Table of Contents

Preface xiii

Acknowledgments xvii

About the Author xix

1 A Few Initial Remarks 1

1.1 What is a hedge fund? 1

1.2 History of hedge funds 2

1.3 Proprietary trading 4

1.4 The growth of the hedge fund industry 4

1.5 Main characteristics of the current industry 6

1.6 Capacity 8

1.7 Commissions 8

1.8 Industry performance overview 9

1.9 The hedge fund manager 12

1.10 Alpha and beta 12

1.11 Investment strategies 13

1.12 Explorers and frontiers 16

1.13 SEC’s vigilance 16

1.14 Considerations on performance sustainability 16

1.15 Capacity and performance sustainability 17

1.16 Ability or chance? 17

1.17 The importance of avoiding losses 18

1.18 Decreasing returns with longer investment horizons 19

1.19 Business case: A hedge fund start-up 19

2 Arbitrage 21

2.1 The transaction costs barrier 22

2.2 ADR arbitrage 23

2.3 Arbitrage between off-the-run and on-the-run thirty-year Treasury Bonds 24

3 Short Selling 27

3.1 A brief history of short selling 27

3.2 What is short selling? 30

3.3 A simplified example of short selling on US markets 31

3.4 Who lends securities for short selling? 32

3.5 Regulations governing short selling 33

3.6 The risks of short selling 34

3.7 Short interest and short interest ratio 35

3.8 Wall Street’s alter ego 36

3.9 Stock picking in short selling 37

3.10 The art of contrary thinking 41

3.11 Measuring the strategy’s historical performance 42

3.12 Conclusions 45

4 Long/Short Equity 47

4.1 History of the first hedge fund 48

4.2 Market exposure 48

4.3 Management styles 52

4.4 Specialized long/short equity funds 55

4.4.1 Long/short equity technology-media-telecommunication (TMT) 56

4.4.2 Long/short equity biotech 57

4.4.3 Long/short equity gold 58

4.4.4 Long/short equity on emerging markets 58

4.5 Share class arbitrage 62

4.6 Pairs trading 62

4.7 Covered call and covered put options sale 64

4.8 Strategy’s historical performance analysis 65

4.9 Equity market neutral 69

4.9.1 Equity market neutral strategy’s historical performance analysis 70

5 Merger Arbitrage 75

5.1 A brief history of M&A 76

5.2 Strategy description 82

5.3 Risk associated with the outcome of an extraordinary corporate event 83

5.4 Types of mergers and acquisitions 86

5.4.1 Cash mergers or tender offers 86

5.4.2 Stock swap mergers or stock-for-stock mergers 87

5.4.3 Stock swap mergers with a collar 89

5.4.4 Multiple bidder situations 90

5.4.5 Leveraged buyouts and hostile takeovers 90

5.4.6 Spin-offs 92

5.5 Risk management 92

5.6 Strategy’s historical performance analysis 93

5.7 Conclusions 96

6 Convertible Bond Arbitrage 99

6.1 Why issue a convertible bond? 101

6.2 A brief history of convertible bonds 101

6.3 The convertible bond market 102

6.4 Definitions 106

6.5 Quantitative models to value convertible bonds 107

6.5.1 Analytical models 108

6.5.2 Numerical models 109

6.6 Implied volatility and historical volatility 110

6.6.1 Credit spreads, implied volatility and risk appetite 110

6.7 Convertible bond arbitrage 110

6.7.1 Cash-flow arbitrage 111

6.7.2 Volatility trading 113

6.7.3 Gamma trading 117

6.7.4 Credit arbitrage 120

6.7.5 Skewed arbitrage 124

6.7.6 Carry trade 124

6.7.7 Refinancing plays 126

6.7.8 Late stage restructuring plays 126

6.7.9 Multi-strategy 126

6.8 Mandatory convertibles 126

6.9 Strategy’s historical performance analysis 128

6.10 Risk control 132

6.11 Conclusions 133

7 Fixed Income Arbitrage 135

7.1 Issuance driven arbitrage or snap trade 137

7.2 Yield curve arbitrage 137

7.3 Intermarket spread trading 140

7.4 Futures basis trading or basis trading 140

7.5 Swap spread trading 140

7.6 Capital structure arbitrage 141

7.7 Long/short credit or credit pair trading 144

7.8 Carry trade 148

7.9 Break-even inflation trades 148

7.10 Cross-currency relative value trade 149

7.11 Treasuries over eurodollars (TED) spread or international credit spread 151

7.12 Leveraged loans 151

7.13 Strategy’s historical performance analysis 153

7.14 Conclusions 157

8 Strategies on CDOs 159

8.1 A brief history of CDOs 162

8.2 Hedge fund investment strategies 163

8.2.1 Carry trade 163

8.2.2 Long/short structured credit 164

8.2.3 Correlation trade 164

8.3 Conclusions 166

9 Mortgage-Backed Securities Arbitrage 167

9.1 A brief history of mortgage-backed securities 167

9.2 Originators of mortgage-backed securities 167

9.3 The industry of mortgage-backed securities 169

9.3.1 Pass-through securities 169

9.3.2 Collateralized mortgage obligations 170

9.3.3 “Interest Only” securities and “Principal Only” securities 170

9.4 The sensitivity of mortgage-backed securities to interest rates 171

9.5 Arbitrage on mortgage-backed securities 173

9.6 Risk factors 174

9.7 Strategy’s historical performance analysis 174

9.8 Conclusions 178

10 Distressed Securities 179

10.1 A brief history of distressed securities 180

10.2 The distressed debt market 181

10.3 Bankruptcy laws 186

10.4 Strategy description 187

10.4.1 Securities involved 187

10.4.2 Investment thesis 192

10.4.3 The valuation process 194

10.4.4 Hedging techniques 195

10.5 Risks 195

10.6 A brief consideration of the directional nature of distressed securities hedge funds 196

10.7 Trade claims 198

10.8 Strategy’s historical performance analysis 202

10.9 Conclusions 206

11 Event Driven or Special Situations 207

11.1 Activist investors 208

11.2 Strategy’s historical performance analysis 211

12 Multi-Strategy 217

12.1 Multi-strategy funds 217

12.2 Strategy’s historical performance analysis 217

13 Managed Futures 223

13.1 What is a futures contract? 224

13.2 A brief history of managed futures 224

13.3 Managed futures strategy 225

13.4 “Do storks deliver babies?” and the predictability of financial time series 233

13.5 Strategy’s historical performance analysis 233

13.6 Conclusions 238

14 Global Macro 239

14.1 A brief history of macro funds 240

14.2 Investment strategies adopted 242

14.3 The characteristics shared by great traders 242

14.4 The legs of a trade 243

14.5 The theory of reflexivity by George Soros 248

14.6 Debt emerging markets 249

14.7 Strategy’s historical performance 255

14.8 Conclusions 258

15 Other Strategies 259

15.1 Holding company arbitrage 259

15.2 Closed-end fund arbitrage 260

15.3 Statistical arbitrage 261

15.4 Index arbitrage 262

15.5 Volatility trading 262

15.5.1 Option trading 263

15.5.2 Delta hedging 264

15.5.3 Variance swaps 264

15.5.4 Other instruments 264

15.6 Split-strike conversion 265

15.7 Lending 265

15.8 PIPEs or Regulation D 268

15.9 Real estate 270

15.10 Natural resources 270

15.11 Energy trading 274

15.12 Natural events 275

16 Hedge Fund Performance Analysis 279

16.1 Risks inherent in hedge fund investments 279

16.2 Hedge fund strategies indices 281

16.2.1 Benchmarking 282

16.3 Statistical analysis of indices 283

16.4 Value at risk 287

16.5 Statistical analysis of data from the LIPPER TASS database 289

17 Conclusions 291

Bibliography 295

Index 299