- Word count: 778
- Category: Investment
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1.What is a hedge fund? How do hedge funds differ from mutual funds?
According to our case, Hedge funds are private group investments that offer equity pooling advantages. Hedge funds have limited partnership which are restricted by law to no more than 1000 investors per fund, so hedge funds set extremely high minimum investment amounts, ranging anywhere from $250,000 to over $1 million. Hedge funds not only require investors pay a management fee, but also collect a percentage of the profits (Investor words). Hedge funds can use multiple ways such as buying and selling undervalued securities and trading options and bonds to reduce risk for investors. Compared to Mutual funds, they are not publicly owned, less regulated, and more privileges. Also, it is have more flexible in investment strategies and risk management than mutual funds. Moreover, Hedge funds differ from mutual funds is their ability to use leverage and their ability to hedge by shorting or using options. Hedge funds can use leverage, but for most part of mutual funds cannot use leverage, so hedge funds can result in a higher return on equity by using debt to finance a portion of the assets in a portfolio. Furthermore, hedge funds have the ability to use options to hedge the of investors’ investment (Pine street capital).
2. What risks does PSC want to hedge and what risks is PSC willing to bear? Why? How would hedge these risks on July 26 using a short-sale strategy? What problems arise with the short-sale strategy?
One of the common investment strategies for Hedge Funds is to leverage those risks that they understand and hedge the risks where they feel they do not have enough expertise. Pine Street Capital specialized in the technological sector. Their competitive advantage lay in their ability to single out performing stocks in the technological sector. On the other hand, they did not feel too comfortable in assessing the movements of the market. As a result, their investment strategies aimed at hedging the general market risk by short-selling while willing to bear the risks of companies in the technological sector. In order to use the short-sale strategy, Pine Street Capital used the following model: Expected PSC Portfolio Return = α+β*(Market Return)
β= market risk of the portfolio
α= expected return if the market risk is eliminated
Thus, Pine Street Capital would hedge by short selling, an amount equivalent to the value of the portfolio value multiplied by β. By short selling, Pine Street Capital would have a neutral position on the market return. This is because if the market would go up, the loss from the short sale would be compensated by the gain made on the long position of the portfolio. On the other hand, when the market would go down, the loss made on the long position would be compensated by the gain made on the short sale. Since the market risk would be eliminated by this strategy, Pine Street Capital’s return on the portfolio would be α. The problem with this strategy was that Pine Street Capital did not hedge the risk of the company stocks in the portfolio. Thus, in the event of the market going down, if these stocks too reflected the market movement (-α), then the portfolio would incur huge amounts of loss. 3. SC is considering using options for its hedging program. How does options hedging help with PSC’s problems?
How would you hedge PSC’s portfolio using options on July 26? 1.PSC is a hedge fund and it uses leverage to increase the return on Equity. Use of Leverage increases the risk of investment. 2.The rate of return of hedged portfolio is more stable than unhedged portfolio, though, Hedging limits the potential gain; it with put options protects the portfolio from downside risks. 3.Short Sale hedging strategy proved to be partially effective during last months, the most damage done on two consecutive dips on Nasdaq. 4.By Exhibit 8, Changes in Equity using different hedge strategies, its clearly visible that historically, put option hedging would have created more Equity value than any other strategy. 5.PSC doesn’t want to let go leverage, as Fund has huge expectations from Tech stocks in near future. Use of put options allows PSC to keep using Leverage, protecting against any large fluctuations.
The Black Scholes Formula for option pricing is used in Ms Excel sheet attached. Given :
Stock Price at 26th July, 2000 : $95.63
Beta of Fund at 26th July, 2000 : 2.41
Portfolio Value at 26th July, 2000 : $34.55 Million
Volatility (by Exhibit 7) : 55%
T-Bill rates: 1 month: 5.97%
2 Month: 6.13%
Black Scholes Formula = Ke^(-rT)* N(-d2) – Se^(-δT)*N(-d1) Δ = e^(-δT)*N(d1)