Introduction
Risk is one of the vital factors involved in modern day business. From time to time different risk mitigation strategies have evolved with some having great success and some having limited success. Hedging is a risk mitigation tool used to offset the risk involved in future. As per (Noel Amenc, 2002), Hedge funds are speculative vehicles designed to exploit superior information held by their managers. While (Logue, 2007, p. 9), Hedge fund is a lightly regulated investment partnership that invests in a range of securities in an attempt to reduce risk and increase expected gain. A hedge fund differs from traditional investment accounts like mutual funds, pensions and endowments. It allows more freedom in choice of investment strategy and can prove beneficial with respect to conservative investment strategy.
Brief History of Hedge Funds
As per (Logue, 2007, p. 15), Alfred Winslow Jones wrote a book in 1941 on the attitudes of Akron’s resident towards the large corporations. The Book titled as “Life, Liberty, and property: A story of conflict and a measurement of conflicting rights”. Magazine Fortune re-printed many section of the book and Jones joined there editorial staff. In 1949, he formed his own company A W Jones & Co. During his stay at Fortune, Jones discovered that modern financial market is inherently unpredictable. He was determined to find a way to reduce risk. He discovered a way of buying stock expected to go up and selling stocks, which expected to go down. Fortune first used the term “Hedge Funds” to describe Jones fund in 1966 article. Jones had two innovations in the modern financial system. He suggested that private-partnership-partnership could remain un-registered as long as investor is accredited. He charged his investors with 20 percent of fund’s profits. From the 1966-72, the hedging strategies moved from pure hedging to speculation. Speculation is a process of seeking the high return by taking on a greater than average amount of risk. Hedging and speculation are opposing strategies but modern hedge funds use a mix of both. The fall of stock market in 1972 has brought huge losses to many of the hedge fund managers. The losses ended the aggressive strategy of hedge funds for about a decade.
In 1970s George Soros, Jim Rogers and Jultan Robertson rejuvenated the hedge funds strategy by taking profit from the big changes in global macro-economy. Soros defines his new approach in his book “Alchemy of Finance” published in 1988. Soros and Robertson enjoyed iconic status in 1990s but both met failures in preceding years.
Understanding the Mechanics of Hedge funds
In the financial world of hedge funds few terms are used very frequently, Alpha is one of the terms used frequently in the hedge funds fraternity. As per (Logue, 2007, p. 19), Alpha originated from the modern portfolio theory (MPT). The theory explains the generation of returns from an investment. The equation describing theory has four terms, which covers risk free rate of return, premium over the risk-free rate, Alpha and Beta. Alpha is the value added by the hedge funds manager. Theoretically, Alpha does not exist and if it exists, it would have a negative value.
Beta is the sensitivity of the investment to the market and Alpha is return from market. If a hedge fund reduces all market risks, its return comes entirely from Alpha. As per (Pascalau, 2011, p. 8), Beta can be defined as multiple regression co-efficient on return of the market.
Hedge Fund Strategies
Since Jones discovery of risk avoidance methodology in modern finance, many different strategies for hedge funds have been developed and employed. The strategy of each hedge fund manager may differ but the basic concepts behind these strategies stay the same, which are discussed briefly in the preceding text.
Buying Low, Selling High: Arbitrage
The word “arbitrage” has emanated from a French word meaning judgment. To understand the basic concept, let us consider an example. A trader in New York noticed that a stock is trading at 11.98$ while the same stock values 11.99$ in London. He buys as many shares as possible in New York by borrowing money if required and sells them immediately in London. He gains one penny per stock. It is a classic example of arbitrage with no risk at all, many people have termed such type of trading as “money on the side walk”. Theoretically, arbitrage does not occur but practically it has been used almost every day. The three forms of market efficiency strong form, semi-strong form and weak form does not allow for any arbitrage. The believers of market efficiency pleads that arbitrage never exists in a market while non-believers of the concept thinks vice versa.
Arbitrage can be further divided in to two types, which are true arbitrage and risk arbitrage. True arbitrage is a risk less trading. The purchase of assets in one market and its sale on the other market happens simultaneously. Risk less arbitrage is possible on rare occasions. No hedge fund can operate for long times on risk less arbitrage. Risk arbitrage is similar to true arbitrage but involves some kind of risk in it. It involves the buying of one security and selling other. Different types of arbitrage used are discussed in the preceding text.
Capital structure Arbitrage
It covers the way of financing of a company. Many companies uses one type of stock but some also uses different types of stock securities. When a company has different trading securities, it difference of pricing among these securities are used of arbitrage. In order to understand this type, let us consider an example. A company has a common stock as well as a 20-year corporate security bond with an interest rate of 5 %. The company stocks maintain their market position but its bond value fluctuates depending on the interest rate. The company’s bond can be bought, once their price fell and can be sold once the price of bond increases. Such type of arbitrage is called capital-structure arbitrage.
Convertible Arbitrage
Some businesses issue convertible bonds or convertible preferred stock. They pay income to shareholders and they can be converted into common stocks into shares of common stock. For example a company offers a 500$ convertible bond that pays 7% interest and is convertible to 100 common stocks. For a stock price less than 15$ the shareholders can collect the interest income. If the stock price goes up, the holders have the option to convert into common stocks.
Fixed-income Arbitrage
Fixed income securities give holders a regular interest rate payment. Let us consider that United States government treasury bonds of one year are giving more returns then the two years bonds. In this case, a hedge fund manager can short his two-year bonds and buys one year bonds till the price level returns to normal. Such an exploitation is termed as Fixed-income Arbitrage.
Index Arbitrage
A market index provides the information on the activity of the market. It is based on the performance of the group of securities trade in the market. Future contracts are available on index on an expected future return value. For example in S&P 500 future contracts are available at very low rate then the index. To make use of this disparity, the on-hand S&P 500 can be sold and its future contracts can be bought to make profits from the difference. Due to limitations of index buying, only large hedge funds employ the use of index arbitrage.
Liquidation Arbitrage
It is a bet against the breakup value of a business. Many businesses own real estate, patent rights, and mineral rights etc, which are not reflected in their market value. Selling of a company piece by piece can be profitable. To get advantage from this approach research on the target company is of vital importance to make profits. For example, a chemical company has been beaten up badly in the stock market due to environmental issues. However, it owns the patent rights of life saving drug, a real estate piece of land in a good location and a fine collection of art collectibles. Shares of this company can be bought in anticipation. As the takeover of the company by a new owner would be base on the value of its all assets other than its market value.
Merger Arbitrage
It differs from the liquidation arbitrage in a sense that it relies on research carried out after the merger announcement rather than before it. A merger announcement usually contains information of acquiring company, acquired company, price of transaction, currency and expected date of merger closure. Any of these variables can change creating a profitable trading situation.
Options Arbitrage
Options are available in different varieties. Two of the most commonly used are calls and puts. Calls deals with price of security going up and puts deals with the vice versa scenario. The European and American Options differ from each other. The American options allow their usage only on expiration date while the European options allow their usage between the date of issue and expiration date. For similar securities in Europe and America, intelligent use of the options can result into profitable circumstances.
Pairs Trading
Pairs trading is a form of short-long hedging which looks for discrepancies among securities in a given industry sector. If one security in appears to be overhauled in one sector than it can be shorted and another security which looks undervalued can be bought.
Scalping
It takes advantage of small price movements throughout the day. It is a common practice in the commodity market. A scalper usually takes advantage of the changes in bid-ask spread. Bid-ask ratio is the difference between the price at which broker buys a security from the seller and price at which he sell it to the buyers. Mostly the spread remains constant, however at times the balance might shift which gives chance to a scalper for making a trade. The shift is utilized, based on profitability and securities can be disposed off once the spread returns to normal.
Statistical Arbitrage
It uses complex mathematical modeling to determine the price of a security. As per this theory, the price change is random. In this strategy, the trader used large databases of the security prices and determines the average pricing for trade. When the trading price deviates from the normal, the trader gets in to a position of making profits from this change.
Warrant Arbitrage
It is somewhat similar to the options discussed above. A company rather than an option exchange issues it. A warrant gives holders a choice to exchange it for share of company’s stock at a pre-determined price. Like options and converts the value of warrant may differ from the stock value, allowing making use of this situation for profitability in the said trade.
Equity based Hedge Fund: Short Selling & Leveraging
As per (Logue, 2007, p. 183), Equity based hedge funds invest in equities. These hedge funds rarely buy and hold stocks like the traditional investments. In short selling, borrowing of an asset (like a stock or bond) is carried out, its selling is accomplished in second step, the asset is then bought back and the loan is paid. If the asset price goes down, the hedge fund makes the difference between the selling prices and repurchase price. It is a way to profit from the decline of a security. It allows freedom to an investor for buying securities at low price and selling them at high price. By shorting of an asset, the investor gives up the risk of price going down. Opposite of the short selling is long, in which the investor owns the security.
In case of leveraging, the money is borrowed to invest. Leverage increases the potential returns but also has some risk associated with it. Leverage allows a hedge fund to magnify its returns. The hedge funds use borrowing of money in leverage, which allows it a high percentage of returns. In the absence of borrowing, such high returns would not have been possible. Leverage has also a down side, the borrowed money has to be repaid, no matter how the trade works out.
Synthetic Securities
A synthetic security is created by matching of one asset by combination of few others that have the same profit and loss profile. For example, consider a stock with a combination of put options. Put options mean that it has a value if the price goes down. A similar option is call in which the stock has value when the prices goes up. Synthetic securities are a combination of these options.
