Alternative Investments

Seminar 4

Hedge Funds

1. List three characteristics that differentiate hedge funds from traditional investment funds

Answer:

A hedge fund is privately organized in most jurisdictions

2. Assume a hedge fund has experienced a negative return after half of the reporting period. What
is a potential problem caused by the incentive fees of hedge funds

Answer:

If a fund experiences negative returns within a reporting period, the fund’s managers may view the
fund as likely to close, in which case the managers may have a strong incentive to take excessive risks
in an attempt to recoup losses and stay in business. Even if the managers do not fear that the fund
will close, if the fund’s NAV falls substantially below its HWM, the managers may foresee no realistic
chance of earning incentive fees in the near term unless the fund’s risk is increased. Thus, an incentive
fee structure may encourage enormous and inappropriate risk taking by the managers.

3. What is the primary difference between a fund of funds and a multistrategy fund?

Answer:

In a multistrategy fund, there is a single layer of fees, and the submanagers are part of the same
organization. The underlying components of a fund of funds are themselves hedge funds with
independently organized managers and with a second layer of hedge fund fees to compensate the
manager for activities relating to portfolio construction, monitoring, and oversight.

4. Describe the strategy of managed futures

Answer:

Managed futures refers to the active trading of futures and forward contracts on physical
commodities, financial assets, and exchange rates. The purpose of the managed futures industry is to
enable investors to receive the risk and return of active management within the futures market, while
enhancing returns and diversification.
5. In a market trending upward, explain how the value of a simple moving average compares to the
value of an exponential moving average?

Answer:

Exponential moving averages place higher weights on more recent observations for typical values of
the exponential weighting parameter. If prices are trending upward the exponential moving average
will tend to recognize an upward trend more quickly and more profoundly due to the higher weight on
the more recent (and higher) prices.

6. What is the difference between discretionary fund trading from systematic fund trading.

Answer:

• Discretionary fund trading is where the decisions of the investment process are made directly
by the judgment of human traders.
• Systematic fund trading, often referred to as black-box model trading because the details are
hidden in complex software, is where the ongoing trading decisions of the investment process
are automatically generated by computer programs.

7. Discuss the following statement: “Short selling of equity in a distressed firm is similar to an
option position.”

Answer:

This statement is true. Shares in highly leveraged firms resemble call options, therefore short-selling
distressed equities is analogous to writing naked call options on the firm’s assets and generates a
negatively skewed return distribution. An investor has a naked option position when the investor is
short an option position for which the investor does not also have a hedged position.

8. Convertible Bond Strategies

a. Describe the positions utilized in a classic convertible bond arbitrage trade.

Answer:

The classic convertible bond arbitrage trade is to purchase a convertible bond that is believed to be
undervalued and to hedge its risk using a short position in the underlying equity.

b. Consider a firm with a borrowing cost of 8% on unsecured, subordinated straight debt and a
current stock price of $40. The firm may be able to issue three-year convertible bonds at an
annual coupon rate of 4% by offering a conversion ratio such as 20 for a face value of $1000.
 What is the bond’s strike price, and what does the conversion option allow the bond
investors to do?

Answer:

The conversion ratio of 20 is equivalent to a $50 strike price using Equation 1c, assuming that the
bond’s face value is $1,000. On or before maturity, bond investors can opt to convert each $1,000
face value bond into 20 shares of the firm’s equity rather than receive the remaining principal and
coupon payments.

Convertible Bond Price = Value of Straight Corporate Debt + Value of the Implicit Equity Call Option (1a)

Conversion Ratio = Number of Shares per Convertible Bond (1b)

Option Strike Price = Convertible Bond Face Value/Conversion Ratio (1c)

Conversion Value = Current Stock Price × Conversion Ratio (1d)

Conversion Premium = (Convertible Bond Price − Conversion Value)/Conversion Value (1e)

c. Returning to the previous question of an 8% unsecured bond rate, a $40 stock price, and a
conversion ratio of 20, and assuming that a three-year European-style call option—given a
current stock price of $40, a strike price of $50, and other parameters, such as volatility and
dividends—is valued at $5.14 per share according to the Black-Scholes option pricing model,
what are the values of the convertible bond, the conversion value, and the conversion
premium?

Answer:

Starting with the straight debt issue, the three-year bond in the example can be valued with a 4%
coupon and an 8% discount rate, found from observing corporate bonds of similar credit risk, at
$896.92, using a financial calculator with annual coupons and compounding for simplicity. Using
representative calculator inputs n = 3, I = 8, PMT = 40, and FV = 1,000 and computing PV yields
896.92. Adding the straight bond value of $896.92 to the value of 20 options, $102.80 (i.e.,
$5.14 × 20), yields a convertible bond valuation of $999.72, a value that is very close to the bond’s
face value of $1,000. The current stock price multiplied by the conversion ratio gives a conversion
value of $800 (i.e., $40 × 20). Therefore, this convertible bond is selling at a conversion premium of
24.97% [i.e., ($999.72 − $800)/$800].

9. Consider a skilled manager implementing a pairs trading strategy. What is the concern that tends
to limit the size of the positions that the manager might take in attempting to increase expected
alpha?

Answer:
The limits to arbitrage, which refers to the potential inability or unwillingness of speculators, such as
pairs traders, to hold their positions without time constraints or to increase their positions without
size constraints. Very large positions with high degrees of leverage increase the probability of
financial ruin and the inability to survive short-term displacements.

10. Explain how limits to arbitrage prevent markets from being perfectly efficient.

Answer:

There is a limit to the risk that an arbitrager can tolerate and/or is allowed to take, which provides a
limit on the level of arbitrage activity by a single manager.

i) Managers who want to be successful in the long run must limit the risk of their fund,
especially in periods where their strategy might be out of favor (e.g., value managers in
the late 1990s/early 2000). This might prevent them from taking aggressive bets.
ii) Market structures may prevent successful arbitrage in some cases. For example,
institutional investors may be too large to participate in micro-cap stocks.
iii) Limits on short selling could be a limit to arbitrage. Some countries do not allow short
selling altogether, recent IPOs or spin-offs may not have shares available to be shorted,
or some shares may be temporarily unavailable for borrowing when the demand to sell
the shares short exceeds the supply of borrowable shares.