Hedging

 The objective of hedging is to reduce or limit risk associated with price changes and this is done by taking a position in the future market. ‡ Example - case of steel An automobile manufacturer purchases huge quantities of steel as raw material for automobile production. The automobile manufacturer enters into a contractual agreement to export automobiles three months hence to dealers in the East European market. This presupposes that the contractual obligation has been fixed at the time of signing the contractual agreement for exports. The automobile manufacturer is now exposed to risk in the form of increasing steel prices. In order to hedge against price risk, the automobile manufacturer can buy steel in futures contracts, which would mature three months hence. In case of increasing or decreasing steel prices, the automobile manufacturer is protected.

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Alfred W. Jones is credited with the creation of the first hedge fund in 1949. An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns. It is a Vehicle for holding and investing the Money of its investors. Morgan Stanley Dean Witter (November 2000, p 1) reported that hedge funds ´exhibit a low correlation with traditional asset classes, suggesting that hedge funds should play an important role in strategic asset allocationµ.

Hedge Fund

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Who can be a Investors in Hedge fund ‡ 65% of Hedge Fund Investor should be an Accredited investor ‡ person with net worth that exceeds $1 million ‡ person with income exceeding $200,000 in each of the two most recent years and joint income with a spouse exceeding $300,000 for those years . ‡ Pension funds, insurance companies, fund of funds, endowments and qualified clients.

Terms 
Arbitrage ´The opportunity to buy an asset at a low price then immediately selling it on a different market for a higher price." Example: If I can buy an asset for $5, turn around and sell it for $20 and make $15 for my trouble, that is arbitrage. The $15 I gain represents an arbitrage profit.  Credit Default Swap (CDS) The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. Example: Insurance is one of the best example of CDS

A look inside hedge

Buccaneer capital
Large Personal Stake High minimum Investment First year lock in Infrequent redemption Use of Hedging Variety of

Arbitrage

Techniques CDS investments Short 2/20 gain Options Leverage

Hedge Fund Chart
Hedge Fund Investors (Limited Partners) Hedge Fund Management Company (LLC)

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Hedge Fund (Bank Account) 2. 7. Hedge Fund (Brokerage Account) RSM Forex Fund, L.P. A Delaware Limited Partnership 4.

Investors make investment in the Fund, payment to the Fund·s bank account*  Manager wires money to the Fund·s brokerage account*  Fund is managed by the Management Company  Fund makes investments  Fund pays Management Company a management fee (or may be paid from brokerage account)*  Fund pays General Partner a performance allocation (or may be paid from brokerage account)  If Investors make withdrawals, the Fund will make a distribution to investors 
Fees Allocations Management Movement of money Withdrawal

Investments

Some suggested measures to measure risk and return
The Sortino Ratio was developed to differentiate between deviations on the upside and on the downside and is more consistent with the investors' concern over risk of losses in their investments.

d-Ratio = Abs (d/U) where, d = number of returns less than zero times their value U = number of returns greater than zero times their value Abs = absolute value.

To calculate the permanence of a manager's skill
Hurst Ratio = log M / (log N - log a) where M(t) = (max(t) - min(t))/S(t) N = length of shorter sub-periods into which a manager's return record has been sub-divided t = number of sub-periods into which a manager's return record has been sub-divided S(t) = standard deviation of data over sub-period t a = constant term that is negligible if track record is five years or less.
Accounting for Various Sources of Risk
Risk Adjusted Return = (Observed Returns ² Benchmark Returns) X Penalty Function Indicated Risk Measure

Hedging Strategies
‡ It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same. Investment returns, volatility, and risk vary enormously among the different hedge fund strategies No standard system is used. A hedge fund will typically commit itself to a particular strategy, particular investment types and leverage limits via statements in its offering documentation, thereby giving investors some indication of the nature of the particular fund.

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Hedging Strategies
‡ Convertible Arbitrage - a strategy designed to take advantage of pricing inefficiencies of the embedded option in a convertible bond. Typically, the arbitrageur would be long the convertible position and short the underlying stock. Equity Market Neutral - a strategy designed to exploit equity price inefficiencies through balanced long and short positions that insulate the portfolio from overall market risk. Long/Short - the most common hedge fund strategy in which a manager takes long and short equity positions. Depending on the mix of long and short positions the portfolio may have a long bias or short bias. Merger Arbitrage - an event-driven strategy in which the arbitrageur takes a position of both companies involved in a merger or acquisition, typically long the stock of the company being acquired and short the stock of the acquirer. Fixed Income Arbitrage - exploit pricing inefficiencies between related fixed income securities Global Macro - (Macro, Trading) Global Macro funds attempt to anticipate global macroeconomic events, generally using all markets and instruments to generate a return.

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Hedging Strategies
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Distressed Securities: Buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Profits from the market·s lack of understanding of the true value of the deeply discounted securities and because the majority of institutional investors cannot own below investment grade securities. (This selling pressure creates the deep discount.) Results generally not dependent on the direction of the markets. Expected Volatility: Low - Moderate Fund of funds refer to funds that invests in a pool of hedge funds. They specialize in identifying fund managers with good performance and rely on their good industry relationships to gain entry into hedge funds with good track records. Sector funds concentrate on selective sectors of the economy. For example, they may focus on technology stocks if these are overpriced and rotate across to other sectors. Event driven funds. These are funds that take positions on corporate events, taking an arbitraged position when companies are undergoing re-structuring or mergers.

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Benefits of Hedge Funds
‡ Many hedge fund strategies have the ability to generate positive returns in both rising and falling equity and bond markets. Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk. Hedge fund strategies provides wide range of choice for investors to meet their investment objectives. Academic research proves hedge funds have higher returns and lower overall risk than traditional investment funds. Hedge funds provide an ideal long-term investment solution, eliminating the need to correctly time entry and exit from markets.

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De-hedging 
The investor would prefer to remove their hedged position to gain exposure to the expected upward price fluctuations of their investment.

Example A hedged investor in gold who feels the price of their asset is about to go up would buy back any gold futures contracts they had sold in the futures market. By doing this, the investor will have positioned themselves to reap the rewards of an increase in the price of gold if their bullish prediction on gold is correct.

QUESTIONS