Part 2: Risks per Strategy

Transcription

1 Part 2: Risks per Strategy Slide 1

2 Portfolio Risks Market Risk. The risk in reducing the value of the portfolio due to changes in markets. Credit Risk. The risk in reducing the value of the portfolio due to changes in the credit quality of the counterparties. Counterparty deafult is an extreme case, but losses can also occur when a counterparty s credit quality decreases. Credit risk is an issue even when the bank holds only payment obligations. Liquidity Risk. The risk of losses because of delays selling assets. Operational Risk. Fraud. Model risk (using the wrong pricing model, for instance: example, CDO s) Human Factor Legal and Regulatory Risk. Transactions that are voided due lack of appropriate licenses. Changes in Tax Laws Slide 2

3 Hedge Fund Strategies A wide range of hedging strategies are available to hedge funds: Selling short - selling shares without owning them, hoping to buy them back at a future date at a lower price in the expectation that their price will drop. Using arbitrage - seeking to exploit pricing inefficiencies between related securities - for example, can be long convertible bonds and short the underlying issuers equity. Trading options or derivatives - contracts whose values are based on the performance of any underlying financial asset, index or other investment. Slide 3

4 Hedge Fund Strategies (cont.) A wide range of hedging strategies are available to hedge funds: Investing in anticipation of a specific event - merger transaction, hostile takeover, spin-off, exiting of bankruptcy proceedings, etc. Investing in deeply discounted securities - of companies about to enter or exit financial distress or bankruptcy, often below liquidation value. Commodity trading Slide 4 Financing

5 Risk-return scatter gram Slide 5

6 Scatter gram again Slide 6

7 Convertible arbitrage Fig. 1: A graphical analysis of a convertible bond. The different colors indicate different exercise strategies of call and put options. Risk management for financial institutions (S. Jaschke, O. Reiß, J. Schoenmakers, V. Spokoiny, J.-H. Zacharias- Langhans). The Galmer Arbitrage GT Slide 7

8 Convertible arbitrage The convertible arbitrage strategy uses convertible bonds. Hedge: shorting the underlying common stock. Quantitative valuations are overlaid with credit and fundamental analysis to further reduce risk and increase potential returns. Growth companies with volatile stocks, paying little or no dividend, with stable to improving credits and below investment grade bond ratings. Slide 8

9 An convertible arbitrage strategy example Consider a bond selling below par, at $ It has a coupon of $4.00, a maturity date in ten years, and a conversion feature of 10 common shares prior to maturity. The current market price per share is $7.00. The client supplies the $80.00 to the investment manager, who purchases the bond, and immediately borrows ten common shares from a financial institution (at a yearly cost of 1% of the current market value of the shares), sells these shares for $70.00, and invests the $70.00 in T-bills, which yield 4% per year. The cost of selling these common shares and buying them back again after one year is also 1% of the current market value. Slide 9

10 Scenario 1 Values of shares and bonds are unchanged: Today 1 yr later Bonds Stock T-Bill Coupon 4 Fee -3.5 Total $80 $83.3 Slide 10

11 Scenario set 2 In the next two examples, the share price has dropped to $6.00, and the bond price has dropped to either $73.00 or $70.00, depending on the reason for the drop in share market values. The net gain to the client is 7.87% and 4.12% respectively, again after deducting costs and fees. Today 1 yr later (a) 1 yr later (b) Bonds Stock T-Bill Coupon 4 4 Fee Total $80 $86.3 $83.3 Slide 11

12 Scenario set 3 In the following three examples, the share price increased to $8.00, and the bond price increased either to $91.00, $88.00 or $85.00, depending on the expectations of investors, keeping in mind that we have one less year to maturity. The net gain to the client is 5.37% and 1% in the first two examples, with an unlikely net loss of 2.12% in the last example. Today 1 yr later(a) 1 yr later(b) 1 yr later(c) Bonds Stock T-Bill Coupon Fee Total $80 $84.3 $81.3 $78.3 Slide 12

13 A Risk Calculation: normal returns If returns are normal, assume the following: Bond mean return: 10% Equity mean return: 5% Libor: 4% Bond/equity covariance matrix (50% correlation): Mean return (gross): =9% Standard deviation: Slide 13

14 Non-normal risk Markets can deviate from normal returns in many ways: Bond (or equity) prices can increase or decrease more than 2 sigmas. Bond-equity correlation can change and become negative: if that is the case, portfolio volatility can nearly double: With a 5% probability, this can lead to portfolio losses (1.65*6.25%>9%). Slide 14

15 Convertible arbitrage: return Sources of return: the bond yield (cash) short interest rebate (cash) Long/short stock moves (equity) a small outflow for short stock dividends (cash) The bond itself (fixed income) Slide 15

16 Convertible Arbitrage: sources of risk Industry/sector concentration Liquidity Interest rate risk Credit risk, credit spreads. Equity volatility, implied volatility Event risk Bond/equity correlation breakdown Slide 16

17 Convertible Arbitrage Declining implied volatility in long term convertibles (CBOE ViX index at 7 year low) Increasing equity prices Slide 17

18 Slide 18

19 Long-short equity William Holbrook Beard ( ) Slide 19

20 Equity hedge growth Slide 20

21 Sample hedge fund portfolio

22 A long-short pair trade The fund has $1000. The manager is going to purchase stock 9 units of stock A, and sell-short 9 units of stock B. Both are valued at $100 each. After a year, A is worth $110, B is $105. Assets at Prime Broker (Before trade) $1000 Assets at Prime Broker (After trade) $1000 -$ A +$900 9 B Assets at Prime Broker (After one year) $ $ 1036 Slide 22

23 A long-short pair trade (v2) The fund has $500. The manager is going to purchase stock 9 units of stock A, and sell-short 9 units of stock B. Both are valued at $100 each. After a year, A is worth $110, B is $105. Assets at Prime Broker (Before trade) $500 Assets at Prime Broker (After trade) $500 -$ A +$900 9 B Assets at Prime Broker (After one year) $ $ 536 Slide 23

24 A long-short pair trade (v3) Assumptions: 50% collateral for long trades, 80% collateral for short trades. Securities at Prime Broker 9 A ($900): 9 B (-$900): Securities at Prime Broker 9 A ($990): 9 B (-$945): Collateral required: $450+$720=$1170 Cash from short sale: $900 Cash required: $270 Profit: $45 ROR: 16.67% Slide 24

25 Long/short risk profile Equity market risk. Counterparty risk (stock lending) Corporate actions. Liquidity (shorting) Correlation breakdown Volatility Slide 25

26 Equity hedge fund risk: equity vol Distressed Periods Tranquil Periods Slide 26

27 Hedge Fund S&P correlations Slide 27

28 HF/S&P Bull correlations Shifted to the left Slide 28

29 HF/S&P Bear correlations Shifted to the right Slide 29

30 HF/S&P-vol correlations Slide 30

31 HF/S&P vol Bull Correlations Slide 31

32 HF/S&P-vol Bear correlations Slide 32

33 Hedge Fund Correlation histogram Slide 33

34 Equity Market Neutral Slide 34

35 Asset growth

36 Equity Market Neutral Top Sharpe ratio of all hedge fund styles. They have portfolios which are designed to be beta neutral. They like to diversify across sectors, market capitalization, industries, etc. For pairs trading, stocks are desired to have high correlation, or return will be too volatile. Leverage is easily arranged through margin trading- and desired, as returns will not be very volatile, but not have great returns either. Slide 36

37 EMN: risk profiles Since they have typically removed the main risk exposure equity exposure- the risk profile of Equity Market Neutral will come from secondary sources, and can be quite exotic, as the following examples show: Imagine a pairs trade: short IBM, long amazon, dollar and beta neutral. Exposure to credit: widening will hurt amazon (lower cap) much more than IBM (large cap). If aware of it, this risk is diversifiable; if not, it can align risk exposures and be the source of nasty surprises. Long Manulife, short Sunlife. Exposure to emerging markets. Long Merryll, short Goldman. Exposure to mortgages. Slide 37

38 Equity market neutral risk exposures Equity volatilities Liquidity Capacity Operational risk Corporate events Transparency Slide 38

39 Short selling Slide 39

40 Short selling This is not a very popular style, and is regarded as difficult by most practitioners. Even during the bear market of , less than 3% of the stocks in NYSE and NASDAQ were borrowed or sold short. Most equity analysts publish sell ratings on less than 10% of stocks. Losses are unlimited when you short a stock: the probability distribution of returns is very skewed to the left (the loss side). This might be a mathematical explanation for the unpopularity of this style. Uptick rule (removed by the SEC in 2007): a stock cannot be sold short at a value which is less than the previous tick value: the stock price must increase before you can short sell that stock. This adds execution risk to short selling strategies in the US; if a stock exhibits a steady collapse in price, it can take a long time before the short selling position is filled, and then it will only be cleared at a very disadvantageous value. Slide 40

41 The uptick rule You want to short sell here You have to short sell here Slide 41

42 Short-selling risks Locate process: before you can borrow a stock, someone else needs to be willing to lend it. This can take time. Furthermore, if the original lender sells the stock, and the broker cannot find another lender, you may be forced to buy back the stock, whether you like it or not. Risk Management systems are therefore much more critical for the short part of the portfolio than for the long part: Stop-loss strategies Options can be used to cover losses, for a fee. Many short-selling trades are based on negative company information, which is often times tied to SEC filings, litigations, etc. Legal risk must be monitored, specially for concentration. Of all the hedge fund styles, this one has the lowest Sharpe ratio. But it has negative correlation to most other indices. Therefore, investors view this style as a hedge in itself against other hedge fund investments. Slide 42

43 Short-selling in context Slide 43

44 Short selling: risks Equity market direction Equity volatility Operational risk Corporate events Liquidity Legal risk Slide 44

45 Merger Arbitrage Slide 45

46 Asset growth

47 Alcatel Lucent merger April 30, A merger was announced between Alcatel (A- rated) and Lucent (BBBrated). Merger arbitrageurs bought Lucent bonds and sold short Alcatel bonds. Lucent s bonds gained 7.57%. Alcatel s remained stable. The deal was off a month later. Bonds came back. Slide 47

48 Bear Stearns CDS/equity arbitrage Luis Seco. Not to be reproduced without permission Slide 48

49 Bear Stearns Facts On Friday March 14, hedge fund sold CDS on BS at 10% of notional up-front. On Monday March 17, JPMorgan agreed to buy BS for $2 a share. CDS prices dropped to par with JPMorgan s: about 1% up-front. The hedge fund who sold CDS on Friday stood to win 90% return on those, if the deal went through. To ensure there was no blockage to the deal from share holders, they actively bought BS stock, driving the price up to $10. Luis Seco. Not to be reproduced without permission Slide 49

50 Hedge Fund IPO s There are two main reasons for a hedge fund IPO: Need of capital of the management company Management companies rarely need capital expansion, as they are not very capital intensive enterprises. But they have difficulty issuing debt, hence equity IPO s is their only alternative. Many hedge funds issue stock privately with strategic partners that can assist in fund

51 Merger Arbitrage Yields Credit Liquidity Model Risk (Operational risk) Corporate actions Slide 51

52 Fixed Income Arbitrage Slide 52

53 1998 mythology: Fixed income is bad Slide 53

54 Fixed income/convertible arb

55 Relative value

56 A Treasury/Eurodolar spread trade Assume T-bills are at 94.20, and Eurodollars futures are trading at An arbitrageur expecting an increase in the TED spread will sell 10 euro-dollar futures and buy 10 T- bills (or T-bill futures). The spread widens to 125: T-bills are at (a loss 25) of and Eurodollar futures at (a gain of 40). Net gain of 15. Slide 56

57 Kessler Investment Advisers Taken from K. Black s book Managing a Hedge Fund 3-year T-bills yield 2.5%. 10-year yield 4.5% With $10M equity, Kessler buys $30M 3-years and borrows $20M of 10- years in the repo market. With negligible interest rate risk, the long side provides 7.5% return on the equity; after factoring the repo return, the net can be around 6% net, from a mere 2% differential. If the yield curve were to flatten out, or become inverted, the differential will decrease and the financing costs for the repo will increase. This strategy would incur into losses (the manager might hedge these with bond futures, but let s not go there here). Slide 57

58 Fixed Income Arb. risks The yield curve is to a FIA manager what a stock is to a long/ short manager. The difference is that, while a stock price is a number at every point in time, the yield curve is a set of many numbers at any point in time. Hence: Managers must be more skilled mathematically. Many trades will originate from numerical assumptions: model risk is an important issue. As is correlation breakdown. These trades lead themselves to highly leveraged positions Slide 58

59 Fixed Income Arbitrage Yields Credit Liquidity Model Risk (Operational risk) Transparency Leverage Slide 59

60 Distressed, PIPES, Reg-D Slide 60

61 Asset growth

62 Distressed securities Companies exhibit problems: Liquidity Debt Operational shortcomings Legal or regulatory difficulties Bankrupt Managers usually take a core position, which usually includes all of the following: Buy equity Lend money Become activists in the management of the company Slide 62

63 Example ABC debt: 11% annual coupon Trading at 50% of par. The hedge fund : buys the debt at 50%. Restructures the company A year later, the hedge fund sells the debt at 70%. Capital gains of 20% of the debt: ROR of 20/50=40% Interest payments of 11% Total ROR=51% Slide 63

64 Reg-D and PIPEs Regulation D is part of the US Securities Act of 1933 that simplifies filing requirements for companies that sell securities exclusively through private placements. Private Placements on Public Companies allows companies with public shares to issue new restricted shares through private deals, usually at a heavy discount Janus (a mutual fund) purchased $930M in Healtheon/WebMD in 2000, 6% discount. An issue in SimPlayer.com in 2000 was discounted by 34%. PIPES cannot be sold for two years, but companies often file with the exchange before that. Sarbanes-Oxley has give recent popularity to pipes. Slide 64

65 Distressed securities: risk profile Equity market direction Equity market volatility Yields Credit risk Liquidity Corporate events Transparency Pricing Capacity Slide 65

66 Global Macro Slide 66

67 Asset growth

68 The strategy Forecasts in world economies, political developments, macroeconomic variables managers seek to profit by taking positions on a wide array of financial instruments: futures, currencies, indices, commodities interest rates, When their perceived value deviates from the actual value. Slide 68

69 Example: Soro s and the British Pound All European central banks were intervening in the early 90 s to keep the GBP within the 3% boundary defined by the EMS. Macro managers were convinced the British pound had to be devalued. They took short positions on the GBP against the continental European currencies in When the GBP was finally allowed to move freely, it dropped 20%. Soro s Quantum fund is said to have made $1B profit in this trade. Slide 69

70 Global Macro: sources of risk Most of them: Market: event risk, political developments, etc. Currency risk. Model risk. Liquidity and execution risk, due to the large orders they usually process. Risks associated with short selling, an integral part of their strategy: volatility, capacity, etc. As macro managers thrive in inefficiency in global markets, many believe their opportunities are over, as global markets are more efficient than ever before. Others believe that new capital markets (electricity, weather) bear even higher degrees of inefficiency, so ample opportunities exist. Slide 70

71 Managed Futures Slide 71

72 Futures Tradition; From LME to Japan rice market in the XVI century. In the middle ages, buyers and sellers of commodities met annually at trading fairs to lock in future needs and prices. Middlemen provided banking and storage to facilitate trade. Transfers risk from the unwilling to the unwilling. Later speculators facilitated risk transfer from the unwilling to the willing. Permits economic certainty and increased economic activity. Futures function as an insurance market, providing price certainty to commercial entities. Liquid, public markets preclude special inside information. Extremely regulated. Cannot trade off-exchange. Exchanges create uniform product, so quality, delivery date and location of product is not a variable. Investors concentrate on price trends. Complete continuous disclosure of price. In 30 countries. Slide 72

73 Futures Protocols Investors provide initial margin or good faith deposit. Mark to market losses must be topped up every day. Customer receives gains of profitable positions daily. All traders participate as equals once margin is posted. Speculators have the same access as the most creditworthy bank. Owned by the members. Clearinghouse is the guarantor and counterparty of all trades. Anonymous trade. Member firms only post their net position to the exchange. Futures contracts have no value; they represent a future obligation. Slide 73

74 CTAs Commodity Trading Advisors, trade exclusively in Futures contracts. Different trading styles: Trend followers. Determine trends, and try to extract value from them. Short-term traders. Very frequent traders, intra-day sometimes, go against current trends. Fundamental. Similar to macro traders. Mechanical. Follow blind quantitative methodologies. Discretionary. Mechanical with an override. Slide 74

75 Managed Futures Risks Leverage. Since only margin is required to trade. High volatility Event risk. Trade reversals are often sudden and pronounced. Trend followers can give back weeks of profits in one day Market risk Model risk No capacity risk No credit risk No liquidity risk Slide 75