Indian Association of Alternative Investment Funds (IAAIF) Swapnil Pawar Scient Capital

Indian Association of Alternative Investment Funds (IAAIF) Swapnil Pawar Scient Capital

Contents Quick introduction to hedge funds and the idea of market inefficiencies Types of hedge funds Background to Credit Pricing Credit arbitrage using bonds or CDS

Relevance of Hedge Funds Theory and Practice NAV 30 25 20 Cumulative value of different assets over time (illustrative) Debt Equity Hedge funds Cumulative value of different assets over time (Actual) 15 10 5 1 2 3 4 5 6 7 8 9 10 Note: This is a stylized representation for illustration only. It is not based on real numbers. Year

Do Hedge Funds Represent Free Lunch? Capital Asset Pricing Model: The Accepted Wisdom on Risks and Returns Returns Too good to be true! Equities The generally ignored axis of Inefficiencies Inefficiencies Moderate risk - high returns ideas Returns Seriou sly?! Equities Debt Risk Debt Risk

Source of Market Inefficiencies: Bounded Rationality The 2/3 rd of Average Game The Fairness Game Rs. 100 to be split between two players Player1 makes offer to Player 2 Player2 Rejects offer Player2 Takes offer Both players lose their share Both players keep their share Rationally, everyone should guess 0 Typically, peaks at 33 and 22! Rationally, player 2 should take anything more than zero, but in reality offers less than 40% are routinely rejected

Summary: Efficient Markets Vs. Real Markets Rational economic agent Cause-and-effect relations Efficient markets Perfect information Stable equilibria Behavioral biases Non-linearity Real markets Reflexivity Unstable equilibria

Contents Quick introduction to hedge funds and the idea of market inefficiencies Types of hedge funds Background to Credit Pricing Credit arbitrage using bonds or CDS

Most Popular HF Strategies - Market timing or trend following (CTA, managed futures, systematic trading): Identifying trends either using discretion or algorithms and trading according to them. - Convertible arbitrage: A convertible bond has an implied call option in its design. This implied call can be either too cheap or too costly. - Merger arbitrage: After the merger announcement but before the merger, the announced ratio has implications for the prices of the two companies. Interestingly, the prices don t always converge to their ratio-based relationship. - 130/30 and equity market neutral: Conventionally mutual funds have been focusing on buying stocks cheap and selling them at fair price or higher. Equity market neutral funds take it to the next level by doing the reverse as well. - Equity long short: Directional long or short calls on individual stocks or indices. They have no preference for long or short exposure and at different times can be net long, net short or net neutral. - Global macro: Similar in spirit to equity long-short, Global Macro strategies are generalized to include - besides equities commodities, currencies, bonds and derivatives.

Classification of HF Strategies Attribute Global Macro Hedge Funds Systematic Hedge Funds Aggressive Bets Driven Hedge Funds Philosophy Discretionary calls on countries, commodities, currencies, companies Systematic targeting of market inefficiencies across different asset classes Aggressive and focused bets on key events, trends and opportunities Tools Observations of economic data, macroeconomic analysis Statistical, fundamental and econometric analysis; Mathematical modeling High risk appetite, focused event and opportunity analysis Benefits Scalable, globally diversified Reliable, sustainable and strategically diversified Potentially very rewarding Risks Wrong judgment, high correlation of bets Strategies losing edge, weak models Each wrong bet Example Carry trade, Mining and AUD pair trade Single-sector basket mean reversion through stat-arb High yield EU sovereign debt, merger arbitrage

Risks in Typical Hedge Fund Strategies Risk type< Quantitative hedge funds Global macro hedge funds Aggressive bets driven hedge funds Outdated/wrong strategy Inadequate risk management Exogenous event Large bet failing Scale of investments too large High (They live by the accuracy of the strategy) High (6 sigma events in 3 sigma models!) Low (Typically well diversified) Low (Very few large bets) High (Most models work on mispricing; which limit size of opportunity in each occurrence) Moderate (Typically opportunity set is quite large and managers have some discretion) High (Over-exposure to some factor) High (Might be exposed to the wrong country, currency, stock at the time of event) Moderate (Occasional wrong bets may go wrong) Low (Most bets are made with highly liquid securities or derivatives) Low (Opportunistic bets typically no systematic strategy) High (Over exposure to some event) High (Might be exposed to the wrong country, currency, stock at the time of event) High (Business model is based on aggressive bets) High (Opportunity size is a common concern)

Where do Strategies Rank on Risk-Return? Returns Global macro Aggressive bets driven Equities Arbitrage Equity market neutral Debt Risk

Contents Quick introduction to hedge funds and the idea of market inefficiencies Types of hedge funds Background to Credit Pricing Credit arbitrage using bonds or CDS

Credit Pricing Fundamentals 1.2 Credit arb The balance, if any!!! 1.5 0.75 1.5 6 Illiquidity Premium Uncertainty Premium Credit spread Risk free rate The premium on account of lack of liquidity The premium on account of non-zero risk (behavioural) The extra spread required to compensate for the probability of default and subsequent loss The base case interest rate for a given tenor

Default Risk Pricing Return(G-Sec) = [1 p(d)] * return (security) + p(d) * recovery rate Loss models for default rate Historical priors of default rate by rating/sector/tenor etc Company specific factors Empirical default forecasting models Loss models for recovery rate Much harder Specific to each company Need to make several assumptions; each hard to justify Part of the reason for large certainty equivalents

Uncertainty Premium 80% chance of gaining Rs. 5,000 20% chance of gaining Nothing 100% certainty of gaining Rs. 3,000 99% chance of gaining Rs. 10,000 1% chance of losing Rs. 25,000 100% certainty of gaining Rs. 9,000 Inferred from two closely and highly rated securities with comparable liquidity and known default probabilities and recovery ratios Uncertainty Premium = return(aaa) weighted average return(aa+)

Contents Quick introduction to hedge funds and the idea of market inefficiencies Types of hedge funds Background to Credit Pricing Credit arbitrage using bonds or CDS

Real Data on Default Histories Actual default rates indicate that Short term credit is safer; and by larger magnitudes for lower ratings Sector level differences in default rates are very large Some securities are routinely conservatively rated (subsequent upgrades) One, Two & Three Year Cumulative Default Rates between 1988 & 2015 Rating Issuer - Months One-Year Two-Year Three-Year CRISIL AAA 16,565 0.00% 0.00% 0.00% CRISIL AA 36,605 0.03% 0.27% 0.77% CRISIL A 47,606 0.56% 2.31% 4.79% CRISIL BBB 101,414 1.09% 2.98% 5.72% CRISIL BB 149,114 4.17% 8.64% 13.07% CRISIL B 131,122 7.95% 15.85% 21.82% CRISIL C 7,034 20.06% 32.84% 40.42% Total 489,460 Source: CRISIL Default Report 2015

YTM Theory and Reality of Credit Pricing in India 14.0% 13.0% 12.0% 11.0% 10.0% 9.0% 8.0% Stylized Expected Fair-Price Yields for Indian Debt 12.00 11.50 11.00 10.50 10.00 9.50 9.00 8.50 Actual Yields of Indian Debt 7.0% 1 2 3 5 10 Outstanding Maturity AAA AA A BBB 8.00 1 2 3 4 5 6 AAA-yield 8.39 8.90 9.94 9.55 9.55 9.79 AA-yield 9.93 9.13 9.62 9.97 10.51 10.17 A-Yield 9.54 10.28 9.62 9.46 9.16 BBB-Yield 11.62 10.46 9.31 9.42 9.62

Credit Default Swaps Basic premise: insurance on credit event Theoretical price: Credit instrument returns = G-Sec returns + CDS price It does not always hold Genuine value addition by diversification and aggregation at the issuer end Illiquidity premium separating credit risk from liquidity risk Mis-priced credit instruments Credit risk of CDS issuer! (the AIG case) Uses of CDS CDS for hedging (while speculating on credit itself) CDS for credit arbitrage (minimizing capital commitment)

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