G R C E CHACKO

Pine Street Capital

Harokd Yoon looked up from his sworkstatiom at the analysis that he had just printed out. Yo
had cometheinmanaging
time.Au
to work atpartner
dam infor
theamomingtoday,
5132 million
Julyhedge
equity
27, 2000.
fund,
soYoon
look was
overuned
ithi analysis
to coming
onein early
more
to the partnership's downtown San Francisco office but this time he had more than the usual
monitoring of pre-market news to take care of
Immediately after the markets closed today, Ipm in San Francisco, he and the other partners of the
hedgrfhand would meet to discuss a potential change of hedging straegy The fund they managed
ternded to be a market-veutral fund, meaning that the fund hedgnd out all market risk. in the past
they had hedged this market risk by short-selling, or shorting" shares of a market index. Howeve
due to the unprecedented volatility (and valuation levels) see in the markets over the past several
months the purtners wene now considering hedging this risk by purchasing put options on this
market index rather than simply shorting

Yoon picked up the analyss that an analyst employed by the fund had carried out. Prior to the
partrers meeting this aftermoom, he nieded to have a recommendation ready as to which hedging
strategy to pursue

Hedge Funds
From 1988 to 1996, the number of hedge funds around the globe increased by almost 425%
reaching an estimated 5530 funds with assets under management. Asets under management during
this time period grew from S42 bilion to $311 billion, Hedge funds are private group imvestments
that offer equity pooling advantagrs milar to mutaal furnds However, because hedge funds are nt
publicly owned, they are les negulated than mutual funds and enjoy additional privileges The lack
of egulation gives hedg funds flexibhility in ivestment strategies and risk management that mutaal
funds do not have. As Exhibit la shows this flexiblity seems to translate into higher expected
muruar runas are mer anuuty to use weverage ana tneir anuury to neageoy snornng or using optons

Leoerage
While hedge funds can use leverage. mutual funds, for the most part, cannot. By using debt to
finance a portion of the assets in a portfolio, a higher returm on the portfolio's equity is possible
compared with an all-equity financed portfolio See Figure 1 for an example of the effect of leverage
on a portfolio. The balance sheets of two portfolios, a portfolio that is leveraged and an all-equity
portfolio, are shown when asets appreciate 100 (100%ROA). By keeping the initial equity amount
($50)the same in the two portfolios,the impactof leveragecan be observedon the portfolio's Return
on Equity (ROE).

Figure 1:BalanceSheet Effects of Leverage(ROA =100)

Leveraged Portolio (initial Debe Equitye) Un-levereged Porntolo
Today Tomorrow ocday Tomorrow
AssetsDebt Dete Assets
100 50 200 50 100
Equty Equty Equity
150

ROE-20% ROE-100

Of course, if leverage is employed and the asets lose value, then leverage works against the
investor, amplifying the loss on equity relative to an all-equity portfolio. Therefore, using leverage
increases the risk of an investment In response, many hedge funds seek arbitrage opportunities in
different markets, searching for payoffs with little to no risk While these opportunities may be
for investoes, hedge funds are able
overlooked their marginal
create higher returms
size by
most to lever these payofs to

Leverage doesn't come without a price. Prime brokens, who help finance and execute trades for
hedge funds, offer loans to hedge funds and charge the interest. These loans are typically known as
margin loans Prime brokers minimize the credit risk associated with their loans to hedge funds
They do so by diligently monitoring their hedge funds' investments and risks If the value of a fund's
investments, or asets, drops to a level such that little equity remains, the broker can force the fund to
put in more equity or the broker can liquidate part or all of the fund's portfolio, quite possibly
putting the fund out of business

Options&Derizatives
A hedge fund's ability to use options give it anotheradvantage over traditional mutual funds.
 Figure 2 gives an exampleof using put options to protect a portfolio's value. (lnformation given:
SaP500 is at 100,SaP volatility-25, the portfolio's beta 15, Risk Free Rate-5%, and the SaP
options are two month, at the money puts) This example shows the balance sheets of two portfolion
an "un-hedged portfolio, enly invested in stock, and a "hedged portfolio" that unes put options to
minimine changes in the value of the portfolio At the beginning (Choday") both portfolios have equal
amosunts of equity and assets In either market outcome, up 5% or down 5 the Retum on Equity
ROE) for the hedged portfolio is more stable than the un-hedged portfolio

igure2Balance Sheet Lfects of iedging with Fut Optiom

Un-Hedgnd Purtfolin
Today Tomorew (54P 500 +5 Tomomow (S4P 500 5
ASSETS ASSETS ASSETS
S100.00 stock SI0750sto s92 50 stoc
EQUITY EQUITY EQUITY
S100.00 $107 50 102.50

HOE 750% ROE 7s0

Hedged Portfolio
Todey Tomoirow (SaP s00-% Tomorrow (AP S00-5
ASSETS ASSETS ASSETS
Se0 09 sock s95.77 stoc s82 41stock
$10.91 54P puts 5 60 S4P pus s19.07 S4Pps
EQUITY EQUITY EOUITY
s100.00 5101.37 S10148

The value of the put options is negatively correlated with the value of the stock in the portfollo In
the euample above. put options are held to insure the portiolio against market fuctuations The ratio
of put opticns to stock needed to perfectly hedge a portiolio is a function of the option and portfolio
deltasWhile the hedge ponition protectsthe portiolio from the downuikde of risk, it abo limits the
potential gains

Hodge Fund Strategies

One way of categorizingg a hedge fund is by its investment strategy. Each fund's paticular
ventss salgy is lanenl un it funal marage killh and wluw the funl masager fewds lw/sl
has a competitive advantage over other investors in assessing risks Skilled managers will usually
take and, in fact, leverage up thoe risks that they understand well, while they will hedge away risks
whene they feel they have no particular comparative advantage. For instance, a manager might feel
confident abouthis ability to value individualcompaniesbut have no view on the performance of the
entire market This manager might then adopt what is called a "market-neutral" strategy, where
markot rik is hodgnd away while fim-epecific riak in kpt in the portiolio.
 Pine Street Capital

Pine Stret Capital (PSC)was a hedge fund that specialized in the technology sector. Holding
undergraduate degrees in engineering/sclences as well as MBAs and/or PhDs specializing in
finance and having worknd at an aotmentof technokogy and financial servics firme prior to
forming PSC in January 1999, the parters of P'SC fedt their strength to be their ability to evaluate the
technology sector and, specifically, to pick out performing stocks in this sector They felt le
comfortable making bets on the direction of the entire market. PCs portfolio reflected the partners
strengths, particlarly Yoon'
Up
to now. PSC had beem unsing a short-salke strategy to eliminate general market risk from the
fund The short-ale was acomplished in the following way. Using the modet:

ExpectedPSC Fortfolio Retun-a (Market Retum)

and data on PSC's portiolio holdings and market retums, PSC established a nelationship between the
performance of the market and PSC's portfolio. Beta (B) measured how PSC portfolio respondedto
changes in the market, while alpha () was the amount of neturn in encs of that due to market risk
Thus, beta was a measure of the market risk of ISC portfolio while alpha meanured SCs expected
ntum if market risk were eliminated from the portfolio. Exhibit 2 & 3 show PSC curent portfolio
allocation and historical risk-retum characteristics

Since PSC gnal was to eliminate market risk, this risk was hedged from PSC portfolio by
shorting the market (PSC used the NASDAQ index as its proxy for the market) in proportion to the
beta of the amsets in the portfolio. Exhibit 4 gives historical price data for the Nasdaq 100 index
while Exhibit 5 shows how PSC's portiolio would have performed on a monthly basis compared to
the NASDAQif the portfolio were completely unhedged
An example of how short selling the market hedges market risk is given below in Figure 3
Eliminating market risk from the kong portfolio leaves the portfolio with a guaranteed 1 retun
which is precisely the alpha of the long positions in the portfolio. Thus, short-selling removes the
market return component, and murket risk corrnpondingly, leving only an alpha return in the
portfolio

Figune 3: Example of Hedging by Short-Selling'

Temorruw's Value
Today Initial Value NASDAQ+t0 NASDAO-1
Long Portolo S100.00 $116.00 s86 00
Short NASDAG S150.00 $135.00 S165.00
TOTAL s250.00 s251.00
Retum on Heaged Portolo: 1.0% 1.0%

defme/ommunicatio ima phamacnticalompay,acomhing fenm, and an imestment bunk

i n the market pore did nst rquine dht wlig ry sock m te NASDAQ t i wold be ntmly espmve
 Of course, the alpha return that PSC was left with in their pertfolio after hedging market risk
could have been negative if they picked the wrang investments, but finding positive alpha stocks in
the technology sector was exactly what PSC feit to be its comparative advantage. Exhibit 6 shows
historical performance of hedge funds in the technology sector, while comparing this performance
with funds focusing on other sectors

Immunizing the portfolio against market fluctuations left mach less risk in the portfolio This
allowed PSC to increase the expected eturn,and corresponding risk, of the portfolio by levering As
a long-run goal, ISC generally maintained a debt ratio of S0 in the fund's capital structure.

Options-Based Hedging
Over the past year, and particularly ovwer the past four months, the technology sector, as measured
by the Nasdaq index, had bem extremely volatile. The technology sector, specially any fims
connected in any way to the Internet, delivered huge returns during 1999 and ihe first quarter of
2000 Fr January uf 1999 Marh 2000, te Naselay epprecitesl nure tan 115% However, fr
early March 2000 to the end of June 2000, the Nasdag declned nearly 40% This enormous volatility
exhibited by a fairly broad stockindex was unprecedented in the recent histoery of the US equity
markets (Exhibit 7 shows the implied volatility of Nasdaq puts options over the prior 1 6
years)
While the fund was protected from market movements due to the shortsale hedging strategy it
employed, this proved to be only partially effective during the previous few months Consecutive
largodips in the Nasdaq had nsulhnd in enormos low for the fund en several days particularly in
March and April of the current year, PSC had been very careful to develop models that would allow
it to accurately measure the beta of their portiolio in order to immunize the fund against market
fuctaations However, the volatility of the past few months had not been foreseen and the firm's
models appeared to break down somehow, leavingthe portfolio underhedged
To protect the fund from future periods of high volatility in the market, one of the partners
pested altering PSC hedging program to ue put options on the Nasdaq instead of shorting the
Nasdaq. Because put options appesared to be more sensitive to market movements this partner felt
that uning put options could better immunize PSCs portfolio to market movements
To this end, Yoon had one of the analysts in the fim put together seme analyses as to how ISCc
wwuld have done over the previous 1 years if the fund had used put options instead of short sales
Exhibits 8 provides a graph comparing how the fund would have performed with an option-based
hedging program vs a short sale-based program vs. no hedging program at alL Additionally, Exhibit
shows this comparative performance en the 20 worst-performing days of the Nandaq over the
previous 1 h years

Conclusion
Yoon looked out the window of his office. The Internet was espanding at a breakneck pace, and
he felt this was just the tip of a technokogical revolution. He could swe it occurring all around him,
and he wante C to paticipate in t fully. One way to enaure this would be to ue a mone
omservative imvestmont iyle by ntilizring lese leverage. hut he fele that this wownld not he in the hes
 ine Stet Capital

interest of the investors in the fund as it would not be maximizing their equity value However
given the nature of the technology sector he knew the market could see more volatile times ahead like
the past few months, and he didn't want to see the fund liquidated, as it almost was back in April
Could an option-based hedging strategy allow the fund to keep utilizing the leverage it had in the
past while also protecting against large, negative fuctuations in the market? Yoon picked upa
printout of option prices from the previous day (see Exhibit 10) to recheck his calculations
Exhibit 2 Pine Street Capital's Portfolio Allocation on July 26, 20000

uha industries, In nooo w

at25 51876.85 236 94

Y Dypress Semiconde as

Ss61.250 162%
SL Corm
1.39 23 30
esan
187

TOund Semcoc 25000 48.625 $1.215.25 74

Emulex Corporation cono 5681 2 330022

A 28

Cempany Netam rad Alpha o + BetalMarket Ketum + E m

Apha in gem mam ane ed amb

d m h ot the undetyng data h plained by the negen mde

Exhibit3 Portfolio Statistics for Days of Ponitive and Negative Market Returms

Half Year 1N2)=lM0

Nandaq OP Nandla D S&P s00 Up
AMCC
ARAA 0.60 92 10 012
4

Y S0 0.90 V.03 16 08 013

S 88 87 87
16 O.02 A

FMO 78 a se
25

0.21

1.65 15
05
32 43 18466 43 ,27
,T6
oL 51
24
gany
31.15 066 07 29

a and a l l a n i wmig the wgrm madd and apprprute praxy lor ie maket

Company Return ()= Alpha ( BetalMarket Retum (eal Eor

he neyig data eplanelby the mg

he slandand
daly hw the
m
dhev ala wme Nhune f he Nanlaq Cip nd e sard
yp wew 3 an
y y

This doument s ahorod tr une ony in eperons&hre d e by Po Amt Pureh GLUM Bom ay 2013 to Jaruy 2014
Eshibits ne Stret Capital'h Portiolio
Returm Compared to the Market Keturn (Nasdaq Composite)
NASDAO *PEC Unhedged

o 00

T0.o0

o.
0.00

z0.00

0.00

0.00%

99 9 00 00
10.00%

30.00

w L M oaay 2013 to
January2014
Exhibit 7 mplied Volatility of Q0Q (Nasdaq) Two Month Put Optkons with Strike Prices 207% Out of the Money

TEHTETTT!!ITIAIIE!I!H
This dacumentis authorae br use ony i e derivatves by Pu Am Paeh GuM hom July 2013 1o Jaruay 2014
Exhibits Changes in Equity Using Dfferent Hedge Strategies (With No Tranaction Costs Purchasing and Selling Options)

Using Shont Sale Hedge *Uaing Pur Ogion Hedge CededPSC Porttolo

S60.000.000.00-

s50.000.000.00

40,000.000 00

30.000.000

S20,000.000 00

$10.000.000.00

Se C

ha aroumet atoraetbr une ony moperton tare d e r s by Put Ana Ponh t GLM tom ay 2013 to Jnany 2014
Ehibit9 Performance of Pine Street Capita>'s Hedge Strahegies During NASDAQ Wonst 20 Days (Over the Period 1/04/99 to 7/26/00)

Oplon Hedge-
Date rafivLes
67%

2-Apr-00 06%% 88 993 (437810.11) 251% 599,279 3.61%

to
0-May-00 59 27% 8.25% 51.321.711 3.89% O09.996.12
.57
6.7
9. Jd-00 544 FAR 503.42 54%%

May-00 .19% 444.170 8

29-Mar00 AAR73) 9.95%

2.382.220.64)
00Feb 0.s6

02% 1.061.2043)
08-Nay-00 (1214707
347 74329
.68

23-Sep-9 B8 63.842.98

u d by Nag iarng wiw

OE
Not inclalang tn
 Pne Stet Cpitl 201471

Exhibit 10 Q000ption Prices and Treanury Rates for July 26th, 200

aoa Share Price 596.83 T-e Rates 1Month: s.97s

2 Month: 613
3 Month: 6.14

Days to Days to
Calle Bid Maturity Puts Nid Ask Maturity
00 Aug 70 25 1/2
21 18
23
000 Aug 70 w16 /16
00 Aug 75 20 5/8 Aug 75 V16 5/16
00 Aug 80 16 38 0 Aug 80 1/2 11/16
00 Aug 85 11 3 2 O Aug 85 1 /16 1 14
00 Aug 90 7 7/8 4 O Aug 9t 2 1/8 2 3/8
00 Aug 9 434 O Aug 9 41/4
00 Aug 100 2 1/2 D Aug 100 634 7 1/8
00 Aug 105 1 1/16 00 Aug 105 10 1/4 10 5/8
00 Aug 110 00 Aug 110 14 1/2 14 7/8
00 Aug 115 4 00 Aug 115 19 38 19 34
00 Aug 120 T8 00 Aug 120 24 38 24 7/8
00 Sep 70 20 34 0 Sep 7 11/16
00 Sep 75 211 1/2 22 14 00 Sep 75
1/2
7/8 11/16
00 Sep 80 173 17 78 00 Sep B0 1 9/16 13/4
00 Sep 85 13 1/2 14 o Sep 85 2/16 2 13/16
00 Sep 90 1011/8 10 00 Sep 90 4 3B
00 5ep 6 71/4 00 Sep 95 6 30
00 Sep 100 4 7/8 00 Sep 10o 858
00 Sep 105 o0 Sep 105 11 34 12 1/4
00 Sep 110 111/16 1 78 00 Sep 110 15 1/2 6
00 Sep 115 11/16 00 ep 115 1934 20 1/4
00 Sep 120 7/16 00 Sep 120 24 14
Souroe: Chago and of Echange
Band equivakne yuids
1) What recommendation would you give to Harold Yoon?

2) What is the current portfolio strategy?

3) How many put options should Yoon take to hedge his portfolio?

4) What advantages/disadvantages can you identify with using8

a) Index futures to hedge beta risk?
b) Put options to hedge beta risk?
I