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 exchange and physical commodities
2 L3: Hedge Fund Strategies
Four CategoriesHedge Fund Strategies Can be Grouped into Four Major Categories
Source: McKinsey Global Institute; Hedge Fund Research, Inc.; David Stowell
Subcategory Description
Arbi
trag
e
Fixed-income based arbitrage
Exploits pricing inefficiencies in fixed-income markets, combining long/short positions of various fixed income securities
Convertible arbitrage
Purchases convertible bonds and hedges equity risk by selling short the underlying common stock
Relative value arbitrage
Exploits pricing inefficiencies across asset classes-e.g., pairs trading, dividend arbitrage, yield curve trades
Even
t Dr
iven
Distressed securities
Invests in companies in a distressed situation (e.g. bankruptcies, restructuring), 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
Equi
ty
Base
d 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
Mac
ro
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
3 L3: Hedge Fund Strategies
Strategies are DiversifiedHedge Fund Strategies Have Become More Diversified
Note 1: Hedge Fund Research’s “Relative Value” classification is comparable to the “Arbitrage” classification used in the book.Source: Hedge Fund Research, Inc.
14%24%
10%
24%37%
32%
39%20%
1990 2008
Macro
Equity-based
Event-driven
Relative Value 1
4 L3: Hedge Fund Strategies
Equity-Based StrategiesEquity Long/Short
Also known as equity hedge strategyIt 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 neutrality).
Non-Hedged EquityNo 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 purchasedVary across securities
Brokers will not lend funds against risky stocksMargin 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 sellPage 139-146, Jaeger’s bookYou open an account with $100,000 and you sell
short 1000 shares of Amazon.com at $100 each.What if the price goes down to $50/share or
goes up to $120/share?Borrowing a stock is costlyAlso note that short selling creates a new
interest-bearing assets Under what condition, short selling is most
profitable? Boxing a short position (page 145-146)
8 L3: Hedge Fund Strategies
Diversification and hedgingBoth are ways to reduce risk
Diversification, see chapter 7, JaegerHedging, see chapter 9, from page 146
Shorting against the boxBasis risk
9 L3: Hedge Fund Strategies
Equity Long/ShortLong/Short Strategy Overview
Continued onto next page…
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):
$9M in proceeds from short sale
$9M in Stock B borrowed
Investor: Short position
$9M in Stock A to prime broker
$9M to purchase Stock A long
Establishes $1M liquidity buffer
STRATEGY
EXECUTION
Screening Security selection
Weight positions & trade
Portfolio long/short
ratio
Manage portfolio
risk
• Fundamental research
• Quant screening• Networking
• Forecasting• Valuation• Mgmt.
interviews
• Devise strategy• Determine
weights• Consider
execution ability• Risk manage
• Gross mkt. exposure• Net mkt. exposure• Beta adj. market
exposure• Leverage
• Focus on short• Volatility• Review limits• Review losses• Review gains
HF Manager
Prime Broker
$10M Initial Investment
Step 1:
Step 2:Prime Broker
Step 3:Prime Broker
Investor: Long position
$9M collateral for borrowing
Stock B
$9M Stock B for short sale
Prime Broker
Step 4:
Step 5:Prime Broker
Step 6:Prime Broker
Sec. Lender(s)
Sec. Lender(s)
10 L3: Hedge Fund Strategies
Equity Long/ShortLong/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
Costs:• Share borrow costs• Margin costs on short position• Transaction costs
Return Attribution:
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
Long Position Short Position
Dividend Income on
Long Position
Rebate on Short
Position
Interest Earned on Liquidity
Buffer
Cost of Borrowing
Shares
Margin Costs on Short Position
Net Return
+3.5%+1.0%
+1.0% +0.2%
-0.2% -0.5%
14.0%
9.0%
11 L3: Hedge Fund Strategies
More on Long-shortBenefits: (1) performance, (2) Interest
rebate, (3) liquidity buffer interestCosts: (1) share borrowing costs, (2)
margin costs on short position, (3) transaction costs
Thoughts from Jacobs & Levy (97, The Long and Short on Long-Short)Market-neutral long-short + long index futureMarket-neutral long-short HF is not an asset
class
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Macro StrategiesGlobal macro
Make leverage bets on anticipated price movements in stock and bond markets, interest rates, foreign exchange, and physical commodities.
Also known as global asset allocators
Emerging marketSecurities of companies and sovereign bonds
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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 considerations
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 currency
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Two types of global Asset allocatorsDiscretionary managers
Rely on some blend of fundamental analysis and technical analysis to form a reasonable investment judgmentGrowth variablesInformation variablesInterest ratesTrade flow and capital flowsEquity valuation variables: P/E, price to cash flow, business
value, etcSystemic managers
Follow definite rules for putting on and taking off positionsPage 237 (JAEGER)
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Emerging MarketsAn 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
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Arbitrage StrategiesFixed income-based arbitrageConvertible arbitrageRelative 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 securities
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 market
However, over a longer period of time, the hedged returns became nearly identical
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
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Fixed Income Arbitrage Another example involves 30-year on-the-run and off-the-
run U.S. Treasury bonds 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
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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
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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)
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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
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Mechanics of Convertible ArbitrageA 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 GenerationThe 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:
Exhibit 12.4 (1 of 7)
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Mechanics of Convertible ArbitrageAssuming 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:
L3: Hedge Fund Strategies 25
Mechanics of Convertible Arbitrage2. Monetizing VolatilityBecause 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).
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Mechanics of Convertible ArbitrageFigure 1: MONETIZING VOLATILITY
60
Conv
ertib
le p
rice,
par
ity
∆2 Rehedge stock at new delta hedge ratio (short more stock as delta higher)
"Ratcheting" profits
∆1 Long convert and short stock at initial delta hedge ratio
80
100
120
40
20
1400
B Stock rises Profit= (CB gain) – (short stock loss)
50 100 150 200
Stock price
A Stock fallsProfit = (short stock gain) – (CB loss)
0
L3: Hedge Fund Strategies 27
Mechanics of Convertible Arbitrage
Figure 2: CONVERTIBLE ARBITRAGE TRADE
Convertible arbitrage fundinitial case Long convertible 101.375 par = $1,013.75
Amount of short shares 21.2037*53% = 11.24Short value = 11.24 (shares)*41.54 (price) = $466.82Net cash outlay = $546.93
+5% scenario Current share price = $43.617Loss from short = $466.82 – (11.24*43.617) = $23.34Gain from convertible = (1,038.071 – 1,013.75) = $24.32Net gain = 24.32-23.34 = $.98New hedge delta = 58.11%
-5% scenario Current share price = $39.463Gain from short = $466.82 – (11.24*39.463) = $23.34Loss from convertible = (1,013.75 – 991.782) = $21.97Net gain = 23.34-21.97 = $1.37New hedge delta = 46.75%
Stock Px = $41.54Convertible delta = 53%Conv. Ratio = 21.2037 sharesConvertible Px = 101.375% par
Note: calculations are not rounded.
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Mechanics of Convertible Arbitrage
Figure 3: LONG-ONLY TRADE (ONE YEAR)
Long-only fundinitial case Long convertible 101.3755 par = $1,013.75
Net cash outlay = $1,013.75+5% scenario Current share price = $43.617
Gain from convertible = (1,038.071 – 1,013.75) = $24.32Coupon for 1 year = 2.5Net gain = $26.82
-5% scenario Current share price = $39.463Loss from convertible = (1,013.75 – 991.782) = $21.97Coupon for 1 year = 2.5Net loss = $19.47
Stock Px = $41.54Convertible delta = 53%Conv. Ratio = 21.2037 sharesConvertible Px = 101.375% par
Note: calculations are not rounded.
Mechanics of Convertible Arbitrage3. Purchasing Undervalued ConvertibleAn 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 ReturnsThe 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 StrategiesPage 242, Jaeger bookMarket 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.
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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 inefficienciesEvent-Driven Investment Opportunities: Catalysts and Events
Source: Highbridge Capital Management, LLC
Strategic (Hard Catalysts)
Risk ArbitrageStrategic Alternative ReviewsSpin-Offs / Breakup CandidatesActivist Shareholders / Proxy ContestsHolding Company Discounts / Stub TradesTakeover Candidates
Operational
Merger / Synergy BenefitsRestructuring Programs / Turnaround StoriesSenior Management Turnover
Financial
Liquidity Events / Credit Re-RatingsRecapitalizationsPrimary Equity and Debt OfferingsBankruptcy ReorganizationsAccounting Changes / Issues
Legal / Regulatory
LitigationRegulationsLegislation
Technical
Broken Risk Arbitrage SituationsSecondary Equity and Equity-Linked Offerings
32 L3: Hedge Fund Strategies
Activist InvestorsActivist 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 value
This strategy is sometimes called Shareholder ActivismActivist 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
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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
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Merger ArbitrageShare for Share Merger Arbitrage
• The Arbitrageur gainso The Arbitrage spread (difference
between Target stock when acquisition announced and bid price when closes)
o Dividends paid on Target stocko 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
• The Target stock will drop to the pre-announcement price (or below), causing losses
• The Acquirer stock price might increase, causing a loss on the short position
UPSIDE:The Deal Closes
DOWNSIDE:The Deal Does NOT Close
In most cases, the amount an arbitrageur will lose if the deal does not close far outweighs the gain if the deal closes
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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 SecuritiesDistressed 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 securitiesPage 277- 281, Jaeger bookProfessional 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 strategyInvestment skill (to tell which security has value)Offer liquidity to traditional investors who prefer
investment gradesDistressed debt investors try to invest in good
companies that have a bad capital structureDistressed debt market is relatively small and it is
linked to the broader economy.
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