Hedge Fund Investment Strategies

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					    Hedge Fund Investment Strategies

1   L3: Hedge Fund Strategies
    Hedge Fund Investment Strategies
     Hedge funds employ dynamic investment strategies designed to find unique
        opportunities in the market and then actively trade their portfolio investments
        (both long and short) in an effort to maintain high and diversified absolute
        returns (often using leverage to enhance returns)
     By contrast, most mutual funds only take long positions in securities and are
        less active in trading their portfolio investments (usually without leverage) as
        they attempt to create returns that track (and ideally outperform) the market
     There are four broad groups of hedge fund strategies: arbitrage, event-driven,
        equity-related and macro
          The first two groups in many cases attempt to achieve returns that are
           uncorrelated with general market movements, where managers try to find
           price discrepancies between related securities, using derivatives and active
           trading based on computer driven models and extensive research
          The second two groups are impacted by movements in the market, and they
           require intelligent anticipation of price changes in stocks, bonds, foreign
2   L3: Hedge Fund Strategies physical commodities
           exchange and
    Four Categories
     Hedge Fund Strategies Can be Grouped into Four Major Categories

                      Subcategory         Description
                      Fixed-income        Exploits pricing inefficiencies in fixed-income markets, combining long/short
                      based arbitrage     positions of various fixed income securities

                      Convertible         Purchases convertible bonds and hedges equity risk by selling short the
                      arbitrage           underlying common stock
                      Relative value      Exploits pricing inefficiencies across asset classes-e.g., pairs trading, dividend
                      arbitrage           arbitrage, yield curve trades
                      Distressed          Invests in companies in a distressed situation (e.g. bankruptcies, restructuring),
                      securities          and/or shorts companies expected to experience distress

                      Merger arbitrage    Generates returns by going long on the target and shorting the stock of the
                                          acquiring company
                      Activism            Seeks to obtain representation in companies' board of directors in order to
                                          shape company policy and strategic direction
                      Equity long/short   Consists of a core holding of particular equity securities, hedged with short

                                          sales of stocks to minimize overall market exposure
                      Equity non-hedge Commonly known as "stock picking"; invests long in particular equity securities
                      Global Macro        Leveraged bets on anticipated price movements of stock markets, interest

                                          rates, foreign exchange, and physical commodities
                      Emerging markets Invests a major share of portfolio in securities of companies or the sovereign
                                       debt of developing or "emerging" countries; investments are primarily long

     Source: McKinsey Global Institute; Hedge Fund Research, Inc.; David Stowell

3   L3: Hedge Fund Strategies
        Strategies are Diversified
    Hedge Fund Strategies Have Become More Diversified


                                                            32%                          Macro

                       37%                                                               Event-driven
                                                                                         Relative Value 1

                      1990                                 2008

    Note 1: Hedge Fund Research’s “Relative Value” classification is comparable to the “Arbitrage” classification used in the book.
    Source: Hedge Fund Research, Inc.
4       L3: Hedge Fund Strategies
    Equity-Based Strategies
     Equity Long/Short
         Also known as equity hedge strategy
         It is different from equity market-neutral strategy, where
            managers utually hold a number of long equity position and an
            equal, or close to equal, dollar amount of offsetting short equity
            position, so that the net exposure is close to zero (dollar

     Non-Hedged Equity
         No hedge involved, and investment is only long (not short)

5   L3: Hedge Fund Strategies
    Equity Long/Short
     A hedge fund manager that focuses on equity long/short investing starts with a
      fundamental analysis of individual companies, combined with research on risks
      and opportunities particular to a company’s industry, country of incorporation,
      competitors and the overall macroeconomic environment in which the
      company operates
     This strategy attempts to shift the principal risk from market risk to manager
      risk, which requires skilled stock selection to generate alpha through a
      concurrent purchase and sale of similar securities in an attempt to exploit
      relative mispricings, while decreasing market risk
     Managers consider ways to reduce volatility by either diversifying or hedging
      positions across industries and regions and hedging undiversifiable market risk
     However, the overall risk in this strategy is determined by whether a manager is
      attempting to prioritize returns (by having more concentration and
      leverage) or low risk (by creating lower volatility through
      diversification, lower leverage and hedging)
6   L3: Hedge Fund Strategies
    Buy on margin (page 133-138, Jaeger)
       Broker typically lend 50% of the value of stock to be
           Vary across securities
             Brokers will not lend funds against risky stocks
             Margin requirement (margin=equity/assets) could be 5% or less for
              government securities. In the security business, the down payment is
              called the haircut.
       Suppose you have $100,000 in a brokerage account, and you
          want to buy $200,000 worth of IBM stock. So you borrow
          $100,000 from the broker, pledging the 2000 shares of stock
          as collateral. The broker charges an interest of 5% annually.
           What if IBM price goes up by 5% or down by 20% in a year?
7     L3: Hedge Fund Strategies
    Short sell
     Page 139-146, Jaeger’s book
     You open an account with $100,000 and you sell short 1000
        shares of at $100 each.
       What if the price goes down to $50/share or goes up to
       Borrowing a stock is costly
       Also note that short selling creates a new interest-bearing
       Under what condition, short selling is most profitable?
       Boxing a short position (page 145-146)

8   L3: Hedge Fund Strategies
    Diversification and hedging
     Both are ways to reduce risk
         Diversification, see chapter 7, Jaeger
         Hedging, see chapter 9, from page 146
           Shorting against the box
           Basis risk

9   L3: Hedge Fund Strategies
     Equity Long/Short
      Long/Short Strategy Overview

       Strategy Overview:
         • Definition: Strategy by which manager concurrently buys and sells similar securities or indexes in an
           attempt to exploit relative mispricings, while neutralizing a risk common in those securities
         • Examples: Equities (Long JP Morgan, Short Citigroup); Yield curve (Short 2 Yr Treasuries, Long 10 Yr
           Treasuries); CDOs (Long equity Tranche, Short mezzanine Tranche)…
         • Direction: Can be neutral, net long, or net short
         • Rationale: Shifts principal risk from market risk to manager risk based on premise that skilled stock
           selection generates alpha

       Mechanics of a Long / Short Strategy (Equity):

                                                                              Weight                  Portfolio                Manage
             S              Screening
                                                                             positions               long/short                portfolio
             T                                      selection
                                                                              & trade                   ratio                    risk
                         • Fundamental          • Forecasting          • Devise strategy       • Gross mkt.               •   Focus on short
                           research             • Valuation            • Determine               exposure                 •   Volatility
             E           • Quant screening      • Mgmt.                  weights               • Net mkt. exposure        •   Review limits
             G           • Networking             interviews           • Consider              • Beta adj. market         •   Review losses
             Y                                                           execution ability       exposure                 •   Review gains
                                                                       • Risk manage           • Leverage

                          Step 1:            $10M Initial                           Step 4:            $9M in Stock B
                              HF             Investment           Prime                    Sec.          borrowed                Prime
                            Manager                               Broker                 Lender(s)                               Broker
                          Step 2:                                                   Step 5:              $9M Stock B
             E                                                                                           for short sale
             C               Prime           Establishes $1M                           Prime                                   Investor:
                             Broker           liquidity buffer                         Broker          $9M in proceeds        Short position
             T                                                                                          from short sale
                                        $9M to purchase
                          Step 3:                                                   Step 6:
             I                            Stock A long
                             Prime                               Investor:             Prime                                      Sec.
             O                                                                                          $9M collateral          Lender(s)
             N               Broker      $9M in Stock A
                                                             Long position             Broker           for borrowing
                                         to prime broker                                                    Stock B
10   L3: Hedge Fund Strategies
      Continued onto next page…
     Equity Long/Short
            Long/Short Strategy Return Sources and Costs:
              Return Sources:
              • Performance
                  • Alpha on long position plus alpha on short position
              • Interest rebate
                  • Short sale proceeds invested by prime broker in short term securities
                  • Rebate = Interest on short sale proceeds – prime broker lender fee and expenses
                  • Rebate is usually = 75-90% of interest on short sale proceeds
              • Liquidity buffer interest
                  • Liquidity buffer posted to pay for daily mark to market adjustments and to pay dividends to stock
                    lenders (arranged by prime brokers)
                  • Liquidity buffer earns short term interest
              • Share borrow costs
              • Margin costs on short position
              • Transaction costs

            Return Attribution:
            16.00%                                                            +0.2%
                                                                 +1.0%                                               14.0%
            14.00%                                +1.0%                                    -0.2%
                                     +3.5%                                                             -0.5%
            10.00%      9.0%
                     Long Position    Short       Dividend      Rebate on    Interest     Cost of    Margin Costs   Net Return
                                     Position    Income on        Short     Earned on    Borrowing    on Short
                                                Long Position    Position    Liquidity    Shares      Position

11   L3: Hedge Fund Strategies                                                Buffer
     More on Long-short
      Benefits: (1) performance, (2) Interest rebate, (3) liquidity
       buffer interest
      Costs: (1) share borrowing costs, (2) margin costs on short
       position, (3) transaction costs
      Thoughts from Jacobs & Levy (97, The Long and Short on
          Market-neutral long-short + long index future
          Market-neutral long-short HF is not an asset class

12   L3: Hedge Fund Strategies
     Macro Strategies
      Global macro
          Make leverage bets on anticipated price movements in stock
           and bond markets, interest rates, foreign exchange, and physical
          Also known as global asset allocators

      Emerging market
          Securities of companies and sovereign bonds

13   L3: Hedge Fund Strategies
      Global Macro
      A macro focused hedge fund makes leveraged bets on anticipated price
       movements in stock and bond markets, interest rates, foreign exchange and
       physical commodities
      This strategy also takes positions in financial derivatives such as forwards,
       options and swaps on assets such as stocks, bonds, commodities, loans, and real
       estate and on indexes that are focused on interest rates, stock and bond
       markets, exchange rates, and instruments that relate to inflation
      A macro-focused fund considers economic forecasts, analysis about global flow
       of funds, interest rate trends, political changes, relations between governments,
       individual country political and economic policies and other broad systemic
      A well-known practitioner of a global macro investment is George Soros, who
       sold short more than $10 billion of pound sterling in 1992, successfully
       profiting from the Bank of England’s reluctance to either raise its interest rates
       to levels comparable to rates in other European countries or to float its
      L3: Hedge Fund Strategies
     Two types of global Asset allocators
      Discretionary managers
          Rely on some blend of fundamental analysis and technical
             analysis to form a reasonable investment judgment
              Growth variables
              Information variables
              Interest rates
              Trade flow and capital flows
              Equity valuation variables: P/E, price to cash flow, business value, etc

      Systemic managers
          Follow definite rules for putting on and taking off positions
            Page 237 (JAEGER)

15   L3: Hedge Fund Strategies
     Emerging Markets
      An emerging market focused hedge fund invests most of its
       funds in either the securities of companies in developing
       (emerging) countries or the sovereign debt of these countries
      Emerging markets is a term used to describe a country’s
       social or business activity that is characterized by rapid
       growth and industrialization
      Typically investors demand greater returns because of
       incremental risks

16   L3: Hedge Fund Strategies
     Arbitrage Strategies
      Fixed income-based arbitrage
      Convertible arbitrage
      Relative value arbitrage

17   L3: Hedge Fund Strategies
     Fixed Income Arbitrage
      Fixed income arbitrage funds attempt to exploit pricing inefficiencies in fixed
       income markets by combining long/short positions of various fixed income
      For example, historically, because of the limited liquidity of the Italian bond
       futures market, the currency-hedged returns from this market in the short term
       were lower than the short-term returns in the very liquid U.S. Treasury bond
      However, over a longer period of time, the hedged returns became nearly
      Fixed income arbitrageurs benefitted from the eventual convergence of hedged
       yields between currency-hedged Italian bond futures and U.S. Treasury bonds
       by shorting relatively expensive U.S. Treasury bonds and purchasing relatively
       cheap Italian bond futures

18   L3: Hedge Fund Strategies
     Fixed Income Arbitrage
      Another example involves 30-year on-the-run and off-the-run U.S. Treasury
      Liquidity discrepancies between the most recently issued 30-year Treasury
       bonds (called on-the-run bonds) and 29.75 year Treasury bonds that were
       originally issued one quarter earlier (called off-the-run bonds) sometimes
       causes a slight difference in pricing between the two bonds
      This can be exploited by buying cheaper off-the-run bonds and shorting the
       more expensive on-the-run bonds
      Since the price of the two bonds should converge within three months (both
       bonds becoming off-the-run bonds), this trading position should create a profit
       for the arbitrageur

19   L3: Hedge Fund Strategies
     Convertible Arbitrage
      A convertible bond can be thought of as a fixed-income security that has an
         embedded equity call option
        The convertible investor has the right, but not the obligation to convert
         (exchange) the bond into a predetermined number of common shares
        The investor will presumably convert sometime at or before the maturity of the
         bond if the value of the common shares exceeds the cash redemption value of
         the bond
        The convertible therefore has both debt and equity characteristics and, as a
         result, provides an asymmetrical risk and return profile
        Until the investor converts the bond into common shares of the issuer, the
         issuer is obligated to pay a fixed coupon to the investor and repay the bond at
         maturity if conversion never occurs
         A convertible’s price is sensitive to, among other things, changes in market
         interest rates, credit risk of the issuer, and the issuer’s common share price and
         share price volatility
20   L3: Hedge Fund Strategies
     Convertible Arbitrage
      Convertible Arbitrage is a market neutral investment strategy that involves the
       simultaneous purchase of convertible securities and the short sale of common
       shares (selling borrowed stock) that underlie the convertible
      An investor attempts to exploit inefficiencies in the pricing of the convertible in
       relation to the security’s embedded call option on the convertible issuer’s
       common stock
      In addition, there are cash flows associated with the arbitrage position that
       combine with the security’s inefficient pricing to create favorable returns to an
       investor who is able to properly manage a hedge position through a dynamic
       hedging process
      The hedge involves selling short a percentage of the shares that the convertible
       can convert into based on the change in the convertible’s price with respect to
       the change in the underlying common stock price (delta) and the change in
       delta with respect to the change in the underlying common stock (gamma)

21   L3: Hedge Fund Strategies
     Convertible Arbitrage
      The short position must be adjusted frequently in an attempt to neutralize the
       impact of changing common share prices during the life of the convertible
       security (this process of managing the short position in the issuer’s stock is
       called “delta hedging”)
      If hedging is done properly, whenever the convertible issuer’s common share
       price decreases, the gain from the short stock position should exceed the loss
       from the convertible holding, and whenever the issuer’s common share price
       increases, the gain from the convertible holding should exceed the loss from the
       short stock position
      The investor will also receive the convertible’s coupon payment and interest
       income associated with the short stock sale
      However, this cash flow is reduced by paying a cash amount to stock lenders
       equal to the dividend the lenders would have received if the stock were not
       loaned to the convertible investor, and further reduced by stock borrow costs
       and interest expense on any borrowings to finance the investment
22   L3: Hedge Fund Strategies
Exhibit 12.4 (1 of 7)
                          Mechanics of Convertible Arbitrage
A convertible arbitrageur attempts to purchase undervalued convertibles and simultaneously short a number of
common shares that the convertible can convert into (the "conversion ratio"). The number of shares sold short
depends on the conversion ratio and the delta. The delta measures the change in the convertible's price with respect
to the change in the underlying common stock price, which represents the convertible's equity sensitivity for very
small stock price changes. The arbitrageur's objective is to create an attractive rate of return regardless of the
changing price of the underlying shares. This is achieved by capturing the cash flows available on different
transactions that relate to the convertible as well as directly from the convertible and by profiting from buying a
theoretically cheap convertible. Many convertibles are originally issued at a price below their theoretical value
because the stock price volatility assumed in the convertible pricing is below the actual volatility that is expected
during the life of the convertible. A summary of potential convertible returns is as follows:

1.          Income Generation
The arbitrageur tries to generate income while hedging the risks of various components of a convertible bond.
Income from a convertible hedge comes from the following: Coupon + interest on Short Proceeds – Stock
Dividend – Stock Borrow Cost. This income is increased if the arbitrageur leverages the investment (two or three
times leverage is common). However, costs associated with hedging interest rate and credit risks reduce the income.
An example of income generation, which is linked to Figure 2, follows:

                                        L3: Hedge Fund Strategies                                              23
Mechanics of Convertible Arbitrage
Assuming that an issuer’s common stock price is $41.54 and dividend yield is 1% when a $1,000
convertible is issued and the convertible has a 2.5% coupon, a conversion ratio of 21.2037, 53%
average short stock position (with 2% interest income available from this position) and a stock borrow
cost of 0.25% on the short proceeds, over a one year horizon, the total income from a delta hedged
convertible would be $28.50, which is equal to 2.9% of the $1,000 convertible:

   Coupon                            2.5% on $1,000 convertible                           = $25.00
 + Short Interest                    2% on $466.83* short proceeds                        = $9.34
 - Stock Dividend                    1% on $466.83* short proceeds                        = ($4.67)
 - Stock Borrow Cost                 0.25% on $466.83* short proceeds                     = ($1.17)
   Total                                                                                  = $28.50
  * The $1,000 convertible can convert into 21.2037 shares (the conversion ratio). $41.54 (current share price) x
   21.2037 = $880.80. Since there is a 53% short position, the value of the shares sold short is $880.80 x 0.53
   = $466.83

                             L3: Hedge Fund Strategies                                                       24
              Mechanics of Convertible Arbitrage
2.          Monetizing Volatility
Because of the nonlinear relationship between prices for the convertible and for the underlying stock,
there is an additional gain potential in creating a delta neutral position between the convertible and the
stock. This is explained in Figure 1. At point 1, the green line represents the long convertible position,
whereas the dotted line represents the delta neutral exposure. Therefore, if the stock price were to fall
from position 1, the gain on the short stock position is greater than the loss from the long convertible
position (position A). However, if the stock were to gain, the loss on the short would be less than the
gain on the convertible (position B).

                            L3: Hedge Fund Strategies                                                25
                                                Mechanics of Convertible Arbitrage

                            140                               ∆1 Long convert and short
                            0                                 stock at initial delta hedge ratio       ∆2 Rehedge stock at new delta hedge
                                                                                                       ratio (short more stock as delta higher)
Convertible price, parity



                                                                                          "Ratcheting" profits
                                  A Stock falls
                                  Profit = (short stock gain) – (CB loss)


                                                                                                             B Stock rises
                            20                                                                               Profit= (CB gain) – (short stock loss)

                                            0                     50                         100                   150                  200
                                                                                   Stock price

                                                              L3: Hedge Fund Strategies                                                        26
                       Mechanics of Convertible Arbitrage

                                                      Convertible arbitrage fund
Stock Px = $41.54
                            initial case              Long convertible 101.375 par = $1,013.75
Convertible delta = 53%
                                                      Amount of short shares 21.2037*53% = 11.24
Conv. Ratio = 21.2037 shares                          Short value = 11.24 (shares)*41.54 (price) = $466.82
Convertible Px = 101.375% par                         Net cash outlay = $546.93
                              +5% scenario            Current share price = $43.617
                                                      Loss from short = $466.82 – (11.24*43.617) = $23.34
                                                      Gain from convertible = (1,038.071 – 1,013.75) = $24.32
                                                      Net gain = 24.32-23.34 = $.98
                                                      New hedge delta = 58.11%
                              -5% scenario            Current share price = $39.463
                                                      Gain from short = $466.82 – (11.24*39.463) = $23.34
                                                      Loss from convertible = (1,013.75 – 991.782) = $21.97
                                                      Net gain = 23.34-21.97 = $1.37
                                                      New hedge delta = 46.75%
Note: calculations are not rounded.

                                      L3: Hedge Fund Strategies                                           27
                       Mechanics of Convertible Arbitrage

                                                      Long-only fund
                              initial case            Long convertible 101.3755 par = $1,013.75
Stock Px = $41.54                                     Net cash outlay = $1,013.75
Convertible delta = 53% +5% scenario                  Current share price = $43.617
Conv. Ratio = 21.2037 shares                          Gain from convertible = (1,038.071 – 1,013.75) = $24.32
Convertible Px = 101.375% par                         Coupon for 1 year = 2.5
                                                      Net gain = $26.82
                              -5% scenario            Current share price = $39.463
                                                      Loss from convertible = (1,013.75 – 991.782) = $21.97
                                                      Coupon for 1 year = 2.5
                                                      Net loss = $19.47
Note: calculations are not rounded.

                                      L3: Hedge Fund Strategies                                           28
                       Mechanics of Convertible Arbitrage
3.       Purchasing Undervalued Convertible
An important source of additional potential profit comes from purchasing a convertible at a price that is below its
theoretical value, from an implied volatility perspective. When this happens and the convertible exposures are properly
neutralized through delta hedging, incremental profits will be created over time based on the below-market purchase.
These profits will be even higher if there is an increase in volatility during the holding period. However, if volatility
decreases, this potential profit opportunity can turn into a potential loss. If a convertible is purchased at a 2% discount
to theoretical value, this could result in a profit of $20 (2% of the $1,000 convertible).

        4.           Summary of Returns
        The total one-year convertible return in this hypothetical, hedged convertible is comprised of

o   Income Generation (2.9%),

o   Monetizing Volatility (1.4%),

o   Purchasing an Undervalued Convertible (2%, calculated for a one-year holding period). This results in a
    hypothetical return of 6.3%.

         If one-half of this convertible is purchased with $500 borrowed from a Prime Broker at 2%, the total one-year
return from this investment would be approximately 10.6% ($1,000 x 6.3% = $63. $63 - $10 interest cost = $53.
$53/$500 = 10.6%)

                                      L3: Hedge Fund Strategies                                                     29
     Relative Value Arbitrage
      Relative value arbitrage exploits pricing inefficiencies across asset classes
      An example of this is “pairs trading”, which involves two companies that are
       competitors or peers in the same industry that have stocks with a strong
       historical correlation in daily stock price movements
      When this correlation breaks down (one stock increases in price while the
       other stock decreases in price) a pairs trader will sell short the outperforming
       stock and buy the underperforming stock, betting that the “spread” between the
       two stocks will eventually converge
      When, and if, convergence occurs, there can be significant trading profits
      Of course, if divergence occurs, notwithstanding the strong historical
       correlations, this trade can lose money

30   L3: Hedge Fund Strategies
     Equity Market Neutral Strategies
      Page 242, Jaeger book
      Market neutral long-short equity
          Pair trading: e.g., taking a long position in Cisco, paired with a
           short position in Microsoft
          Single-sector fundamental investors: long-short stocks in the
           single sector – develop a detailed knowledge of the companies
           in which he is investing, from both the long and short sides
          Multi-sector fundamental investors: scoring stocks based on a
           wide variety of factors; then buying the stocks that score high
           and selling short the stocks that score low.
          Multi-sector technical traders: care about price movement and
           relative pricing. Look for situations in which prices have gotten
           out of line but are expected to go back in line within days.
31   L3: Hedge Fund Strategies
     Event Driven Strategies
      Event driven strategies focus on significant transactional events such as M&A
          transactions, bankruptcy reorganizations, recapitalizations and other specific
          corporate events that create pricing inefficiencies
     Event-Driven Investment Opportunities: Catalysts and Events

      Strategic (Hard Catalysts)                      Operational
      Risk Arbitrage                                  Merger / Synergy Benefits
      Strategic Alternative Reviews                   Restructuring Programs / Turnaround Stories
      Spin-Offs / Breakup Candidates                  Senior Management Turnover
      Activist Shareholders / Proxy Contests
      Holding Company Discounts / Stub Trades         Legal / Regulatory
      Takeover Candidates
      Financial                                       Regulations
      Liquidity Events / Credit Re-Ratings
      Primary Equity and Debt Offerings               Technical
      Bankruptcy Reorganizations                      Broken Risk Arbitrage Situations
      Accounting Changes / Issues                     Secondary Equity and Equity-Linked Offerings

     Source: Highbridge Capital Management, LLC
32   L3: Hedge Fund Strategies
     Activist Investors
      Activist investors take minority equity or equity derivative
       positions in a company and then try to influence the company’s
       senior management and board to consider initiatives that the
       activist considers important in order to enhance shareholder
      This strategy is sometimes called Shareholder Activism
      Activist investors often attempt to influence other major
       investors to support their recommendation to the company,
       which sometimes leads to proxy solicitations designed to
       change the management composition of the company
      Activist investors commonly push for lower costs, lower cash
       balances, greater share repurchases, higher dividends and
       increased debt, among other things
33   L3: Hedge Fund Strategies
         Merger Arbitrage
     • In a stock-for-stock acquisition, some traders will buy the target company’s
           stock and simultaneously short the acquiring company’s stock, creating a “risk
           arb” position that is called Merger Arbitrage or Risk Arbitrage
     •     The purchase is motivated by the fact that after announcement of a pending
           acquisition, the target company’s share price typically trades at a lower price in
           the market compared to the price reflected by the Exchange Ratio that will
           apply at the time of closing
     •     Traders who expect that the closing will eventually occur can make trading
           profits by buying the target company’s stock and then receiving the acquiring
           company’s stock at closing, creating value in excess of their purchase cost
     •     To hedge against a potential drop in value of the acquiring company’s stock, the
           trader sells short the same number of shares to be received at closing in the
           acquiring company’s stock based on the Exchange Ratio
     •     Risk arb trading puts downward pressure on the acquiring company’s stock and
           upward pressure on the selling company’s stock
34       L3: Hedge Fund Strategies
     Merger Arbitrage
     • As an example, if an acquiring company agrees to purchase a
       target company’s stock at an Exchange Ratio of 1.5x, then at
       closing, the acquirer will deliver 1.5 shares for every share of the
       target’s stock
     • Assume that just prior to when the transaction is announced, the
       target’s stock price is $25, the acquirer’s stock is $20, and it will
       be six months until the transaction closes
     • Since 1.5 acquirer shares will be delivered, the value to be
       received by target company shareholders is $30 per share
     • However, because there is some probability the acquisition doesn’t
       close in 6 months, the target company stock will likely trade
       below $30 until the date of closing
35   L3: Hedge Fund Strategies
     Merger Arbitrage
     • If the target stock trades at, for example, $28 after announcement, for every
       share of target stock that risk arbs purchase at $28, they will simultaneously
       short 1.5 shares of the acquirer’s stock
     • This trade enables risk arbs to profit from the probable increase in the target’s
       share price up to $30, assuming the closing takes place, while hedging its
       position (the shares received by risk arbs at closing will be delivered to the
       parties that originally lent shares to them)
     • The objective for risk arbs is to capture the spread between the target
       company’s share price after announcement of the deal and the offer price for
       the target company, as established by the Exchange Ratio, without exposure to a
       potential drop in the acquirer’s share price
     • However, if the transaction doesn’t close or the terms change, the risk arbs’
       position becomes problematic and presents either a diminution in profit or a
       potential loss

36   L3: Hedge Fund Strategies
           Merger Arbitrage
     Share for Share Merger Arbitrage

                              UPSIDE:                                             DOWNSIDE:
                          The Deal Closes                                   The Deal Does NOT Close

         • The Arbitrageur gains                                • The Target stock will drop to the
               o   The Arbitrage spread (difference               pre-announcement price (or below), causing
                   between Target stock when acquisition          losses
                   announced and bid price when closes)         • The Acquirer stock price might increase,
               o   Dividends paid on Target stock                 causing a loss on the short position
               o   Interest on proceeds of short selling
                   (less borrow costs and dividends paid on
                   shorted Acquirer stock)
         • The arbitrage spread can be accentuated if the
           bid is repriced higher, possibly through the
           presence of another bidder

                       In most cases, the amount an arbitrageur will lose if the deal does not close
                                         far outweighs the gain if the deal closes
37         L3: Hedge Fund Strategies
     Distressed Securities
      Distressed securities investment strategies are directed at companies in
         distressed situations such as bankruptcies and restructurings or companies that
         are expected to experience distress in the future
        Distressed securities are stocks, bonds and trade or financial claims of
         companies in, or about to enter or exit, bankruptcy or financial distress
        The prices of these securities fall in anticipation of financial distress when their
         holders choose to sell rather than remain invested in a financially troubled
         company (and there is a lack of buyers)
        If a company that is already distressed appears ready to emerge from this
         condition, the prices of the company’s securities may increase
        Due to the market’s inability to always properly value these securities, and the
         inability of many institutional investors to own distressed securities, these
         securities can sometimes be purchased at significant discounts to their risk
         adjusted value

38   L3: Hedge Fund Strategies
          Distressed Securities
     Distressed Securities Return

     Capitalize on the knowledge, flexibility, and patience that creditors of a company do not have

       Bonds              Many institutional investors, like pension funds, are barred by their charters or
                          regulators from directly buying or holding below investment-grade bonds (Ba1 / BB+
                          or lower)
       Bank Debt          Banks often prefer to sell their bad loans to remove them from their books and use
                          the freed-up cash to make other investments
       Trade Claims       Holders of trade claims are in the business of producing goods or providing services
                          and have limited expertise in assessing the likelihood of being paid once a distressed
                          company files for bankruptcy

39        L3: Hedge Fund Strategies
       More on distressed securities
      Page 277- 281, Jaeger book
      Professional investors in distressed companies assume that
       the equity is worthless, so their task is to decide which class
       of debt offers the most attractive risk-reward tradeoff.
      Value of the strategy
        Investment skill (to tell which security has value)
        Offer liquidity to traditional investors who prefer investment
      Distressed debt investors try to invest in good companies that
       have a bad capital structure
      Distressed debt market is relatively small and it is linked to
       the broader economy.
40     L3: Hedge Fund Strategies

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