Chapter 12 – Hedge FundsGeneral Characteristics▪Category of investing that represents a broad range of different strategies▪Different asset class▪Lightly regulated pools of capital▪Great flexibility in investment strategies utilized▪Started as limited partnerships in US - now taking form of mutual fund trusts ▪Majority of return from manager’s skill not marketWho Can Invest?-sophisticated investor-accredited investor- Retail Investor - Commodity Pools- Closed-end Funds- Principal-protected notesHistory of Hedge FundsAlfred Jones – father of hedge funds - wanted to create a fund that offered protection from the probability of declining markets-combined short selling & leverage- his strategy entailed - in rising market-long securities that will rise more than the market-short securities that will rise less than the market- in falling market-short securities that will decline more than the market-long securities that will fall less than the market- his fund outperformed mutual funds in 50s & 60s- many new funds started in mid-60s –didn’t adhere to Jones model – decimated in bear markets of 1969 & 1974-hedge fund revival in late 80s-hundreds of new funds with highly specialized strategies created-Long-Term Capital Management scandal in 1998-In Canada – 180 funds – about 1% of MF assets-In US – 5,000 funds – about 7.5% of MF assetsPortfolio Theory & Hedge FundsReturnRiskSharpe Ratio = Return – Risk Free Rate of ReturnRiskCorrelation CoefficientEfficient Frontier - maximizes the expected return for each level of risk in a combinedportfolioEfficient frontier with Hedge FundsRfSharpe ratio = (Portfolio return – Risk free rate)/ standard deviation of portfolio-if >1, then excess risk is greater than risk incurred to earn that returnBeta - market risk - if adding hedge funds to diversify your portfolio – want funds with a beta of much less than 1Alpha = portfolio return – market return -- value added of the manager = portfolio return – risk-free return – (portfolio beta *(market return – risk-free return)) Performance – Table 12.3, p. 12.9 and handoutsHedge Fund Benefits1)low correlation to traditional asset classes2)risk minimization3)absolute returns4)potentially lower volatility & higher returnsHedge Fund Risk1)Market Risk - risk of being invested in particular market2)Manager risk - have a wider investment mandate than MF-manager might start to think invincible or become complacent-might take in more money than can efficiently invest-style drift - manager drift to different investment style than when you bought3)Complexity - investor doesn’t understand techniques being used4)Lack of Transparency - investor can’t fully seea.Manager’s investment styleb.Processes for implementing approachc.Positions in portfoliod.Fees & expenses5)Liquidity - of investments- liquidity premium- ability to turn investments into cash quickly at good price- of fund - redemption policy- lockup period- specified maturity date6)Leverage - borrowed too much - received a margin call7)Pricing - difficult to price some securities - illiquid, wide bid/ask spread8)Data risk - hedge fund managers are not obligated to report numbers9)Event risk - global, unanticipated events10)Business event risk - unexpected company newsDue diligence - p. 12-13TermsLockup - time period initial funds cannot be redeemedBank Notes - some have principal guarantees from bank-performance linked to performance of a hedge fund using options-wound up at specific timeLiquidity dates - once lockup period over, investor can redeem on liquidity dates Incentive fees - management fees based on performanceHigh water mark - can only take performance fees on net new profits- sets bar above which manager gets paid % of profitsHedge Fund CategoriesHedge Funds – 6Fund of Funds- 2 types - single-strategy-multi-strategy Advantages:-due diligence-reduced volatility-professional management-access to hedge funds-diversification-risk control Disadvantages:-additional costs-no guarantee of positive returns -lack of diversification-additional leveragePrincipal Protected Notes-importance to hedge funds-costsRisk-performance risk-liquidity riskEvaluation Factors-due diligence-liquidity-taxes-fees, costs & commissions-strategy & structureTracking PerformanceA. Questions1)Calculate the Net Exposure for the following:a) Fund X has capital of $175 million; it purchased $175 million of imperial Oilshares & shorted $85 million of PetroCanadab) Fund Y has capital of $535 million; it is long $535 of Barrick Gold and short $300million of placer Dome2)What is the Leverage in question 1 for:a)b)3)If a hedge fund manager has a performance fee based on “1 + 20 with a T-bill hurdlerate”. What fee would be earned for each of the following situations?a) $200 million invested; T-bill rate = 4%; fund return = 9%b) $85 million invested; T-bill rate = 3%; fund return = 12%4)When would a manager, who has a high water mark requirement, earn a performancefee in the following cases?a) initial investment of $100 million in 2002; earned 4% in 2003; 5% in 2004; and– 6 % in 2005b) value in 2004 of $235; earned – 9% in 2005B.Matching1)Accredited investor ________2)Hedge ___________3)Long-Term Capital Management _____4)Efficient Frontier __________5)Sharpe Ratio _________6)Alfred Jones _________7)Correlation Coefficient ________8)Different asset class ________9)Alpha ________10)Majority of return ________ a)Return per unit of riskb)Not correlated to traditional marketsc)Value added of managerd)$150,000 hedge fund investmente)protect self from negative outcomef)relationship between returns on 2 securitiesg)from manager’s skillh)highest return at specified risk leveli)scandalj) long/short fundC.Identify whether the following is a characteristic of a Mutual Fund (MF) or aHedge Fund (HF).1)Not highly regulated ________2)Manager compensated by management fee _______3)Focus on relative return ___________4)Little correlation to traditional markets ________5)Try to never lose money _________6)Small minimum investment _______7)Offered by prospectus to general public ________8)Can utilize long & short positions _________9)Redemption daily _________10)Investment process not widely communicated ____11)Can utilize long & short positions ______12)Usually capped at maximum size ______13)Managers invest their own assets ______14)Use derivatives only in a limited way ______15)Restricted in advertising to public ________D.Match the type of risk with Hedge Fund exposure.1)Lack of Transparency _______2)“ “_______3)Event Risk _______4)“ “_______5)Manager Risk _______6)“ “_______7)Style Drift _______8)Lockup _______9)Liquidity Dates _______10)Bank Note _______11)“ “_______12)Leverage _______13)“ “_______14)Pricing Risk _______15)High Water Mark _______16)“ “_______ a)from unhedged short positionb)only take performance fees on net newprofitsc)can’t fully see Investme nt styled)changes over timee)sets bar for manager performance feesf)negative unanticipated eventg)linked to hedge fund performanceh)wide bid/ask in investmentsi)can’t see positions in portfolioj)global impactk)initial funds can’t be redeemed for some timel)problem if margin callsm)may have principal guarantee from bank n)takes in too much moneyo)when investor can redeemp)becomes over confidentE.Identify whether the following are true or false. If false, indicate why.1) A Long/Short fund follows the Jones model. _____2)Profit from a Merger Arbitrage fund comes from trading profits. ____3)One risk of a Distressed Securities fund is political risk. ______4) A Short Bias fund makes profits when markets decline. ____5)Approximately 75% of Canadian hedge funds are Long/Short funds. _____6)One risk of a Fixed Income Arbitrage fund is interest rate risk. _____7)In rising markets, Long/Short funds will profit from the short part of their strategy.______8)Equity Market Neutral funds are subjected to manager risk. ______9)One strategy of a Fixed Income Arbitrage fund is to take advantage of mispricing inthe yield curve. _____10)In a Convertible Arbitrage fund, the common shares are purchased and theconvertible bond is shorted. _________11)A Long/Short fund uses a directional strategy. _____12)Profits in an Equity Market Neutral fund are generated by correctly forecasting thedirection of the equity market. ______13)The Relative Value category of hedge funds has the highest correlation to the equitymarkets of the 3 categories. ______14)The Event Driven category has higher volatility than the Relative Value category ___15)One risk of the Distressed Securities style is leverage. _____16)One risk of the Distressed Securities style is default risk. _____17)The Global Macro fund uses a strategy based on expectations of changes in globalmarkets or trends. _______18)The Long/Short fund generally uses a strategy of 2/3 longs & 1/3 shorts. ____19)Fixed Income Arbitrage funds profit if the market moves away from a normalsituation. ______20)A Distressed Securities fund searches for companies selling at a deep discount tovalue. _______。
Exercises (Part 1 &2 )1．The principal lender-savers areA) governments B) businesses C) households D) foreigners.2. Which of the following can be described as direct finance?A) A corporation issues new shares of stock.B) People buy shares in a mutual fund.C) A pension fund manager buys a short-term corporate security in the secondary market.D) An insurance company buys shares of common stock in theover-the-counter markets.3. Which of the following can be described as indirect finance?A) You make a loan to your neighbor.B) A corporation buys a share of common stock issued by another corporation in the primary market.C) You buy a U.S. Treasury bill from the U.S. Treasury.D) You make a deposit at a bank.4. ________ work in the secondary markets matching buyers with sellers of securities.A) Dealers B) Underwriters C) Brokers D) security issuers5. The higher a security's price in the secondary market the ________ funds a firm can raise by selling securities in the ________ market.A) more; primary B) more; secondary C) less; primary D) less; secondary6. Of money's three functions, the one that distinguishes money from other assets is its function as aA) store of value B) unit of account.C) standard of deferred payment. D) medium of exchange.7. The currency component includes paper money and coins held inA) bank vaults B) ATMsC) the hands of the nonbank public D) the central bank8. The M1 measure of money includesA) small denomination time deposits. B) traveler's checks.C) money market deposit accounts. D) money market mutual fund shares.9. A credit market instrument that requires the borrower to make the same payment every period until the maturity date is known as aA) simple loan B) fixed-payment loanC) coupon bond D) discount bond.10 .All of the following are examples of coupon bonds exceptA) Corporate bonds B) U.S. Treasury billsC) U.S. Treasury notes D) U.S. Treasury bonds11. Everything else held constant, if the expected return on U.S. Treasury bonds falls from 8 to 7 percent and the expected return on corporate bonds falls from 10 to 8 percent, then the expected return of corporate bonds ________ relative to U.S. Treasury bonds and the demand for corporate bonds ________.A) rises; rises B) rises; falls C) falls; rises D) falls; falls12.When the price of a bond is above the equilibrium price, there is an excess ________ bonds and price will ________.A) demand for; rise B) demand for; fallC) supply of; fall D) supply of; rise13. Everything else held constant, if interest rates are expected to fall in the future, the demand for long-term bonds today ________ and the demand curve shifts to the ________.A) rises; right B) rises; left C) falls; right D) falls; left14.A factor that could cause the supply of bonds to shift to the right is:A) a decrease in government budget deficits.B) a decrease in expected inflation.C) a recession.D) a business cycle expansion.15. The Bush tax cut reduced the top income tax bracket from 39% to 35% over a ten-year period. Supply and demand analysis predicts the impact of this change was a ________ interest rate on municipal bonds and a ________ interest rate on Treasury bonds.A) higher; lower B) lower; lowerC) higher; higher D) lower; higher16. Financial markets promote greater economic efficiency by channeling funds from ________ to ________.A) investors; savers B) borrowers; saversC) savers; borrowers D) savers; lenders17. The price paid for the rental of borrowed funds (usually expressed asa percentage of the rental of $100 per year) is commonly referred to as A) inflation rate. B) exchange rate.C) interest rate. D) aggregate price level.18. Everything else held constant, a decline in interest rates will cause spending on housing toA) fall. B) remain unchanged.C) either rise, fall, or remain the same. D) rise.19. High interest rates might cause a corporation to ________ buildinga new plant that would provide more jobs.A) complete B) consider C) postpone D) contemplate20. Which of the following statements about the characteristics of debt and equity is false?A) They can both be long-term financial instruments.B) They can both be short-term financial instruments.C) They both involve a claim on the issuer's income.D) They both enable a corporation to raise funds.21. When I purchase ________, I own a portion of a firm and have the right to vote on issues important to the firm and to elect its directors. A) bonds B) bills C) notes D) stock22. Which of the following benefit directly from any increase in the corporation's profitability?A) a bond holder B) a commercial paper holderC) a shareholder D) a T-bill holder23. Which of the following is not a secondary market?A) foreign exchange market B) futures marketC) options market D) IPO market24. Which of the following is not included in the monetary aggregate M2?A) Currency B) bondsC) Traveler's checks D) Checking deposits25. A liquid asset isA) an asset that can easily and quickly be sold to raise cash.B) a share of an ocean resort.C) difficult to resell.D) always sold in an over-the-counter market.26. A financial market in which only short-term debt instruments are traded is called the ________ market.A) bond B) money C) capital D) stock27. Equity instruments are traded in the ________ market.A) money B) bond C) capital D) commodities28. U.S. Treasury bills are considered the safest of all money marketinstruments because there is no risk of ________.A) defeat B) default C) desertion D) demarcation29. A short-term debt instrument issued by well-known corporations is calledA) commercial paper. B) corporate bonds.C) municipal bonds. D) commercial mortgages.30. ________ are short-term loans in which Treasury bills serve as collateral.A) Repurchase agreements B) Negotiable certificates of depositC) Federal funds D) U.S. government agency securitiesTrue / False1. If expected profitability on making new investments by companies goes up affecting the supply of bonds, all things being equal, the rates on bonds should go down.2. Investors expect the rates on bonds to fall over the longer term. This should push rates down today, all things being equal.3. Unless a bond defaults, an investor cannot lose money investing in bonds.4. A coupon bond is purchased at a premium (higher than its face value) and is held to maturity, then the bond’s coupon rate is higher than its yield to maturity.5. Suppose recently the yield to maturity on the U.S. bonds decreased, then the return of U.S. bonds hold by Chinese government will decrease accordingly.6. U.S. Government bonds are default- free bonds.7. Both debit card and credit card are electronic money.8. NYSE-Euronext belongs to OTC market.9. If money supply increased, the interest rate must be lowered.10. If M2 increased quickly, the current CPI will also go up accordingly.。
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