Name the risks hedge funds run and describe their strategies, which are managed futures, global macro, emerging markets, fixed income arbitrage, convertible arbitrage, merger arbitrage, distressed securities, dedicated short and long-short equity.
The idea
Hedge funds run leverage, liquidity, model, counterparty, operational and tail risks, and strategies differ in which dominates. Managed futures funds trade futures, often trend following. Global macro funds take leveraged views on rates, currencies and commodities. Emerging market funds are mostly long because shorting is hard, facing sovereign and currency risk. Fixed income arbitrage takes small relative-value bets in bonds with heavy leverage, so the risk is spreads widening and liquidity drying up. Convertible arbitrage buys convertible bonds and shorts delta times the conversion shares of the stock. Merger arbitrage buys the target, often shorting the acquirer in a share deal, and loses heavily if the deal fails. Distressed securities funds buy debt of troubled firms. Dedicated short funds only short. Long-short equity funds hold both longs and shorts. A common mistake is calling arbitrage riskless. The exam point is matching each strategy to its position and its characteristic risk.
Formulas
Shares to short in a delta-neutral convertible arbitrage
Shares short = Δ × N × CR
- Δ
- the delta of the conversion option
- N
- the number of convertible bonds held
- CR
- the conversion ratio, shares per bond
Delta changes with the share price, so the hedge must be adjusted. Shorting all the conversion shares, ignoring delta, over-hedges the equity exposure.
Deal completion probability implied by a target's price
p = (P − F) ÷ (O − F)
- P
- the target's current price
- F
- the price the target is expected to fall to if the deal fails
- O
- the offer value per share
For a cash offer, ignoring time value. The payoff is like a written put: a small gain if the deal closes and a large loss if it fails.
Net market exposure of a long-short fund
Net exposure = (Long − Short) ÷ Capital
- Long
- the value of long positions
- Short
- the value of short positions
- Capital
- the fund's capital
Measures market direction. Gross exposure adds the two sides instead and measures total leverage.
A practice question
In a share-for-share takeover announced by a listed acquirer, which position does a typical merger arbitrage fund take?
- Short the target and long the acquirerWhy not: Reverses the position: the target trades at a discount to the deal value and the fund buys it.
- Long both the target and the acquirerWhy not: Leaves the fund fully exposed to the acquirer's share price rather than hedging it.
- Long the target and short the acquirer - correct
- Short both firms, expecting the deal to failWhy not: This is a bet on failure; arbitrage funds normally bet on completion.
The target usually trades below the offer value. The fund buys it and shorts the acquirer's shares to hedge the acquirer's price in the exchange ratio, earning the spread if the deal completes.
A harder one
A long-short equity fund with USD 100 million of capital holds USD 130 million of long positions and USD 70 million of short positions. What are its net and gross market exposures as a percentage of capital?
- Net 200 percent, gross 60 percentWhy not: Swaps the two measures: gross adds the long and short, net subtracts them.
- Net 60 percent, gross 130 percentWhy not: Computes gross from the long side only and ignores the short positions.
- Net 130 percent, gross 70 percentWhy not: Reports the long and short books separately instead of net and gross.
- Net 60 percent, gross 200 percent - correct
Net = (130 - 70) / 100 = 60 percent. Gross = (130 + 70) / 100 = 200 percent. Net measures market direction exposure and gross measures total leverage.
The hardest tier
A fixed income arbitrage fund has USD 50 million of equity. It is long USD 1 billion of off-the-run Treasuries with modified duration 7 and short USD 1 billion of on-the-run Treasuries, so interest rate risk is hedged. The spread between the two widens by 4 basis points, equivalent to a yield rise of 4 basis points on the long position only. What is the loss as a percentage of equity?
- 11.2 percentWhy not: Counts the 4 basis points on both legs, although the short leg hedges parallel yield changes and only the spread matters.
- 0.28 percentWhy not: Divides the loss by the position size of USD 1 billion instead of by the fund's equity.
- 5.6 percent - correct
- 0 percentWhy not: Assumes a hedged position has no risk, ignoring spread (convergence) risk.
DV01 of the long position = 1,000m x 7 x 0.0001 = 0.7m per basis point; 4 bp costs 2.8m. 2.8 / 50 = 5.6 percent. Small spread moves become large losses at 20 times leverage, which is the central risk of the strategy.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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