Part 2: Risks per Strategy
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Slide 1
Portfolio Risks
Market Risk. The risk in reducing the value of the portfolio due to changes in
markets.
Credit Risk. The risk in reducing the value of the portfolio due to changes in the
credit quality of the counterparties.
– Counterparty deafult is an extreme case, but losses can also occur when a
counterparty’s credit quality decreases.
– Credit risk is an issue even when the bank holds only payment obligations.
Liquidity Risk. The risk of losses because of delays selling assets.
Operational Risk.
– Fraud.
– Model risk (using the wrong pricing model, for instance: example, CDO’s)
– Human Factor
Legal and Regulatory Risk.
– Transactions that are voided due lack of appropriate licenses.
– Changes in Tax Laws
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Slide 2
Hedge Fund Strategies
A wide range of hedging strategies are available to hedge funds:
Selling short - selling shares without owning them, hoping to buy
them back at a future date at a lower price in the expectation
that their price will drop.
Using arbitrage - seeking to exploit pricing inefficiencies
between related securities - for example, can be long
convertible bonds and short the underlying issuers equity.
Trading options or derivatives - contracts whose values are
based on the performance of any underlying financial asset,
index or other investment.
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Slide 3
Hedge Fund Strategies (cont.)
A wide range of hedging strategies are available
to hedge funds:
Investing in anticipation of a specific event merger transaction, hostile takeover, spin-off,
exiting of bankruptcy proceedings, etc.
Investing in deeply discounted securities - of
companies about to enter or exit financial
distress or bankruptcy, often below liquidation
value.
Commodity trading
Slide 4
Financing
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Risk-return scatter gram
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Slide 5
Scatter gram again
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Slide 6
Convertible arbitrage
Fig. 1: A graphical analysis of a convertible
bond. The different colors indicate different
exercise strategies of call and put options.
Risk management for financial institutions (S. Jaschke, O.
Reiß, J. Schoenmakers, V. Spokoiny, J.-H. ZachariasLanghans).
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The Galmer Arbitrage GT
Slide 7
Convertible arbitrage
The convertible arbitrage strategy uses convertible
bonds.
Hedge: shorting the underlying common stock.
Quantitative valuations are overlaid with credit and
fundamental analysis to further reduce risk and
increase potential returns.
Growth companies with volatile stocks, paying little or
no dividend, with stable to improving credits and
below investment grade bond ratings.
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Slide 8
An convertible arbitrage strategy
example
Consider a bond selling below par, at $80.00. It has a coupon of
$4.00, a maturity date in ten years, and a conversion feature of
10 common shares prior to maturity. The current market price
per share is $7.00.
The client supplies the $80.00 to the investment manager, who
purchases the bond, and immediately borrows ten common
shares from a financial institution (at a yearly cost of 1% of the
current market value of the shares), sells these shares for
$70.00, and invests the $70.00 in T-bills, which yield 4% per
year. The cost of selling these common shares and buying them
back again after one year is also 1% of the current market
value.
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Slide 9
Scenario 1
Values of shares and bonds are unchanged:
Today
1 yr later
Bonds
80
80
Stock
-70
-70
T-Bill
+70
+72.8
Coupon
4
Fee
-3.5
Total
$80
$83.3
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Slide 10
Scenario set 2
In the next two examples, the share price has dropped to $6.00, and the
bond price has dropped to either $73.00 or $70.00, depending on the
reason for the drop in share market values. The net gain to the client
is 7.87% and 4.12% respectively, again after deducting costs and
fees.
Today
1 yr later (a)
1 yr later (b)
Bonds
80
73
70
Stock
-70
-60
-60
T-Bill
+70
+72.8
72.8
Coupon
4
4
Fee
-3.5
-3.5
$86.3
$83.3
Total
$80
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Slide 11
Scenario set 3
In the following three examples, the share price increased to $8.00, and
the bond price increased either to $91.00, $88.00 or $85.00, depending on
the expectations of investors, keeping in mind that we have one less year
to maturity. The net gain to the client is 5.37% and 1% in the first two
examples, with an unlikely net loss of 2.12% in the last example.
Today
1 yr later(a)
1 yr later(b)
1 yr later(c)
Bonds
80
91
88
85
Stock
-70
-80
-80
-80
T-Bill
+70
+72.8
+72.8
+72.8
Coupon
4
4
4
Fee
-3.5
-3.5
-3.5
$84.3
$81.3
$78.3
Total
$80
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Slide 12
A Risk Calculation: normal returns
If returns are normal, assume
the following:
Bond mean return: 10%
Equity mean return: 5%
Libor: 4%
Bond/equity covariance matrix
(50% correlation):
Mean return (gross):
10-5+4=9%
Standard deviation:
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Slide 13
Non-normal risk
Markets can deviate from normal returns in many ways:
Bond (or equity) prices can increase or decrease more than 2
sigmas.
Bond-equity correlation can change and become negative: if
that is the case, portfolio volatility can nearly double:
With a 5% probability, this can lead to portfolio losses
(1.65*6.25%>9%).
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Slide 14
Convertible arbitrage: return
Sources of return:
the bond yield (cash)
short interest rebate (cash)
Long/short stock moves (equity)
a small outflow for short stock dividends
(cash)
The bond itself (fixed income)
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Slide 15
Convertible Arbitrage: sources of risk
Industry/sector concentration
Liquidity
Interest rate risk
Credit risk, credit spreads.
Equity volatility, implied volatility
Event risk
Bond/equity correlation breakdown
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Slide 16
Convertible Arbitrage
Declining
implied
volatility
in
long
term
convertibles
(CBOE
ViX
index
at
7
year
low)
Increasing
equity
prices
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Slide 17
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Slide 18
Long-short equity
William
Holbrook
Beard without
(1824-1900)
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Not for dissemination
permission.
Slide 19
Equity hedge growth
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Slide 20
Sample hedge fund portfolio
A long-short pair trade
The fund has $1000. The manager is going to
purchase stock 9 units of stock A, and sell-short 9
units of stock B. Both are valued at $100 each. After
a year, A is worth $110, B is $105.
Assets at Prime Broker
Assets at Prime Broker
Assets at Prime Broker
(Before trade)
(After trade)
(After one year)
• $1000
• $1000
• $1000
• -$900 + 9 A
• 990
• +$900 – 9 B
• -945
• -9
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$ 1036
Slide 22
A long-short pair trade (v2)
The fund has $500. The manager is going to
purchase stock 9 units of stock A, and sell-short 9
units of stock B. Both are valued at $100 each. After
a year, A is worth $110, B is $105.
Assets at Prime Broker
Assets at Prime Broker
Assets at Prime Broker
(Before trade)
(After trade)
(After one year)
• $500
• $500
• $500
• -$900 + 9 A
• 990
• +$900 – 9 B
• -945
• -9
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$ 536
Slide 23
A long-short pair trade (v3)
Assumptions: 50% collateral for long trades, 80%
collateral for short trades.
Securities at Prime Broker
Securities at Prime Broker
• 9 A ($900):
• 9 A ($990):
• – 9 B (-$900):
• – 9 B (-$945):
Collateral required:
Profit: $45
$450+$720=$1170
ROR: 16.67%
Cash from short sale: $900
Cash required: $270
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Slide 24
Long/short risk profile
Equity market risk.
Counterparty risk (stock lending)
Corporate actions.
Liquidity (shorting)
Correlation breakdown
Volatility
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Slide 25
Equity hedge fund risk: equity vol
Distressed
Periods
Tranquil
Periods
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Slide 26
Hedge Fund – S&P correlations
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Slide 27
HF/S&P Bull correlations
Shifted
to
the
left
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Slide 28
HF/S&P Bear correlations
Shifted
to
the
right
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Slide 29
HF/S&P-vol correlations
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Slide 30
HF/S&P vol Bull Correlations
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Slide 31
HF/S&P-vol Bear correlations
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Slide 32
Hedge Fund Correlation histogram
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Slide 33
Equity Market Neutral
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Slide 34
Asset growth
Equity Market Neutral
Top Sharpe ratio of all hedge fund styles.
They have portfolios which are designed to be beta
neutral.
They like to diversify across sectors, market
capitalization, industries, etc.
For pairs trading, stocks are desired to have high
correlation, or return will be too volatile. Leverage is
easily arranged –through margin trading- and
desired, as returns will not be very volatile, but not
have great returns either.
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Slide 36
EMN: risk profiles
Since they have typically removed the main risk
exposure –equity exposure- the risk profile of Equity
Market Neutral will come from secondary sources,
and can be quite exotic, as the following examples
show:
Imagine a pairs trade: short IBM, long amazon, dollar
and beta neutral.
– Exposure to credit: widening will hurt amazon (lower cap)
much more than IBM (large cap).
– If aware of it, this risk is diversifiable; if not, it can align risk
exposures and be the source of nasty surprises.
Long Manulife, short Sunlife. Exposure to emerging
markets.
Long Merryll, short Goldman. Exposure to mortgages.
Slide 37
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Equity market neutral risk exposures
Equity volatilities
Liquidity
Capacity
Operational risk
Corporate events
Transparency
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Slide 38
Short selling
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Slide 39
Short selling
This is not a very popular style, and is regarded as difficult by most
practitioners.
Even during the bear market of 2000-2, less than 3% of the stocks in
NYSE and NASDAQ were borrowed or sold short.
Most equity analysts publish sell ratings on less than 10% of stocks.
Losses are unlimited when you short a stock: the probability distribution
of returns is very skewed to the left (the loss side). This might be a
mathematical explanation for the unpopularity of this style.
Uptick rule (removed by the SEC in 2007): a stock cannot be sold short
at a value which is less than the previous tick value: the stock price
must increase before you can short sell that stock. This adds execution
risk to short selling strategies in the US; if a stock exhibits a steady
collapse in price, it can take a long time before the short selling position
is filled, and then it will only be cleared at a very disadvantageous
value.
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Slide 40
The uptick rule
You
want
to
short
sell
here
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You
have
to
short
sell
here
Slide 41
Short-selling risks
Locate process: before you can borrow a stock, someone else
needs to be willing to lend it. This can take time. Furthermore, if
the original lender sells the stock, and the broker cannot find
another lender, you may be forced to buy back the stock,
whether you like it or not.
Risk Management systems are therefore much more critical for
the short part of the portfolio than for the long part:
– Stop-loss strategies
– Options can be used to cover losses, for a fee.
Many short-selling trades are based on negative company
information, which is often times tied to SEC filings, litigations,
etc. Legal risk must be monitored, specially for concentration.
Of all the hedge fund styles, this one has the lowest Sharpe
ratio. But it has negative correlation to most other indices.
Therefore, investors view this style as a hedge in itself against
other hedge fund investments.
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Slide 42
Short-selling in context
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Slide 43
Short selling: risks
Equity market direction
Equity volatility
Operational risk
Corporate events
Liquidity
Legal risk
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Slide 44
Merger Arbitrage
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Slide 45
Asset growth
Alcatel – Lucent merger
April 30, 2001. A merger was announced
between Alcatel (A- rated) and Lucent (BBBrated).
Merger arbitrageurs bought Lucent bonds and
sold short Alcatel bonds.
Lucent’s bonds gained 7.57%. Alcatel’s
remained stable.
The deal was off a month later. Bonds came
back.
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Slide 47
Bear Stearns
CDS/equity arbitrage
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Slide 48
Bear Stearns Facts
On Friday March 14, hedge fund sold CDS on BS at 10% of
notional up-front.
On Monday March 17, JPMorgan agreed to buy BS for $2 a
share.
CDS prices dropped to par with JPMorgan’s: about 1% up-front.
The hedge fund who sold CDS on Friday stood to win 90%
return on those, if the deal went through.
To ensure there was no blockage to the deal from share holders,
they actively bought BS stock, driving the price up to $10.
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Slide 49
Hedge Fund IPO’s
There are two main reasons for a hedge
fund IPO:
Need of capital of the management
company
Management companies rarely need capital
expansion, as they are not very capital
intensive enterprises. But they have
difficulty issuing debt, hence equity IPO’s is
their only alternative.
Many hedge funds issue stock privately with
strategic partners that can assist in fund
Merger Arbitrage
Yields
Credit
Liquidity
Model Risk (Operational risk)
Corporate actions
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Slide 51
Fixed Income Arbitrage
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Slide 52
1998 mythology:
“Fixed income is bad”
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Slide 53
Fixed income/convertible arb
Relative value
A Treasury/Eurodolar spread trade
Assume T-bills are at 94.20, and Eurodollars futures
are trading at 93.10.
An arbitrageur expecting an increase in the TED
spread will sell 10 euro-dollar futures and buy 10 Tbills (or T-bill futures).
The spread widens to 125: T-bills are at 93.95 (a loss
25) of and Eurodollar futures at 92.70 (a gain of 40).
Net gain of 15.
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Slide 56
Kessler Investment Advisers
Taken from K. Black’s book “Managing
a Hedge Fund”
3-year T-bills yield 2.5%.
10-year yield 4.5%
With $10M equity, Kessler buys $30M 3-years and borrows $20M of 10years in the repo market.
With negligible interest rate risk, the long side provides 7.5% return on
the equity; after factoring the repo return, the net can be around 6%
net, from a mere 2% differential.
If the yield curve were to flatten out, or become inverted, the differential
will decrease and the financing costs for the repo will increase. This
strategy would incur into losses (the manager might hedge these with
bond futures, but let’s not go there here).
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Slide 57
Fixed Income Arb. risks
The yield curve is to a FIA manager what a stock is to a long/
short manager.
The difference is that, while a stock price is a number at every
point in time, the yield curve is a set of many numbers at any
point in time. Hence:
– Managers must be more skilled mathematically.
– Many trades will originate from numerical assumptions: model risk
is an important issue. As is correlation breakdown.
– These trades lead themselves to highly leveraged positions
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Slide 58
Fixed Income Arbitrage
Yields
Credit
Liquidity
Model Risk (Operational risk)
Transparency
Leverage
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Slide 59
Distressed, PIPES, Reg-D
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Slide 60
Asset growth
Distressed securities
Companies exhibit problems:
– Liquidity
– Debt
– Operational shortcomings
– Legal or regulatory difficulties
– Bankrupt
Managers usually take a core position, which usually
includes all of the following:
– Buy equity
– Lend money
– Become activists in the management of the company
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Slide 62
Example
ABC debt:
– 11% annual coupon
– Trading at 50% of par.
The hedge fund :
– buys the debt at 50%.
– Restructures the company
A year later, the hedge fund sells the debt at
70%.
– Capital gains of 20% of the debt: ROR of
20/50=40%
– Interest payments of 11%
– Total ROR=51%
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Slide 63
Reg-D and PIPEs
Regulation D is part of the US Securities Act of 1933 that
simplifies filing requirements for companies that sell securities
exclusively through private placements.
Private Placements on Public Companies allows companies
with public shares to issue new restricted shares through private
deals, usually at a heavy discount
– Janus (a mutual fund) purchased $930M in Healtheon/WebMD in
2000, 6% discount.
– An issue in SimPlayer.com in 2000 was discounted by 34%.
PIPES cannot be sold for two years, but companies often file with
the exchange before that.
Sarbanes-Oxley has give recent popularity to pipes.
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Slide 64
Distressed securities: risk profile
Equity market direction
Equity market volatility
Yields
Credit risk
Liquidity
Corporate events
Transparency
Pricing
Capacity
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Slide 65
Global Macro
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Slide 66
Asset growth
The strategy
Forecasts in world economies, political
developments, macroeconomic variables
managers seek to profit by taking positions on
a wide array of financial instruments:
– futures,
– currencies,
– indices,
– commodities
– interest rates,
When their perceived value deviates from the actual
value.
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Slide 68
Example: Soro’s and the British
Pound
All European central banks were intervening in the
early 90’s to keep the GBP within the 3% boundary
defined by the EMS.
Macro managers were convinced the British pound
had to be devalued.
They took short positions on the GBP against the
continental European currencies in 1992.
When the GBP was finally allowed to move freely, it
dropped 20%.
Soro’s Quantum fund is said to have made $1B profit
in this trade.
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Slide 69
Global Macro: sources of risk
Most of them:
Market: event risk, political developments, etc.
Currency risk.
Model risk.
Liquidity and execution risk, due to the large orders they usually
process.
Risks associated with short selling, an integral part of their
strategy: volatility, capacity, etc.
As macro managers thrive in inefficiency in global markets, many
believe their opportunities are over, as global markets are more
efficient than ever before.
Others believe that new capital markets (electricity, weather) bear
even higher degrees of inefficiency, so ample opportunities
exist.
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Slide 70
Managed Futures
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Slide 71
Futures
Tradition; From LME to Japan rice market in the XVI century.
In the middle ages, buyers and sellers of commodities met annually at
trading fairs to lock in future needs and prices. Middlemen provided
banking and storage to facilitate trade.
Transfers risk from the unwilling to the unwilling. Later speculators
facilitated risk transfer from the unwilling to the willing.
Permits economic certainty and increased economic activity.
Futures function as an insurance market, providing price certainty to
commercial entities.
Liquid, public markets preclude special “inside” information.
Extremely regulated. Cannot trade off-exchange.
Exchanges create uniform product, so quality, delivery date and
location of product is not a variable. Investors concentrate on price
trends.
Complete continuous disclosure of price. In 30 countries.
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Slide 72
Futures Protocols
Investors provide initial margin or good faith deposit.
– Mark to market losses must be topped up every day.
– Customer receives gains of profitable positions daily.
All traders participate as equals once margin is posted.
Speculators have the same access as the most creditworthy
bank.
Owned by the members. Clearinghouse is the guarantor and
counterparty of all trades. Anonymous trade.
Member firms only post their “net” position to the exchange.
Futures contracts have no value; they represent a future
obligation.
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Slide 73
CTAs
Commodity Trading Advisors, trade
exclusively in Futures contracts.
Different trading styles:
– Trend followers. Determine trends, and try to
extract value from them.
– Short-term traders. Very frequent traders, intra-day
sometimes, go against current trends.
– Fundamental. Similar to macro traders.
– Mechanical. Follow blind quantitative
methodologies.
– Discretionary. Mechanical with an override.
Slide 74
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Managed Futures Risks
Leverage. Since only margin is required to
trade. High volatility
Event risk. Trade reversals are often sudden
and pronounced. Trend followers can give
back weeks of profits in one day
Market risk
Model risk
No capacity risk
No credit risk
No liquidity risk
Slide 75
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