Hedge Fund Investment Strategies
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L3: Hedge Fund Strategies
Hedge Fund Investment Strategies
 Hedge funds employ dynamic investment strategies designed to find unique
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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
L3: Hedge
Fund Strategies
exchange
and physical commodities
Four Categories
Equity
Based
Event
Driven
Arbitrage
Hedge Fund Strategies Can be Grouped into Four Major Categories
Subcategory
Description
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
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
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
Macro
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
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L3: Hedge Fund Strategies
Strategies are Diversified
Hedge Fund Strategies Have Become More Diversified
20%
39%
32%
Macro
Equity-based
37%
Event-driven
24%
Relative Value 1
10%
14%
1990
24%
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.
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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
neutrality).
 Non-Hedged Equity
 No hedge involved, and investment is only long (not short)
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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)
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L3: Hedge Fund Strategies
Buy on margin (page 133-138, Jaeger)
 Broker typically lend 50% of the value of stock to be
purchased
 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?
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L3: Hedge Fund Strategies
Short sell
 Page 139-146, Jaeger’s book
 You open an account with $100,000 and you sell short 1000





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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 costly
Also 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)
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
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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):
S
T
R
A
T
E
G
Y
• Fundamental
research
• Quant screening
• Networking
Step 1:
E
X
E
C
U
T
I
O
N
10
HF
Manager
Step 2:
Prime
Broker
Step 3:
Prime
Broker
L3: Hedge Fund Strategies
Continued onto next page…
Weight
positions
& trade
Portfolio
long/short
ratio
• Devise strategy
• Determine
weights
• Consider
execution ability
• Risk manage
• Gross mkt.
exposure
• Net mkt. exposure
• Beta adj. market
exposure
• Leverage
Security
selection
Screening
• Forecasting
• Valuation
• Mgmt.
interviews
Step 4:
$10M Initial
Investment
Prime
Broker
Step 5:
Prime
Broker
Establishes $1M
liquidity buffer
$9M to purchase
Stock A long
Investor:
$9M in Stock A
to prime broker
Sec.
Lender(s)
Long position
Step 6:
Prime
Broker
$9M in Stock B
borrowed
$9M Stock B
for short sale
$9M in proceeds
from short sale
$9M collateral
for borrowing
Stock B
Manage
portfolio
risk
•
•
•
•
•
Focus on short
Volatility
Review limits
Review losses
Review gains
Prime
Broker
Investor:
Short position
Sec.
Lender(s)
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
Costs:
• Share borrow costs
• Margin costs on short position
• Transaction costs
Return Attribution:
16.00%
+1.0%
14.00%
+3.5%
12.00%
10.00%
+0.2%
+1.0%
14.0%
-0.2%
-0.5%
9.0%
8.00%
6.00%
4.00%
2.00%
0.00%
Long Position
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L3: Hedge Fund Strategies
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
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
Long-Short)
 Market-neutral long-short + long index future
 Market-neutral long-short HF is not an asset class
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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
commodities.
 Also known as global asset allocators
 Emerging market
 Securities of companies and sovereign bonds
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L3: Hedge Fund Strategies
Global Macro
 A macro focused hedge fund makes leveraged bets on anticipated price
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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
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)
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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
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L3: Hedge Fund Strategies
Arbitrage Strategies
 Fixed income-based arbitrage
 Convertible arbitrage
 Relative value arbitrage
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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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L3: Hedge Fund Strategies
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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L3: Hedge Fund Strategies
Convertible Arbitrage
 A convertible bond can be thought of as a fixed-income security that has an





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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
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)
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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
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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
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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
+ Short Interest
- Stock Dividend
- Stock Borrow Cost
Total
2.5% on $1,000 convertible
2% on $466.83* short proceeds
1% on $466.83* short proceeds
0.25% on $466.83* short proceeds
= $25.00
= $9.34
= ($4.67)
= ($1.17)
= $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
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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
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Mechanics of Convertible Arbitrage
Figure 1: MONETIZING VOLATILITY
Convertible price, parity
140
0
∆1 Long convert and short
stock at initial delta hedge ratio
120
∆2 Rehedge stock at new delta hedge
ratio (short more stock as delta higher)
100
80
60
"Ratcheting" profits
A Stock falls
Profit = (short stock gain) – (CB loss)
40
B Stock rises
Profit= (CB gain) – (short stock loss)
20
0
100
50
150
200
Stock price
L3: Hedge Fund Strategies
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Mechanics of Convertible Arbitrage
Figure 2: CONVERTIBLE ARBITRAGE TRADE
Stock Px = $41.54
initial case
Convertible delta = 53%
Conv. Ratio = 21.2037 shares
Convertible Px = 101.375% par
+5% scenario
-5% scenario
Convertible arbitrage fund
Long convertible 101.375 par = $1,013.75
Amount of short shares 21.2037*53% = 11.24
Short value = 11.24 (shares)*41.54 (price) = $466.82
Net cash outlay = $546.93
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%
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
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Mechanics of Convertible Arbitrage
Figure 3: LONG-ONLY TRADE (ONE YEAR)
initial case
Stock Px = $41.54
Convertible delta = 53% +5% scenario
Conv. Ratio = 21.2037 shares
Convertible Px = 101.375% par
-5% scenario
Long-only fund
Long convertible 101.3755 par = $1,013.75
Net cash outlay = $1,013.75
Current share price = $43.617
Gain from convertible = (1,038.071 – 1,013.75) = $24.32
Coupon for 1 year = 2.5
Net gain = $26.82
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
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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
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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
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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.
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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
Strategic Alternative Reviews
Spin-Offs / Breakup Candidates
Activist Shareholders / Proxy Contests
Holding Company Discounts / Stub Trades
Takeover Candidates
Merger / Synergy Benefits
Restructuring Programs / Turnaround Stories
Senior Management Turnover
Financial
Liquidity Events / Credit Re-Ratings
Recapitalizations
Primary Equity and Debt Offerings
Bankruptcy Reorganizations
Accounting Changes / Issues
Source: Highbridge Capital Management, LLC
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L3: Hedge Fund Strategies
Legal / Regulatory
Litigation
Regulations
Legislation
Technical
Broken Risk Arbitrage Situations
Secondary Equity and Equity-Linked Offerings
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
value
 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
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L3: Hedge Fund Strategies
Merger Arbitrage
• In a stock-for-stock acquisition, some traders will buy the target company’s
•
•
•
•
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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
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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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
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L3: Hedge Fund Strategies
Merger Arbitrage
Share for Share Merger Arbitrage
UPSIDE:
DOWNSIDE:
The Deal Closes
The Deal Does NOT Close
• The Arbitrageur gains
o
The Arbitrage spread (difference
between Target stock when acquisition
announced and bid price when closes)
o
o
Dividends paid on Target stock
Interest on proceeds of short selling
(less borrow costs and dividends paid on
shorted Acquirer stock)
• 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
• 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
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L3: Hedge Fund Strategies
Distressed Securities
 Distressed securities investment strategies are directed at companies in


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
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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
L3: Hedge Fund Strategies
Distressed Securities
Distressed Securities Return
Capitalize on the knowledge, flexibility, and patience that creditors of a company do not have
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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
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
grades
 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.
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L3: Hedge Fund Strategies