Hedge world: August 2008

A Short History and the Definition of a Hedge Fund

The first hedge fund was set up by Alfred W. Jones in 1949. Jones was the first to use short sales and leverage techniques in combination. In 1952, he converted his general partnership fund into a limited partnership investing with several independent portfolio managers and created the first multi-manager hedge fund. In the mid 1950's other funds started using the short-selling of shares, although for the majority of these funds the hedging of market risk was not central to their investment strategy.

In 1966, an article in Fortune magazine about a "hedge fund" run by a certain A. W. Jones shocked the investment community. Apparently, the fund had outperformed all the mutual funds of its time, even after accounting for a hefty 20% incentive fee. This is because the rate of return was higher on the hedge fund versus all other mutual funds.

"Hedge fund" is a general, non-legal term that was originally used to describe a type of private and unregistered investment pool that employed sophisticated hedging and arbitrage techniques to trade in the corporate equity markets. Hedge funds have traditionally been limited to sophisticated, wealthy investors. Over time, the activities of hedge funds broadened into other financial instruments and activities. Today, the term "hedge fund" refers not so much to hedging techniques, which hedge funds may or may not employ, as it does to their status as private and unregistered investment pools.

Hedge funds are similar to mutual funds in that they both are pooled investment vehicles that accept investors’ money and generally invest it on a collective basis. However, they are regulated in significantly different ways. Up until 2005, hedge funds in the United States often relied on Section 4(2) and Rule 506 of Regulation D of the Securities Act of 1933 to avoid having to register their securities with the Securities and Exchange Commission of the United States (SEC). Further, to avoid regulation regarding mutual funds (a type of “investment company”), hedge funds relied on Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940. In short, hedge funds escaped most U.S. regulation directed at other investment vehicles such as mutual funds.

European nations regulate hedge funds by either regulating the type of investor who can invest in a hedge fund or by regulating the minimum subscription level required to invest in a hedge fund. In the years to come, experts are predicting the rise of an alternative regulatory framework that will be tiered yet flexible.

The “Hedge Fund Rule” and the Effect on Hedge Fund Clients

The increasing incidence of hedge fund fraud (which exceeded $1 billion in recent years) prompted the SEC to introduce regulations aimed at protecting the security markets. In addition to fraud, the SEC was also concerned with the increasing growth of hedge funds and wanted to find a way to police the $870 billion wrapped up in the hedge fund business. During the 1990s and the early 2000s, hedge funds experienced a five-fold increase in size. Additionally, wealthy individuals were no longer the only investors in hedge funds; instead, pensions, universities, charities, and endowments began to place their money in hedge funds. In order to protect these investors, the SEC revised the Investment Advisors Act of 1940 to create the “hedge fund rule.”

The hedge fund rule, effective February 2005, adopted the interpretation of “client” to mean shareholders, limited partners, members, or beneficiaries of the funds. (Sec. 203(b)(3) of the Investment Advisors Act of 1940). This interpretation required hedge fund advisers previously exempt from registration, since they had less than 15 “clients” under the previous interpretation, to register with the SEC. According to the SEC, mandatory registration was expected to have a number of benefits such as serving as a deterrent to fraud, providing it with examination authority, fostering strong compliance practices and raising standards for investments in hedge funds. However, in June 2006, a D.C. Circuit Court case ruled that the SEC’s interpretation of “client” was incorrect and that clients of hedge fund managers only include the funds they manage, not the individual investors of the funds. Therefore, hedge fund managers who manage fewer than 15 funds are once again exempt from SEC registration. (Goldstein v. SEC)

Hedge funds are also exempt from other requirements that apply to mutual funds for the protection of investors, such as regulations requiring a certain degree of liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to assure fairness in the pricing of fund shares, disclosure regulations, and regulations limiting the use of leverage. These exemptions permit hedge funds to engage in leveraging and other sophisticated investment techniques to a much greater extent, which typically allows them to generate higher returns than other investment vehicles. Of course, like mutual funds, hedge funds are subject to the anti-fraud provisions of U.S. federal securities laws.

Facts about Hedge Funds

Estimated to be a $1 trillion worldwide industry and growing at about 20% per year, with approximately 8350 active hedge funds in the world.
Includes a variety of investment strategies, some of which use leverage while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or derivatives.
Their returns over a sustained period of time have outperformed standard equity and bond indexes with less volatility and less risk of loss than equities.
The popular misconception is that all hedge funds are volatile -- that they all use risky techniques and strategies and place large “bets” on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are of this sort. Most hedge funds use derivatives only for hedging or don’t use derivatives at all, and many use no leverage.

A Classification of Hedge Funds:

It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same -- investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds.

This is a classification of hedge funds:

Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share. This type of fund hedges by shorting equities where earnings disappointment is expected or by shorting stock indexes.
Distressed Securities: Buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Profits from the market’s lack of understanding of the true value of the deeply discounted securities and because the majority of institutional investors cannot own below investment grade securities.
Emerging Markets: Invests in equity or debt of emerging (less mature) markets which tend to have higher inflation and volatile growth. Short selling is not permitted in many emerging markets, and, therefore, effective hedging is often not available.
Fund of Funds: Mixes and matches hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Volatility depends on the mix and ratio of strategies employed.
Income: Invests with primary focus on yield or current income rather than solely on capital gains. May utilize leverage to buy bonds and sometimes fixed income derivatives in order to profit from principal appreciation and interest income.
Macro: Aims to profit from changes in global economies, typically brought about by shifts in government policy which impact interest rates, in turn affecting currency, stock, and bond markets. Participates in all major markets -- equities, bonds, currencies and commodities -- though not always at the same time. Uses leverage and derivatives to accentuate the impact of market moves.
Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer.
http://www.magnum.com/offshore/hedgefunds/mortgagebackedsecurities.asp
Market Neutral - Securities Hedging: Invests equally in long and short equity portfolios generally in the same sectors of the market. Market risk is greatly reduced, but effective stock analysis and stock picking is essential to obtaining meaningful results. Leverage may be used to enhance returns.
Market Timing: Allocates assets among different asset classes depending on the manager’s view of the economic or market outlook.
Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids, and other event-driven opportunities. May utilize several of these investing styles at a given time and is not restricted to any particular investment approach or asset class.
Short Selling: Sells securities short in anticipation of being able to re-buy them at a future date at a lower price due to the manager’s assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments often due to accounting irregularities, new competition, change of management, etc. http://www.magnum.com/offshore/hedgefunds/reducingmarketrisk.asp
Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may be out of favor with analysts. Long-term holding, patience, and strong discipline are often required until the ultimate value is recognized by the market.

Currency Crosses

After going through the School of Pipsology and doing a little demo trading, there’s probably one thing you’ve noticed about trading currencies – it’s all about the US Dollar! Or is it?
Well, with central banks across the world holding trillions in USD reserves, commodities priced in the Greenback, and other major financial transactions passing through the dollar daily, it pretty much IS all about the dollar.

In general, approximately 90% of all transactions in the almost US$2 trillion daily traded Foreign Exchange market involves the dollar. Wow!
Also, in your demo trading, I’m sure you’ve noticed that no matter what major pair you trade (i.e. EURUSD, AUDUSD, USDCHF, etc.) that US news pretty much dominates the movement regardless of data releases from anywhere else. So, why look at anything else besides the major currency pairs?

Well, serious trading opportunities can be found by following the other major currencies with currency crosses, especially if you want to avoid the unpredictable volatility that US dollar can bring.
Hopefully, this lesson will open up your outlook on Crosses and give you basic understanding on how to analyze them.

What is a Currency-Cross?
Basically, a currency-cross is any currency pair in which the US Dollar is neither the base nor counter currency. For example, GBPJPY, EURJPY, EURCAD, and AUDNZD are all considered currency crosses.

Back to Basics

When it comes down to it, currency trading is all about matching weak currencies and strong currencies.
Just find a country that has weak a fundamental outlook or maybe a distressful political situation, and then match it with a country with positive or better fundamentals (i.e. rising employment, growing trade surplus, etc) or maybe a positive political outlook, then you can match their currencies together to make an intelligent directional trade.

Let’s take a look at a recent, real world example:
On January 11th, 2007, both the Bank of England and the European Central Bank were set to release their decisions on their interest rate policy. Leading up to that morning, the markets speculated that the ECB hint that they would raise interest rates soon and the BoE would hold any hikes. Well, what a surprise the market got as the Bank of England raised rates to 5.25% and the ECB held rates at 3.50% on concerns of slowing growth in the Eurozone.
So, why would a currency trading pro, such as yourself, play a currency cross instead of matching either the Euro or the British Pound with the US Dollar? Well, here are a couple of scenarios to think about:

US Retail sales numbers were coming out soon after the interest rate decisions. If you had a weak outlook on the Euro and went short EURUSD, then a weak US Retail report would probably been bad for your trade as the US dollar would sell off.
Or if you maintained a strong outlook on the British Pound and decided to go long GBPUSD, then a dollar rally on a strong US retail sales report would have been very bad for you trade.

After the interest rate releases, we know the outlook on the Euro is weaker and the outlook of the British Pound is stronger, why don’t we just short EURGBP? By taking this trade you get rid of the event risk of upcoming US data, plus you get a positive carry on your position!
Here’s how you may have faired taking a short trade on EURGBP using this analysis:

As you can see from the chart, had you shorted at 0.6650 an hour or so after the interest rate decisions were announced, you would have caught the slow and steady move to 0.6600, and possibly further until fundamentals change for either the Euro or the Pound.
Again, this is just one example of matching weak with relatively stronger currencies. With six major currencies other than the US dollar, there are plenty of possibilities to find profitable trades, and avoid erratic volatility with the US dollar.

Synthetic Pairs

You’ve done your analysis and you’ve come to the conclusion that the British Pound looks strong and the Swiss Franc may get weaker.
Or maybe the Australian dollar is looking pretty good against the Canadian dollar, but you look in your trading platform and see that your broker doesn’t have GBPCHF or AUDCAD.
Oh no! I guess that’s an opportunity missed, right? Heck No! You can create a “synthetic” pair to go long on GBPCHF or AUDCAD.

To create synthetic pairs using the four major currency pairs and three commodity currencies is relatively easy. All it takes is to buy or sell two pairs with equal position sizes.
Let’s say you want to go long the British Pound against the Swiss Franc, or buy GBPCHF.
You would have to buy GBPUSD and buy USDCHF at the same time. Still not clear? Let me show you…

Pretty simple, right? The only trick to it is making sure you buy the same amount of each pair.
Using our GBPCHF example, let’s say the current exchange rate for GBPUSD is 1.9000 and the exchange rate for USDCHF is 1.2500 and you want to buy US$10,000 worth of each pair. Here’s how you do it:

For pairs with USD as the counter currency (i.e. AUDUSD, GBPUSD, EURUSD, etc.), then you would take the dollar amount you want to purchase and divide it by the exchange rate:
US$10,000 (desired position size) divided by 1.9000 (current rate of GBPUSD) = 5263 Units of GBPUSD

For pairs with USD as the base currency (i.e. USDCHF, USDJPY, USDCAD), just purchase amount of units you want to buy because you are buying US dollars
$10,000 (desired position size) * 1 Unit = 10,000 Units
So, to buy US$10,000 worth of GBPCHF, we purchase 5,263 units of GBPUSD (if your broker doesn’t offer flexible lot sizes you can always round up or down) and 10,000 units of USDCHF. Got it? Great! I knew you would!

Summary

As you can see, there are many, many trade opportunities presenting themselves in the foreign exchange market other than figuring out what the Greenback will do any given day - and now you know how to find them! Just remember a few things:

Do your due diligence/analysis and match the weak currencies with strong currencies.
What if the pair you are looking to trade is not available with your broker, no sweat right? You now know how to create synthetic pairs by simultaneously going long or short two major pairs to create one currency cross.
Last tip; please be conscientious of the pip value of the cross you are trading. For example, a standard lot (100,000 units) of EUR/GBP will be approximately $19.70 per pip. Some crosses will have a higher or lower pip value than the majors. This information is good to know for your risk analysis.

So, on the days you many not see any opportunities in the major pairs, or if you want to avoid the volatility of a US news event, check out some the currency crosses. You may never know what you may find! Good luck!

www.babypips.com

Getting a lift from the carry trade

Correctly assessing the risk environment paves the way to capitalizing on the interest-rate differentials between currencies. BY KATHY LIEN

Just as markets that offer the highest returns will attract the most volume, so, too, in the world of international capital flows, nations that offer the highest interest rates will generally attract the most investment and create the most demand for their currencies.

The “carry trade” is a forex strategy based on this reality. Although it is particularly popular among global macro hedge funds, it is actually very simple to understand and execute. Carry trades involve buying (or lending) a currency with a high interest rate and selling (or borrowing) a currency with a low interest rate. With lackluster equity market performance and progressively lower yields from the U.S. bond market as a result of interest rate cuts by the U.S. Federal Reserve, this strategy’s popularity surged in 2002. As money piled into carry trades, unhedged traders enjoyed earning yield and capital appreciation.

If executed correctly, an investor can earn a high return without taking on excessive risk. However, the chances of loss are great if you do not understand how, why and when carry trades work best.

How do carry trades work?

Traders looking to “earn carry” will buy a high-yielding currency while simultaneously selling a low-yielding currency. Carry trades are profitable because an investor is able to earn the difference in interest (the spread) between the two currencies as well as, ideally, capital appreciation. Table 1 lists the interest rates of several major countries as of Sept. 22.

TABLE 1 — GLOBAL INTEREST RATES
Country	Interest rate
New Zealand (NZD)	6.25%
Australia (AUD)	5.25%
United Kingdom (GBP)	4.75%
Canada (CAD)	2.25%
Europe (EUR)	2.00%
United States (USD)	1.75%
Japan (JPY)	0.00%
Switzerland (CHF)	0.75%
*As of Sept. 22, 2004

The reason this trade is so popular is because it’s not limited to speculators.Imagine you are an investor in Switzerland who is earning an interest rate of 0.75-percent per year on your bank deposit denominated in Swiss francs (CHF). At the same time, a bank in Australia is offering 5.25 percent per year on a deposit denominated in Australian dollars (AUD). Seeing that interest rates are much higher at the Australian bank, wouldn’t you want to convert your Swiss francs into Australian dollars?

Large investors who are able to move money freely across borders will take advantage of higher yields offered abroad. By trading their deposit of Swiss francs paying 0.75 percent for a deposit of Australian dollars paying 5.25 percent, what these investors have effectively done is “sell” their Swiss franc deposit, and “buy” an Australian dollar deposit.

After this transaction they now own an Australian dollar deposit that pays 5.25 percent in interest per year — 4.50 percent more than the Swiss franc deposit. This is a carry trade. The net effect of millions of people doing this transaction is that capital flows out of Switzerland and into Australia as investors take their Swiss francs and trade them for Australian dollars. Australia attracts more capital because of the higher rates it offers.

This capital inflow increases the value of the currency Aside from earning the 4.50- percent interest rate differential, traders engaging in such unhedged carry trades are also hoping, as in this example, their Australian dollar deposits appreciate in value against the Swiss franc.

Let’s look at another example. Assume the British pound (GBP) offers an interest rate of 4.75 percent, while the Swiss franc offers an interest rate of 0.75 percent. To execute the carry trade, an investor buys the British pound and sells the Swiss franc — or, buys the GBP/CHF currency pair (see Figure 2). In doing so, he or she can earn a profit of 4 percent (4.75 percent in interest earned minus 0.75 percent in interest paid), as long as the exchange rate between the British pound and Swiss franc remains stable.

The leveraged carry trade

Now, a 4-percent annualized yield may not sound very attractive, but when you factor in leverage, the profits are noticeably higher (as are the risks). Although many FX firms offer up to 200:1 leverage, we will look at a more conservative example that employs 20:1 leverage.

Let’s say you have $5,000 to invest and decide to put $1,000 of that into a carry trade. The original 4.75 percent yield would earn you $47.50 over the course of the year or approximately $0.13 per day. With 20:1 leverage, the buying power of your $1,000 becomes $20,000. Interest then becomes $950 per year or $2.64 per day on the original investment — a return of 95 percent. Now here is where we insert the caution statement: This scenario works only if the underlying values of the currencies do not move — which of course is not possible. Currency values fluctuate every second. Therefore, using higher leverage also means you incur the possibility of larger losses.

For example, instead of a 10-pip (or point) fluctuation in the euro-U.S. dollar rate (EUR/USD) representing $1, 20:1 leverage magnifies it to $20 — and currencies will fluctuate dramatically. Between September 2003 and July 2004, the Australian dollar strengthened nearly 15 percent against the U.S. dollar (see Figure 3, p. 7). If you factor in the currency appreciation and interest rate return on leverage, the profits can be sizeable. However, 15 percent depreciation could have just as easily occurred, which would significantly hurt a leveraged trade.

Because most traders engaging in this type of strategy are looking to earn both yield and the appreciation of the currency pairs, the next question is, how do you determine the type of environment in which carry trades will

perform well?

When will carry trades work best?

Carry trades generally are most profitable when investors as a whole have a very specific attitude toward risk. Psychology drives the markets and people’s moods tend to change over time. Sometimes they may feel more daring and willing to take chances, other times they may be more timid and conservative. Investors, as a group, are no different. Sometimes they are willing to make relatively high risk investments, other times they are morefearful and seek safer assets.

When investors as a whole are willing to assume risk, we say they have low risk aversion, or, in other words, they are comfortable taking risk. When investors re drawn to more conservative investments and are less willing to take on risk, we say they have high risk aversion (see Table 2).

TABLE 2 — CONDITIONS FOR CARRY TRADE
Carry trade profitability
(-)	(+)
High risk aversion	Low risk aversion
Investors are less willing to take risks; they remove funds from risky currencies.	Investors are more willing to take risks.


Capital flows out of riskier high-interest currencies and into low-interest, “safe-haven” currencies	Capital flows away from low-interest currencies and into those that pay higher interest rates



Low-interest currencies appreciate as investors get out of risky trades	Low-interest currencies tend to remain weak, and are used to finance risky trades.


Source: FXCM

Carry trades are most profitable when investors have low risk aversion, which makes sense when you consider what a carry trade involves. When buying a currency with a high interest rate, the investor is taking a risk — there is uncertainty about whether the country’s economy will continue to perform well and be able to pay high interest rates.

Countries with better growth prospects can afford to pay higher interest rates on the money that is invested in them, but there is always a chance something might change. Ultimately, investors must be willing to take this chance. If investors as a whole were not willing to take on this risk, then capital would never move from one country to another, and the carry-trade opportunity would not exist.

Other considerations

While risk aversion is one of the most important things to consider before making a carry trade, it is not the only one. Here are some additional issues to take into account.

Low interest rate currency appreciation: Even if market participants are in risk-seeking mode, there are factors that can lead to a rally in the currency with the lower interest rate. When the low interest rate currency in a carry trade (the currency being sold) appreciates, it negatively affects the profitability of the carry trade.

For example, geopolitical risks or fears of terrorism tend to have a positive affect on the Swiss franc, which is widely considered the “safe-haven” currency. In Japan, although interest rates are low, increased optimism about the Japanese economy has recently led to an increase in the Japanese stock market.

Increased investor demand for Japanese stocks and currency has caused the yen to appreciate, and this yen appreciation negatively affects the profitability of carry trades such as the Australian dollar (high interest rate) vs. Japanese yen.

Trade balances: Trade balances (the difference between a country’s imports and exports) can also affect the profitability of a carry trade. When investors have low risk aversion, capital will typically flow from the low interest rate paying currency to the high interest rate paying currency. However, this does not always happen.

To understand why, consider that even though Japan currently pays historically low interest rates, there is strong demand for the Japanese yen. Although this can be attributed partially to the country’s recent recovery, a more important factor is Japan’s huge trade surplus. There is strong foreign demand for Japanese goods — electronics, cars, etc. As a result, although the country offers low rates of return, Japan attracts trade flows into the yen. The point is that even when investors have low risk aversion, large trade imbalances can cause a low interest rate currency to appreciate.

Time-horizon: In general, a carry trade is a long-term strategy. Before entering into a carry trade, an investor should be willing to commit to a time horizon of at least six months. This commitment helps to make sure the trade will not be affected by the “noise” of shorter-term currency price movements.

When to close the carry trade

Because carry trades are least profitable when investors are highly risk averse, traders who already have carry trades must stay abreast of the risk environment and prepare for when it changes.

Investors’ willingness to make risky trades can change dramatically from one moment to the next. Often such large shifts are caused by significant global events. When investor risk aversion does rise quickly, the result is generally a large capital inflow into low-interest rate, “safe-haven” currencies.

Such conditions can set the stage for carry trades to lose money. For example, in the summer of 1998 the Japanese yen appreciated against the dollar by more than 20 percent in two months, mainly because of the Russian debt crisis and the LTCM hedge-fund bailout. Similarly, just after the Sept. 11, 2001, terrorist attacks, the Swiss franc rose by more than 7 percent against the dollar over a 10-day period.

Bottom line

The leveraged carry trade strategy is still very popular in the currency markets. By properly assessing the risk environment, traders can increase the probability of successfully executing the carry trade strategy.

Kathi Lien – activetrademag.com

Arbitrage

There is no free lunch.

Old Stock Exchange adage

Arbitrage strategies are very popular in the hedge fund world, but before turning to their description, it is necessary to clarify the specific meaning of the term “arbitrage” in this context.

From an academic point of view, an arbitrage stands for a risk-free transaction that generates an instant profit: a theoretical example of arbitrage is the concurrent purchase and sale of the same security on different markets at different prices. By buying the same security at a lower price and selling it right away at a higher price, an arbitrageur earns an immediate profit at no risk, saving the settlement and delivery risks.

But in the hedge fund business the term arbitrage has developed a different sense, in that it does not refer to risk-free positions, but rather to positions involving risks other than the market risk. Hedge fund arbitrages in practice are directional positions on spreads: if the spread widens or narrows as anticipated, the manager makes a profit; otherwise he suffers a loss. Therefore we must not be misled by the word arbitrage: a hedge fund may well suffer a loss even when it has constructed an arbitrage position – what it takes, is for the spread to widen or narrow contrary to predictions.

An arbitrage opportunity may appear when given technical, geographical, legal or administrative barriers interfere with the correct interaction between two markets trading the same security, thus preventing the security from having the same price on both markets.

In a perfect world, there would be no arbitrage opportunities, and in the real world most arbitrage opportunities tend to disappear quickly, unless there are high transaction costs that hamper frequent arbitrages. Over time, inevitably, other arbitrageurs will get organized to take advantage of arbitrage opportunities, narrowing down the price difference until it disappears. Arbitrage opportunities draw various arbitrageurs to the market, and they will erode each other’s profits by competing against one another. Once again, to make a return it is necessary to take on risks!

It is important to note that arbitrageurs are not asked to forecast the absolute movement of two securities, but rather the relative movement of one over the other, irrespective of market direction.

Any arbitrage opportunity faces so-called steamroller risks. Through a colorful analogy, an arbitrageur is seen as somebody who picks up a few coins from the ground in front of a moving steamroller: the man runs no risk provided he never forgets that the steamroller is forging ahead towards him. In order to earn a few coins the man runs the risk of being steamrolled.

Risks can also come from regulatory or tax changes, which may force the arbitrageur to close a position while losing money. Or, as illustrated below in the ADR arbitrage example, sometimes conditions regulating the short sale of a security may change suddenly, and the security may be called in by the owner; or sometimes the borrowed security may pay out a dividend, which is going to represent an unexpected cost for the arbitrageur.

The greater the number of arbitrageurs operating on a given market, the higher the competition, which means that the returns realized by the arbitrageurs will be lower. The current trend in the hedge fund business is that the massive money flow towards arbitrage strategies makes it more and more difficult for managers to generate interesting returns.

Most of the low-hanging fruits have already been picked!

This article is a part of “Investment Strategies of Hedge Funds” ebooks by Filippo Stefanini for closed private educations only. You should buy his books for the best completely informations.

The Carry Trade

Did you know there is a trading system that can make money if price stayed exactly the same for long periods of time?

Well there is and it’s one the most popular ways of making money by many of the biggest and baddest money manager mamajamas in the financial universe!
It's called the Carry Trade.

A carry trade involves borrowing or selling a financial instrument with a low interest rate, then using it to purchase a financial instrument with a higher interest rate. While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased. Thus your profit is the money you collect from the interest rate differential. For example:

Let's say you go to a bank and borrow $10,000. Their lending fee is 1% of the $10,000 every year. With that borrowed money, you turn around and purchase a $10,000 bond that pays 5% a year.
What's your profit?
Anyone?

You got it! It's 4% a year! The difference between interest rates!
By now you're probably thinking, "That doesn't sound as exciting or profitable as catching swings in the market." However, when you apply it to the spot forex market, with its higher leverage and daily interest payments, sitting back and watching your account grow daily can get pretty sexy.

How Does the Carry Trade Work for Forex?

In the forex market, currencies are traded in pairs (for example, if you buy the USDCHF pair, you are actually buying the US dollar and selling Swiss Francs at the same time). Just like the example above, you pay interest on the currency position you sell, and collect interest on the currency position you buy.

What makes the carry trade special in the spot forex market is that interest payments happen every trading day based on your position. Technically, all positions are closed at the end of the day in the spot forex market - you just don't see it happen if you hold a position to the next day.
Brokers close and reopen your position, and then they debit/credit you the overnight interest rate difference between the two currencies. This is the cost of "carrying" (also known as “rolling over”) a position to the next day.

The amount of leverage available from forex brokers has made the carry trade very popular in the spot forex market. Forex trading is completely margin based, meaning you only have to put up a small amount of the position and you broker will put up the rest. Many brokers ask as little as 1% - 2% of a position - what a deal, eh?

Let's take a look at a generic example to show how awesome this can be.
For this example we'll take a look at Joe the newbie forex trader. It's Joe's birthday and his grandparents, being the sweet and generous people they are, give him $10,000. Schweeeet!
Now, instead of going out and blowing his birthday present on video games and posters of bubble gum pop stars, he decides to save it for a rainy day. Joe goes to the local bank to open up a savings account and the bank manager tells him, "Joe, your savings account will pay 1% a year on your account balance. Isn't that fantastic?" Joe pauses and thinks to himself, "At 1%, my $10,000 will earn me $100 in a year. Man, that sucks!"

Joe, being the smart guy he is, has been studying BabyPips.com and knows of a better way to invest his money. So, Joe kindly responds to the bank manager, "Thank you sir, but I think I’ll invest my money somewhere else yo.”

Joe has been demo trading several systems, including the carry trade, for over a year, so he has a pretty good understanding of how forex trading works. He opens up a real account, deposits his $10,000 birthday gift, and puts his plan into action. Joe finds a currency pair whose interest rate differential is +5% a year and he purchases $100,000 worth of that pair. Since his broker only requires a 1% deposit of the position, they hold $1,000 in margin (100:1 leverage). So, Joe now controls $100,000 worth of a currency pair that is receiving 5% a year in interest.
What will happen to Joe’s account if he does nothing for a year?
Well, here are 3 possibilities.Let’s take a look at each one:

Currency position loses value. The currency pair Joe buys drops like a rock in value. If the loss brings the account down to the amount set aside for margin, then the position is closed and all that’s left in the account is the margin - $1000.
The pair ends up at the same rate at the end of the year. In this case, Joe did not gain or lose any value on his position, but he collected 5% interest on the $100,000. That means on interest alone, Joe made $5,000 off of his $10,000. That’s a 50% gain! Sweet!
Currency position gains value. Joe’s pair shoots up like a rocket! So, not only does Joe collect $5000 in interest on his position, but he also takes home any gains! That would be a nice present to himself for his next birthday!

Because of 100:1 leverage, Joe has the potential to earn around 50% a year from his initial $10,000. Here is an example of a currency pair that offers a 5% differential rate based on current interest rates:

If you buy USD/JPY and held it for a year, you earn a "positive carry" of 5%.
Of course, if you sell USD/JPY, it works the opposite way:

If you sold USD/JPY and held it for a year, you would earn a "negative carry" of 5%.
Again, this is a generic example of how the carry trade works. Any questions on the concepts? No? I knew you could catch on quick! So, now it’s time to move on to the most important part of this lesson: Carry Trade Risk.

Carry Trade Risk

Being that you are a professional trader, you already know what the first question you should ask before entering a trade is, right?

“What is my risk?”

Correct! Before entering a trade you must always asses your max risk and whether or not it is acceptable according to your risk management rules.

In the previous example with Joe the Newbie Trader, his maximum risk would have been $9000. His position would be automatically closed out once his losses hit $9000.
Eh? That doesn’t sound very good, does it?

Remember, this is the worst possible scenario and Joe is a newbie, so he hasn’t fully appreciated the value of stop losses.

When doing a carry trade, you can still limit your losses like a regular directional trade. For instance, if Joe decided that he wanted to limit his risk to $1000, he could set a stop order to close his position at whatever the price level would be for that $1000 loss. He would still keep any interest payments he received while holding onto the position.

Carry Trade Criteria

It’s pretty simple to find a suitable pair to do a carry trade. Look for two things:

Find a high interest differential.
Find a pair that has been in an uptrend – where the currency you are long has been gaining value against the currency you are short.

Pretty simple, huh? Let’s take a real life example of the carry trade in action:

This is a weekly chart of GBP/JPY. Up until recently, the Bank of Japan has maintained a Zero Interest Rate Policy (current interest rate is 0.25% as of this writing - 11/01/2006). With the Bank of England touting one of the higher interest rates among the major currencies (currently at 4.75% as of this writing), many traders have flocked to this pair (one of the factors creating a nice little uptrend in the pair). From the end of 2000 to mid-2006, this pair moved from a price of 150.00 to 223.00 – that’s 7300 pips! If you couple that with interest payments from the interest rate differential of the two currencies, this pair has been a nice long term play for many investors and traders able to weather the volatile up and down movements of the currency market.
Of course, economic and political factors are changing the world daily. The interest rates and interest rate differentials between currencies may change as well, bringing popular carry trades (such as the Yen carry trade) out of favor with investors.

Summary

As you can see there are other ways to make money in the forex market without having to buy low and sell high, which can be pretty tough to do day after day.
If you catch the right pair (one with a positive interest rate differential) at the right time, then you’ll be sure to do well collecting money out of the market.
When properly applied, the carry trade can add significant income to your account, along with your directional trading strategies.

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HEDGE FUND INVESTMENT STRATEGIES

Hedge funds invest in CDOs with three different strategies:

1. Carry trade;

2. Long/short structured credit;

3. Correlation trade.

These strategies enable hedge fund managers to express certain views on credit markets efficiently.

Carry Trade

This is the easiest and riskiest CDO strategy and consists of buying the equity tranche of CDOs. The return generated by the equity tranche depends on the leverage, the maturity and the composition of the basket of credit forming the CDO. Purchasing CDO equity tranches is equal to selling credit protection.

In June 2003, a hedge fund bought Fixed Income Senior Notes for a par value of $5.5 million (hereafter called simply “Notes”) totaling $148 million. These Notes were part of the CDO tranche with the higher claim collateralized by a private placement of high-yield bonds carried out in 1998. The issuance also included another tranche of Senior Notes, characterized by a floating rate for a par value of $34 million.

The Notes subscribed by the hedge fund were due on August 2010 and paid a fixed 6.71% yearly coupon. Technically the issue had defaulted, and the rating of the tranche subscribed by the hedge fund had deteriorated, going from AA3 in 1998 to Baa3 in 2002, turning into a “container” receiving all the capital and interest payments, which were used to pay Senior Notes first, both at a fixed and floating rate, and Subordinated Notes next.

At the time of purchase in June 2003, the par value of the Notes was $4.26 million and the hedge fund bought them for $3.63 million. The Notes were then bought for a price of 85.27 cents, at a substantial discount on the liquidation value of 94.73 cents.

At the time of purchase, the hedge fund had made a conservative assumption according to which 30% of the high-yield bonds would default and the recovery rate would be of 28 %. As a result, the internal rate of return had been fixed at 13.64 %. The investment was expected to be paid back in 3.5–4 years.

At the time of purchase, the underlying portfolio comprised 117 high-yield bonds characterized by an average price of 74.97 cents, including defaulted securities. The initial analysis conducted by the hedge fund also included the expectation that over the short term the default rate of the collateral high-yield bonds would rise, only to decrease again during the residual life of the securities.

Two months after the Notes had been purchased by the hedge fund, $949 786 had been paid out in terms of capital redemptions for the underlying high-yield notes (accounting for more than 25% of the initial original cost incurred by the hedge fund), against an initial estimate of $500 000. Over the same period, $142 808 worth of interest were also paid out. Moreover, the price of the Notes grew significantly with respect to the initial cost incurred by the hedge fund.

The improved performance of the collateral and the higher than expected capital redemptions generated a return on investment of 15.88 %, well above the estimated 13.64 %.

Long/short Structured Credit

This strategy’s objective is to generate absolute returns, regardless of economic and market conditions such as credit spread moves and the general direction of interest rates. The strategy is naturally long credit and benefits from spread tightening. The effect of market spread widening on long positions can be offset by the manager’s ability to short credits that widen more than the general market in a deteriorating environment. The fund employs fundamental credit analysis to determine long and short relative-value positions in different corporate credits. The fund expresses long views through the purchase of CDO equity tranches, and short views through the purchase of single-name Credit Default Swaps.

The long position in CDO equity tranches locks in positive carry. Furthermore, the ability of the hedge fund manager in performing the credit analysis on the companies underlying the CDO generates the trading ideas: a CDO is a basket of credits and the manager can choose inside this basket the credits he wants to be long or short. So the manager can take advantage of opportunities ranging from sector allocation, allocation to single companies and relative-value trading. Finally, the manager can limit the downside from spread widening through the long positions in credit default swaps.

The ideal portfolio built with long positions in CDO equity tranches and with long positions in CDS can have a convexity return profile: an instantaneous equal proportional shift in all spreads, assuming correlation remains constant, should have positive returns irrespective of spread moves. The most difficult challenge for a hedge fund manager implementing this strategy is the ability to manage the correlation risk among the CDO tranches.

Correlation Trade

CDOs are a recent innovation that enable investors to buy (or sell) limited protection on credit portfolios. The protection attaches (and detaches) once the portfolio realizes certain default losses. The proper compensation for bearing this specialized risk depends not only on the individual portfolio credits, but also on their prospective dynamics, including their prospective interplay. People use the term “correlation” to discuss this interplay, and the term “correlation trading” to capture involvement in these tranched portfolio protection products.

In a correlation trade, credit protection is sold via the purchasing of CDO equity tranches delta-hedged with credit default swaps (CDS). The correlation trade consists of assuming a long position in the equity tranche of a certain CDO and a simultaneous short position in the mezzanine tranche (or a more senior tranche) of the same CDO, in the attempt to take advantage of the spreads among the different tranches of the CDO. This way the hedge fund is long the implied correlation among the CDO tranches.

Note that the implied correlation is primarily a market-based factor, driven by the demand and supply of protection for each individual CDO tranche. This trade has a positive carry, and returns can be generated if the credit spreads in the underlying portfolio move in a parallel way, that is, widen or shrink simultaneously. The correlation trade is exposed to the risk of an unexpected default in the underlying CDO portfolio but, given that in 2005 the prevailing default rate is at historically low levels, many hedge fund managers are comfortable with assuming that risk.

Some investors are reluctant to embrace correlation trading as a model-driven arbitrage strategy. On 4th May 2005, Tracinda Corp., a company that already owned about 4% of General Motors, offered $870 million to acquire 4.95% of General Motors, and GM shares at the end of the day jumped by 18.1 %. On 5th May 2005, Standard & Poor’s had downgraded the GM bonds (from BBB– to BB) to the status of “junk bond”, maintaining a negative outlook.

This was a surprising capital structure movement, where the riskiest part of the capital, equities, jumped at a time when the less risky part of the capital, bonds, dropped. Many hedge funds were positioned in a correlation trade: they had short positions (buy protection) in CDO senior tranches and long positions (sell protection) in CDO equity tranches, delta-hedging with single-name CDS or iBoxx index. This correlation trade expected implied correlation to increase and had positive carry.

Because of the downgrade of GM, the equity tranche of many CDOs declined sharply while the mezzanine tranche soared because of a “fly to quality” movement. This means that the spreads moved in a non-parallel way. Merrill Lynch estimated that the CDO correlation trades in April lost 12 %, and for some hedge funds this loss was worsened by the use of leverage.

CONCLUSIONS

The important point to note is that these new strategies are relatively untried and untested in periods of market stress, and hence investors could underestimate certain risks, i.e. correlation.

This article is a part of “Investment Strategies of Hedge Funds” ebooks by Filippo Stefanini for closed private educations only. You should nuy his books for the best completely informations.

About hedge - wikipedia

In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity. Typically, a hedger might invest in a security that he believes is under-priced relative to its "fair value" (for example a mortgage loan that he is then making), and combine this with a short sale of a related security or securities. Thus the hedger is indifferent to the movements of the market as a whole, and is interested only in the performance of the 'under-priced' security relative to the hedge. Holbrook Working, a pioneer in hedging theory, called this strategy "speculation in the basis,^[1] where the basis is the difference between the hedge's theoretical value and its actual value (or between spot and futures prices in Working's time).

Some form of risk taking is inherent to any business activity. Some risks are considered to be "natural" to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. Someone who has a shop, for example, expects to face natural risks such as the risk of competition, of poor or unpopular products, and so on. The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract. Not all hedges are financial instruments: a producer that exports to another country, for example, may hedge its currency risk when selling by linking its expenses to the desired currency. Banks and other financial institutions use hedging to control their asset-liability mismatches, such as the maturity matches between long, fixed-rate loans and short-term (implicitly variable-rate) deposits.

Origins

The term is derived from the phrase "hedging your bets" used in gambling games such as roulette. The hedges on a roulette table are the lines between numbers or number groups. Placing a hedged bet is one where the chips lie across one or more hedges (i.e. on a line between two numbers or on a corner between three or four numbers). The bet then covers all the numbers involved at an appropriately reduced stake (e.g. 1/2, 1/3, 1/4).

The term gradually moved into common usage within English-speaking cultures and today covers a broad range of risk-reduction activities or conditions.
In the finance lending industry, the term "hedge loan" has come to mean a specific type of financial product based on the melioration of price fluctuation risk in a stock portfolio serving as collateral for a nonrecourse debt structured stock loan.

Example hedge

A stock trader believes that the stock price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets. He wants to buy Company A shares to profit from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation.

Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares × price) of the shares of Company A's direct competitor, Company B. If the trader were able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a call option on Company A shares) the trade might be essentially riskless and be called an arbitrage. But since some risk remains in the trade, it is said to be "hedged."
The first day the trader's portfolio is:

Long 1000 shares of Company A at $1 each
Short 500 shares of Company B at $2 each

(Notice that the trader has sold short the same value of shares.)
On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, goes up by 10%, while Company B goes up by just 5%:

Long 1000 shares of Company A at $1.10 each — $100 gain
Short 500 shares of Company B at $2.10 each — $50 loss

(In a short position, the investor loses money when the price goes up.)
The trader might regret the hedge on day two, since it reduced the profits on the Company A position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash -- 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B:
Value of long position (Company A):

Day 1 — $1000
Day 2 — $1100
Day 3 — $550 => $450 loss

Value of short position (Company B):

Day 1 — -$1000
Day 2 — -$1050
Day 3 — -$525

Without the hedge, the trader would have lost $450. But the hedge - the short sale of Company B - gives a profit of $475, for a net profit of $25 during a dramatic market collapse.

Types of hedging

The example above is a "classic" sort of hedge, known in the industry as a "pairs trade" due to the trading on a pair of related securities. As investors became more sophisticated, along with the mathematical tools used to calculate values, known as models, the types of hedges have increased greatly.

Natural hedges

Many hedges do not involve exotic financial instruments or derivatives. A natural hedge is an investment that reduces the undesired risk by matching cash flows, i.e. revenues and expenses. For example, an exporter to the United States faces a risk of changes in the value of the U.S. dollar and chooses to open a production facility in that market to match its expected sales revenue to its cost structure. Another example is a company that opens a subsidiary in another country and borrows in the local currency to finance its operations, even though the local interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the local currency, the parent company has reduced its foreign currency exposure.

Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but faces costs in a different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in U.S. dollars.

One of the oldest means of hedging against risk is the purchase of insurance to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life.

Categories of hedgeable risk

For the following categories of the risk, for exporters, that the value of their accounting currency will fall against the value of the importers, also known as volatility risk.

Interest rate risk – is the risk that the relative value of an interest-bearing asset, such as a loan or a bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using fixed income instruments or interest rate swaps.
Equity – the risk, or sometimes reward, for those whose assets are equity holdings, that the value of the equity falls
Securities Lending - Hedged portfolio stock secured loan financing (see HedgeLoan) is a form of individual portfolio risk reduction that results typically in a limited recourse loan.

Futures contracts and forward contracts are a means of hedging against the risk of adverse market movements. These originally developed out of commodity markets in the nineteenth century, but over the last fifty years a huge global market developed in products to hedge financial market risk.

Hedging credit risk

Credit risk is the risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks, but an unwanted risk for commercial traders, naturally an early market developed between banks and traders: that involving selling obligations at a discounted rate. See for example forfeiting, bill of lading, or discounted bill.

Hedging currency risk

Currency hedging (also known as Foreign Exchange Risk hedging) is used both by financial investors to parse out the risks they encounter when investing abroad, as well as by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure.

For example, labor costs are such that much of the simple commoditized manufacturing in the global economy today goes on in China and South-East Asia (Philippines, Vietnam, Indonesia, etc.). The cost benefit of moving manufacturing to outsource providers outweighs the uncertainties of doing business in foreign countries, so many businesses are moving manufacturing operations overseas. But the benefits of doing this have to be weighted also against currency risk.

If the price of manufacturing goods in another country is fixed in a currency other than the one that the finished goods will be sold for, there is the risk that changes in the values of each currency will reduce profit or produce a loss. Currency hedging is akin to insurance that limits the impact of foreign exchange risk.

Currency hedging is not always available, but is readily found at least in the major currencies of the world economy, the growing list of which qualify as major liquid markets beginning with the "Major Eight" (USD, GBP, EUR, JPY, CHF, HKD, AUD, CAD), which are also called the "Benchmark Currencies", and expands to include several others by virtue of liquidity.

Currency hedging, like many other forms of financial hedging, can be done in two primary ways: with standardized contracts, or with customized contracts (also known as over-the-counter or OTC).

The financial investor may be a hedge fund that decides to invest in a company in, for example, Brazil, but does not want to necessarily invest in the Brazilian currency. The hedge fund can separate out the credit risk (i.e. the risk of the company defaulting), from the currency risk of the Brazilian Real by "hedging" out the currency risk. In effect, this means that the investment is effectively a USD investment, in Brazil. Hedging allows the investor to transfer the currency risk to someone else, who wants to take up a position in the currency. The hedge fund has to pay this other investor to take on the currency exposure, similar to insuring against other types of events.

As with other types of financial products, hedging may allow economic activity to take place that would otherwise not have been possible (as a loan, for example, may allow an individual to purchase a home that would be "too expensive" if the individual had to pay cash). The increased investment is assumed in this way to raise economic efficiency.

source : http://en.wikipedia.org

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