The Major Hedge Fund Strategies Case Study
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Equity Long-Short y is an investing strategy that is utilized principally by hedge funds and which entails undertaking long positions in stocks that are anticipated to increase in worth and short positions in stocks that are anticipated to reduce in worth. A long position involves purchasing a stock that will increase in value while a short position involves obtaining a stock you do not possess, selling it, then hoping it decreases in value, at which time you can purchase it once more at a lower cost.
Convertible Arbitrage is an investment strategy that entails undertaking a long position in convertible securities and undertaking a short position in the common stock of the same company. A convertible security refers to a security which can be transformed into a different security at a prearranged time and price, and mostly involves bonds that can be changed into common stock.
Relative-Value Arbitrage is an investing strategy that looks to exploit value differentials between related monetary instruments, for example, bonds and stocks, by purchasing and selling these securities simultaneously, therefore allowing the investor to gain from the relative value arising from the two securities.
Event-Driven strategy is an investing that entails exploiting pricing inefficiencies that may happen prior to or following a corporate occurrence, for example, an acquisition, merger, insolvency, or spinoff.
Distressed Securities strategy entails investing in securities of companies which are undergoing some type of distress, especially bankruptcy. When a company is under financial distress, investors bearing its securities often act in response to the likelihood of bankruptcy by selling their securities, mostly at lower prices, attracting speculative investors.
The investment strategies employed by LTCM
Long-term capital management LP used relative value and convergence investment strategies. Relative-Value investing strategy looks to exploit value differentials between related monetary instruments, for example, bonds and stocks, by purchasing and selling these securities simultaneously, therefore allowing the investor to gain from the relative value arising from the two securities. A find that uses this strategy attempts to find out securities that they consider are mispriced relative to one another. This fund will then attempt to benefit from that difference by purchasing the security that it considers to be underpriced and selling the security that it considers to be overpriced. A fund using this strategy considers that such a technique protects it from general movements and changes in the type of securities in which it invests in while allowing it to benefit from the relative changes in these two specific securities. In the case of LTCM, the fund undertook to find out what it believed were inefficiencies within the bond security markets and assume positions that it considered would get to be profitable when these apparent inefficiencies were eradicated. The achievement of this method was predicated upon different arbitrageurs discovering the same inefficiencies and utilizing them, which thus would move the bond market toward the specific trades that LTCM had undertaken. In the event that Long-Term had a long position and others were purchasing, this purchasing would raise the price of that security and therefore result in a profit. Moreover, if Long-Term had a short position on a certain security, other sales done by other funds would bring about benefits for LTCM.
A convergence trade refers to a form of relative-value trade that entails two securities' prices that are essentially guaranteed to converge on the grounds that they bear the same payoff when they mature. LTCM’s strategy was to purchase or sell bonds when the prices veered off from the standard, then wait for these prices to converge again and earn profits.
The financing strategies employed by LTCM
LTCM acquired finances to use in its investing activities from investors who invested in the fund. The fund owners borrowed huge amounts of money, totaling $1.25 billion to finance its trading activities. John Meriwether formed LTCM as a hedge fund similar to the arbitrage group that he headed at Salomon Brothers and recruited top successful traders and academic experts to join as partners in the fund. The hedge fund was structured as two partnerships, Long-Term Capital Partnership based in Delaware, Connecticut, and Long-Term Capital Portfolio based in the Cayman Islands. The partnership based in the Cayman Islands was responsible for all records pertaining to the securities held by the hedge fund while partnership in Delaware was responsible for all office and trade operation of the hedge fund.
The adoption of this partnership model was more appropriate and favorable as compared to a corporate structure as it enabled the fund to avoid double taxation as well as provide its investors with limited liability. The financing exercise was handled by Merrill Lynch, which enabled the fund to collect $1.25 billion in start-up capital. Of this amount, 4% was raised by wealthy individuals while the rest was raised by financial institutions, which included commercial banks and other financial organizations from within the United States and abroad that LTCM had created strong relationships with.
These financial organizations were important investors to LTCM as they leading commercial banks in strategic geographical markets and therefore they were able to provide important information regarding the financial issues and macro-economic aspects affecting their specific regional markets. Rather than investing directly in the fund, the investors invested their monies through several investment vehicles and entities that included off-shore entities to cater for foreign investors.
The risk management strategies employed by LTCM
LTCM used the Value at Risk (VaR) system risk management strategy, which is primarily used by financial institutions to measure the amount of exposure they face to market risk. These models are intended to measure, for a specified portfolio, the most extreme amount that a financial institution could lose over a particular time period with a particular probability. As such, they give a review calculation of the risk presentation produced by the given portfolio. Management then chooses whether it feels okay with this level of risk exposure or not and takes the appropriate actions. Value at Risk models are widely utilized for reporting and controlling market risk, measuring performance and allocating capital. Calculating VaR relies upon the technique utilized. It basically includes utilizing historical information pertaining to the market rates and prices, the present portfolio positions, in addition to the models used to price those positions. These three inputs are then mixed in different ways based on the calculating method or technique utilized, to determine an estimation of a specific percentile of the probable loss distribution, normally the 99th percentile loss. The three most used methods of calculating VaR are the Monte-Carlo method, Historic-Simulation method, and the Delta-Normal method.
The liquidity strategies employed by LTCM
The founders of LTCM were able to raise $1.25 billion as start-up capital for the hedge fund, which was the largest amount ever raised to start a such a fund and which offered them a large amount of money to invest in placed a minimum requirement of $10 million for potential investors wishing to invest in the fund. LTCM also required that all investors wanting to invest in the fund had to let their money stay for a minimum three years. This allowed the fund to be able to invest in illiquid securities without having to worry about being required to liquidate some of its positions in order to pay some of its investors back their monies. The fund undertook to trade in the bond market and used relative value and convergence investment strategies. It looked for securities within the market that were mispriced comparative to each other, and would take a long position in the low-priced securities and a short position in highly priced securities. Most of these securities were illiquid and when the "flight to liquidity" occurred in 1998 due to the financial crisis in Russia, most investors began to move from Japanese and European securities to U.S treasury securities that were more liquid. Most began to offload their illiquid assets and bought the most liquid securities, specifically the "on-the-run" or recently issued Treasuries.
While the U.S. Treasury market is moderately liquid in typical economic situations, this worldwide flight to liquidity was unexpected and targeted the on-the-run Treasuries, making the spread between the yields on-the-run Treasuries and off-the-run Treasuries enlarged significantly. This was despite the fact that the off-the-run securities were hypothetically cheap in respect to the on-the-run securities, yet they got to be less expensive. LTCM had neglected to consider that a considerable part of its balance sheet was prone to adjustments in the "cost" of liquidity.
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