Microsoft will increase, but Apple will decrease
  • If Microsoft improves relative to Apple, the fund should profit irrespective of how the wider market and sector moves

Investing in emerging markets, countries with characteristics of a developed market, but is not yet developed. Economies include China (excluding Hong Kong and Macau), and India.

There are also sector funds, which invest in emerging technology, healthcare, biotechnology, pharmaceuticals, energy and basic materials.

Fundamental growth strategy looks at companies with more earnings growth than overall market, and fundamental value strategy invests in undervalued companies.

Quantitative directional uses quantitative and financial signal processing techniques for equity trading.

4 MiscellaneousFund of funds

Diversified portfolio of numerous single-manager hedge funds.

Multi strategy

Using a combination of different strategies to reduce market risk

130-30 funds

Equity funds buying long (say $100), shorting 30% (say $30) of that position in a stock they believe to be undervalued, then grabbing proceeds from the short to purchase an additional 30% (say $30) in stocks thought to be undervalued. This thus ends up with $130 buying long, and $30 short.

Risk parity

Reduce risk by diversification, but maximizing gains by leveraging.

Interest rate swap

Parties agree to exchange interest rate payments, to hedge against risk associated with exchange rate fluctuations.

Need help?

Assessment e-submission

(Formative assessments are not assessed for marks. Assessments are made on the unit level.



Classroom toolbox

Blinker reminds you to blink. Blinking increases tears, which helps to lubricate, protect and nourish your eyes.

Wolfram Alpha search engine lets you find answers to mathematical problems using natural language:

Merriam Webster has a dictionary and synonym tool. The dictionary tool also provides information about words that "rhyme with".
Derivatives - Financial markets - MR. SHUM'S CLASSROOM