Financial Engineering 6

Lecture 22

Introduction to Hedge Funds

References: Villalobos

Lecture Topics • Introduction • Purpose • Long Term Capital Management (LTCM)

Definition • Hedge funds seek a positive annual return (the higher the

better), limited swings in value, and, above all else, capital preservation.

• They do so by using the best of what modern financial science can provide:

– Rapid price discovery. – Massive mathematical and statistical processing. – Risk measurement and control techniques. – Leverage and active trading in corporate equities, bonds,

foreign exchange, futures, options, swaps, forwards, and other derivatives.

• “Demystifying Hedge Funds”, Angel Ubide. – http://www.imf.org/external/pubs/ft/fandd/2006/06/basics.htm

Hedge Funds • Because of their nature, hedge funds are restricted to large-

scale investors. • Historically, they have attracted high-net-worth individuals and

institutional investors. • In recent years, institutional investors increased to include

pension funds, charities, universities, endowments, and foundations.

• Funds of funds are starting to introduce hedge funds to retail markets, but on a rather limited scale.

• Currently, there are about 8,500 hedge funds operating worldwide, managing over $1 trillion in assets

Hedge History • The first recorded hedge fund–style investment was a "call option" trade and

appears to have occurred about 2,500 years ago. – Aristotle told the story of a poor philosopher, Thales, who proved to

doubters that he had developed a "financial device, which involves a principle of universal application," by making a profit from negotiating with owners of olive presses for the exclusive rights to use their equipment in the upcoming harvest.

– Olive press owners were happy to pass on the risks of future olive prices and to accept payment now as a hedge against a bad harvest later.

– It just happens that Thales correctly predicted a bountiful harvest, and the demand for olive presses rose.

– He sold his rights to use the presses and made a profit. – Thales's "call option" risked only his down payment. – Although he did not invest in fields, workers, or olive presses, he

participated actively in olive production by taking on a kind of risk olive growers and press owners were unable or unwilling to take, enabling them to concentrate on growing and processing olives.

– They made a profit from their work, and he made a profit from his.

Hedge History • Modern hedge fund history began with Alfred Winslow Jones, a

sociologist and journalist who wrote about market behavior in the 1930s and 1940s and founded one of the first hedge funds in 1949.

• Jones' fund used leverage and short selling to "hedge" its stock portfolio against drops in stock prices.

• There was little widespread interest until 1966, when an article in Fortune magazine generated considerable interest by pointing out that Jones was earning 44 percent higher returns than the best-performing equity asset fund, even though he charged a fee equaling 20 percent of the fund's gain.

• By 1968, there were about 200 hedge funds, although many failed in the 1969–70 and 1973–74 market downturns.

• Hedge fund business increased significantly in the 1990s, fueled mainly by new wealth generated during the 1990s equity bull market.

Hedge Funds and Hedging • Hedge fund managers focus on risk-adjusted absolute returns.

– Their objective is to maximize the increase in investment value per year rather than to simply perform better than the average.

• Therefore, most hedge fund managers are paid based on the amount of increase in their investors' wealth.

– A percent of the return, rather than performance to a benchmark.

– This objective focuses the manager’s performance exclusively on positive returns.

• Although managers are also paid a 1 to 2 percent commission per year for the assets under their management, most of their compensation depends on delivering a positive absolute return.

• In addition, managers typically invest significant amounts of their own capital in the fund.

– This aligns their interests with the investors and discourages reckless or high risk investments.

Hedge Funds and Hedging • Some funds include a "high-water mark“ where capital losses

must be recovered before a performance fee is paid. – This introduces a strong incentive toward capital

preservation. – Minimizes swings in value and immunizes the hedge fund's

portfolio from general swings in market values. – Hedging becomes key to maximizing long-term returns.

Hedge Funds and Hedging • So, in regards to hedge funds, what is hedging? • It is a technique aimed at protecting a portfolio against sharp

movements in market values. • It essentially implies buying and holding assets that have good

long-term prospects while simultaneously selling assets that have doubtful prospects.

• The latter technique, short selling, involves borrowing someone else's shares of stock and selling them, with the intent to buy the shares back at a lower price and return them to the original lender.

• The profit is the difference between the selling price at time zero and what was paid at a later time to buy the stocks back.

• The development of market-traded stock and stock index futures, options, and related derivatives over the past half- century has created an extraordinary number of ways to engage in short selling and hedging.

Long Term Capital Management • The most famous case is that of Long-Term Capital

Management (LTCM), a well-known hedge fund that lost all its capital in the fall of 1998.

• A sudden spike in market volatility in the summer of 1998 led to a very rapid increase in LTCM's losses, forcing its liquidation.

• In addition to the doubtful soundness of some of its strategies, LTCM's failure happened for two main reasons:

– Risk management systems in LTCM and its banks were weak.

– LTCM's investment positions had become too large relative to the total market volume in those assets.

• When prices turned unfavorable, LTCM could not sell its holdings quickly enough.

Long Term Capital Management • As LTCM engaged in a fire sale to adjust its portfolio, its losses

grew out of control – snowballed.

• Because its positions were so large, and were linked to so many other financial institutions, LTCM became a potential systemic risk, convincing the authorities to intervene.

• As a result of a thorough review of the hedge fund business after the LTCM failure, companies that interact with hedge funds have tightened counterparty risk management.

• National and foreign financial regulatory institutions have upgraded their supervisory oversight of hedge funds.

Long Term Capital Management

Source: Wikipedia

Assignments • Watch “The Trillion Dollar Bet” video.

http://mslgoee.asu.edu/Mediasite/Viewer/?peid=816aa765-a674- 4e8e-852e-50cbcc4429a9

• Read the “JP Morgan Risk Metrics” paper section on Value at Risk.