Download - Hedge Fund Strategies

Hedge FundsHedge Funds

AgendaAgenda

Hedge Funds an OverviewHedge Funds an OverviewType of Hedge FundsType of Hedge FundsHedge Funds StrategiesHedge Funds Strategies

Equity Long/ShortEquity Long/Short Distress SecuritiesDistress Securities Convertible ArbitrageConvertible Arbitrage Fixed Income ArbitrageFixed Income Arbitrage Global MacroGlobal Macro Merger ArbitrageMerger Arbitrage

Hedge Funds StrategiesHedge Funds Strategies

Hedge fund strategy-Categories Hedge fund strategy-Categories

Relative Value strategiesRelative Value strategies Take advantage of relative pricing discrepancies Take advantage of relative pricing discrepancies

between instruments such as equities, debt, options between instruments such as equities, debt, options and futures. and futures.

Managers may use mathematical, fundamental, or Managers may use mathematical, fundamental, or technical analysis to arrive at valuation differences. technical analysis to arrive at valuation differences.

Securities may be mispriced relative to the Securities may be mispriced relative to the underlying security, related securities, groups of underlying security, related securities, groups of securities or overall market. securities or overall market.

Many hedge funds in this category use leverage Many hedge funds in this category use leverage and seek opportunities globally. and seek opportunities globally.

Event Driven strategies Event Driven strategies

Investing in opportunities created by significant corporate Investing in opportunities created by significant corporate events, such as mergers and acquisitions, bankruptcy events, such as mergers and acquisitions, bankruptcy reorganisations and share buybacks.reorganisations and share buybacks.

Leverage may be used by some managers to increase Leverage may be used by some managers to increase the exposure to an investment. the exposure to an investment.

Fund managers may hedge against downside market Fund managers may hedge against downside market risk by using derivative strategies such as purchasing risk by using derivative strategies such as purchasing put options or put option spreads.put options or put option spreads.

Directional strategies Directional strategies

Buying and/or selling a security or financial instrument Buying and/or selling a security or financial instrument believed to be significantly under-priced or over-priced believed to be significantly under-priced or over-priced by the market, relative to its potential value.by the market, relative to its potential value.

This discipline may concentrate on a specific company, This discipline may concentrate on a specific company, industry or country. industry or country.

The strategy most familiar to investors is the long/short The strategy most familiar to investors is the long/short (hedged equity) strategy, which typically involves a core (hedged equity) strategy, which typically involves a core holding of equities which the manager owns (‘long holding of equities which the manager owns (‘long positions’) hedged at all times with short positions (sale positions’) hedged at all times with short positions (sale of equities borrowed, not owned) giving the portfolio an of equities borrowed, not owned) giving the portfolio an overall long or short exposure. overall long or short exposure.

Directional StrategyDirectional Strategy

Equity Long/ ShortEquity Long/ Short

Define- Equity Long/ShortDefine- Equity Long/Short

Long/short equity is an investment strategy, which earns Long/short equity is an investment strategy, which earns return from stock picking, and isolates the risk (as well return from stock picking, and isolates the risk (as well as the return) of a particular stock from the risk/return of as the return) of a particular stock from the risk/return of the broader market or industry of which it is a part.the broader market or industry of which it is a part.

The trade would involve purchasing the shares in one of The trade would involve purchasing the shares in one of

the companies (going ‘long’) and selling the competitor the companies (going ‘long’) and selling the competitor short. short.

Strategy OverviewStrategy Overview Picking stocks which are sufficiently balanced to keep Picking stocks which are sufficiently balanced to keep

the portfolio buffered from a severe market swing.the portfolio buffered from a severe market swing. Baskets of long and short investments are beta neutral.Baskets of long and short investments are beta neutral. Market-neutral long/short equity trading balance their Market-neutral long/short equity trading balance their

longs and shorts in the same sector or industry.longs and shorts in the same sector or industry. The key to the success of this strategy is the fund The key to the success of this strategy is the fund

manager’s ability to select a basket of long stocks that manager’s ability to select a basket of long stocks that will perform better than the basket of shorts.will perform better than the basket of shorts.

Quantitative analysis is the most common method for Quantitative analysis is the most common method for identifying optimal long and short positions, some hedge identifying optimal long and short positions, some hedge fund managers rely on fundamental analysis, fund managers rely on fundamental analysis, systematically analyzing industries and companies to systematically analyzing industries and companies to find those on the brink of positive, or negative, change.find those on the brink of positive, or negative, change.

Strategy Overview- Contd.Strategy Overview- Contd. One strategy known as "One strategy known as "pairs tradingpairs trading " matches its " matches its

long and short investments one pair at a time. long and short investments one pair at a time. This tendency to earn small, steady gains characterizes This tendency to earn small, steady gains characterizes

market neutral long/short equity funds in general, market neutral long/short equity funds in general, resulting in annual returns of about 10-12 percent, resulting in annual returns of about 10-12 percent, unlevered. unlevered.

Strong stock-picking ability – can provide consistently Strong stock-picking ability – can provide consistently good performance in any market and even excel in a good performance in any market and even excel in a market decline, which, in today’s investment climate, is market decline, which, in today’s investment climate, is an attractive feature to investors. an attractive feature to investors.

Long/ short equity funds posted average returns of 12.6 Long/ short equity funds posted average returns of 12.6 percent for three years 2003-2005 according to HFR.percent for three years 2003-2005 according to HFR.

Equity Long/Short – Example - 1Equity Long/Short – Example - 1 A long/short fund manager might sell short one A long/short fund manager might sell short one

automobile industry stock, while buying (automobile industry stock, while buying (taking a long taking a long positionposition) on another -- short of DaimlerChrysler, long on ) on another -- short of DaimlerChrysler, long on Ford.Ford.

Thereafter, any general development that improves the Thereafter, any general development that improves the yield of auto industry stocks in general will help this yield of auto industry stocks in general will help this fund's Ford position, but will hurt its DaimlerChrysler fund's Ford position, but will hurt its DaimlerChrysler position. position.

The two positions are offsetting, so the portfolio is The two positions are offsetting, so the portfolio is hedgedhedged against developments that affect the auto against developments that affect the auto industry in general.industry in general.

Equity Long/Short – Example - 2Equity Long/Short – Example - 2 Imagine McDonald’s has just come out with a low-fat Imagine McDonald’s has just come out with a low-fat

burger. Burger King’s new fat-free burger, on the other burger. Burger King’s new fat-free burger, on the other hand, is dry and tasteless, producing moans in the back hand, is dry and tasteless, producing moans in the back seat.seat.

So, sensing a trend here, you rush out and buy $5,000 So, sensing a trend here, you rush out and buy $5,000 worth of McDonald’s stock and sell short $5,000 of worth of McDonald’s stock and sell short $5,000 of Burger King.Burger King.

if the market goes up, both McDonald’s and Burger King if the market goes up, both McDonald’s and Burger King positions will rise in price, but McDonald’s should rise positions will rise in price, but McDonald’s should rise more provided the analysis is correct and is ultimately more provided the analysis is correct and is ultimately recognized by other investors.recognized by other investors.

Thus, the profit from the McDonald’s position will more Thus, the profit from the McDonald’s position will more than offset the loss from the short position in Burger than offset the loss from the short position in Burger King.King.

As a bonus, we will receive a rebate from broker on the As a bonus, we will receive a rebate from broker on the short position (typically the risk-free rate of interest).short position (typically the risk-free rate of interest).

Equity- Long/ Short- TradesEquity- Long/ Short- Trades Long “good stocks”/short “bad stocks” For Eg. Infosys Long “good stocks”/short “bad stocks” For Eg. Infosys

and Polarisand Polaris

Long value/short growth – For eg. SBI and ICICILong value/short growth – For eg. SBI and ICICI

Long small-cap/short large-cap – For eg. HLL and ITCLong small-cap/short large-cap – For eg. HLL and ITC

Long defensive/short cyclicals – Agro and SAILLong defensive/short cyclicals – Agro and SAIL

Representative Funds - USRepresentative Funds - USTop US Funds – (Source Bloomberg, Hedge Fund Top US Funds – (Source Bloomberg, Hedge Fund Research)Research)Fund NameFund Name Hedge FundHedge Fund 3 Year 3 Year

return(2003-05)return(2003-05)JK NavigatorJK Navigator Steelhead Steelhead

PartnersPartners71.4%71.4%

Axiom Axiom International International OpportunityOpportunity

Axiom Axiom International International InvestorsInvestors

44.5%44.5%

Value PartnersValue Partners Value PartnersValue Partners 33.8%33.8%

Representative Funds - UKRepresentative Funds - UKTop UK Funds (Source Bloomberg, Hedge Fund Top UK Funds (Source Bloomberg, Hedge Fund Research)Research)Fund NameFund Name Hedge FundHedge Fund 3 Year 3 Year

return(2003-05)return(2003-05)SabreSabre Mathews Mathews

Capital/AustraliaCapital/Australia108.4%108.4%

Dynamic Power Dynamic Power HedgeHedge

Goodman & Co. Goodman & Co. Investment Investment CounselCounsel

63.0%63.0%

SR PhoeniciaSR Phoenicia Sloane RobinsonSloane Robinson 43.0%43.0%

Convertible ArbitrageConvertible Arbitrage

Define - Convertible ArbitrageDefine - Convertible Arbitrage

Convertible arbitrage is a market neutral Convertible arbitrage is a market neutral investment strategy often associated with investment strategy often associated with hedge funds. hedge funds.

It involves simultaneous purchase of It involves simultaneous purchase of convertible securities and the short sale of convertible securities and the short sale of the same issuer's common stock.the same issuer's common stock.

Strategy OverviewStrategy Overview Convertible is sometimes priced inefficiently relative to the Convertible is sometimes priced inefficiently relative to the

underlying stockunderlying stock The number of shares sold short usually reflects a delta neutral or The number of shares sold short usually reflects a delta neutral or

market neutral ratio. As a result, under normal market conditions, market neutral ratio. As a result, under normal market conditions, the arbitrageur expects the combined position to be insensitive to the arbitrageur expects the combined position to be insensitive to fluctuations in the price of the underlying stock.fluctuations in the price of the underlying stock.

However, maintaining a market neutral position may require However, maintaining a market neutral position may require rebalancing transactions, a process called dynamic delta hedging.rebalancing transactions, a process called dynamic delta hedging.

When a stock declines, the associated convertible bond will decline When a stock declines, the associated convertible bond will decline less, because it is protected by its value as a fixed-income less, because it is protected by its value as a fixed-income instrument: it pays interest periodically (while the stock may only instrument: it pays interest periodically (while the stock may only pay a dividend, which can be suspended in bad times).pay a dividend, which can be suspended in bad times).

At times convertible bonds declined more than the stocks into which At times convertible bonds declined more than the stocks into which they were convertible, apparently for liquidity reasons (the market they were convertible, apparently for liquidity reasons (the market for the stocks being much more liquid than the relatively small for the stocks being much more liquid than the relatively small market for the bonds). market for the bonds).

Example – 1 Example – 1 Take a 5% convertible bond maturing in one year at Take a 5% convertible bond maturing in one year at

$1,000, exchangeable into 100 shares of non-dividend-$1,000, exchangeable into 100 shares of non-dividend-paying common stock currently trading at $10 per share.paying common stock currently trading at $10 per share.

An arbitrage strategy might hedge against this long An arbitrage strategy might hedge against this long convertible bond with a short position of 50 shares of convertible bond with a short position of 50 shares of underlying common stock at $10 per share. underlying common stock at $10 per share.

Adding to gains on the downside is the fact that Adding to gains on the downside is the fact that convertible bonds can only fall in value as low as their convertible bonds can only fall in value as low as their "investment value" -- the value of the same company "investment value" -- the value of the same company bond if not convertible. In this case, let's say the bond if not convertible. In this case, let's say the investment value is $920. investment value is $920.

Return When No Change in Stock Price:Return When No Change in Stock Price:

Interest payments on $1,000 Interest payments on $1,000 convertible bond (5%) convertible bond (5%)

$50 $50

Interest earned on $500 short sale Interest earned on $500 short sale proceeds (5%) proceeds (5%)

$25 $25

Fees paid to lender of common stock Fees paid to lender of common stock (0.25% per annum) (0.25% per annum)

($1.50) ($1.50)

Net cash flow Net cash flow $73.50 $73.50

Annual ReturnAnnual Return 7.3%7.3%

Return When 25% Rise in Stock Price:Return When 25% Rise in Stock Price:

Gain on convertible bond Gain on convertible bond $250 $250

Loss on shorted stock (50 shares @ $2.50/share) Loss on shorted stock (50 shares @ $2.50/share) ($125) ($125)

Interest payments on $1,000 convertible bond Interest payments on $1,000 convertible bond (5%) (5%)

$50 $50

Interest earned on $500 short sale proceeds Interest earned on $500 short sale proceeds (5%) (5%)

$25 $25

Fees paid to lender of common stock (0.25% per Fees paid to lender of common stock (0.25% per annum) annum)

($1.50) ($1.50)

Net trading gains and cash flow Net trading gains and cash flow $198.50 $198.50


Return When 25% Fall in Stock Price:Return When 25% Fall in Stock Price:

Loss on convertible bond (only falling as low as Loss on convertible bond (only falling as low as

"investment value")"investment value") ($80) ($80)

Gain on shorted stock (50 shares @ $2.50/share) Gain on shorted stock (50 shares @ $2.50/share) $125 $125

Interest payments on $1,000 convertible bond Interest payments on $1,000 convertible bond (5%) (5%)

$50 $50

Interest earned on $500 short sale proceeds Interest earned on $500 short sale proceeds (5%) (5%)

$25 $25

Fees paid to lender of common stock (0.25% per Fees paid to lender of common stock (0.25% per annum) annum)

($1.50) ($1.50)

Net trading gains and cash flow Net trading gains and cash flow $118.50 $118.50


Example 1 – Contd.Example 1 – Contd. As this example shows, if a convertible bond As this example shows, if a convertible bond

arbitrage position is properly constructed, it arbitrage position is properly constructed, it should profit not only from the bond coupons should profit not only from the bond coupons and short rebate but from changes and short rebate but from changes up or downup or down in in the underlying equity price.the underlying equity price.

If the stock price drops, the gain from the short If the stock price drops, the gain from the short common stock position should exceed the common stock position should exceed the corresponding loss on the long convertible bond corresponding loss on the long convertible bond and vice a versa. and vice a versa.

Distressed SecuritiesDistressed Securities

Define - Distressed SecuritiesDefine - Distressed Securities Distressed securities are securities of Distressed securities are securities of

companies that are either already in default, companies that are either already in default, under bankruptcy protection, or in distress and under bankruptcy protection, or in distress and heading toward such a condition.heading toward such a condition.

Distressed Securities have also been defined as Distressed Securities have also been defined as securities, if not in default, that have a Yield to securities, if not in default, that have a Yield to Maturity in excess of 1000 basis points over the Maturity in excess of 1000 basis points over the riskless rate of return. riskless rate of return.

Strategy OverviewStrategy Overview Securities often trade at discounts to a rational Securities often trade at discounts to a rational

assessment of their risk-adjusted value for a variety of assessment of their risk-adjusted value for a variety of reasons. reasons.

Distressed securities are stocks, bonds, and trade or Distressed securities are stocks, bonds, and trade or financial claims of companies in, or about to enter or exit, financial claims of companies in, or about to enter or exit, bankruptcy or financial distress.bankruptcy or financial distress.

The prices of these securities fall in anticipation of the The prices of these securities fall in anticipation of the financial distress when their holders choose to sell rather financial distress when their holders choose to sell rather than remain invested in a financially troubled company.than remain invested in a financially troubled company.

Investment professionals who specialize in researching Investment professionals who specialize in researching distressed securities and who understand the true risks distressed securities and who understand the true risks and values involved can scoop up these securities or and values involved can scoop up these securities or claims at discounted prices, seeing the glow beneath the claims at discounted prices, seeing the glow beneath the tarnish. tarnish.

Strategy Overview- Contd.-1Strategy Overview- Contd.-1 A distressed opportunity typically arises when a company, unable to A distressed opportunity typically arises when a company, unable to

meet all its debts, files for Chapter 11 (reorganization) or Chapter 7 meet all its debts, files for Chapter 11 (reorganization) or Chapter 7 (liquidation) or bankruptcy.(liquidation) or bankruptcy.

As companies get into financial trouble, there is usually the As companies get into financial trouble, there is usually the opportunity to buy at steep discounts from people to whom money is opportunity to buy at steep discounts from people to whom money is owed who don’t want to or can’t wait for the reorganization to be owed who don’t want to or can’t wait for the reorganization to be completed.completed.

The investor, if he’s employing this strategy wisely, will not only The investor, if he’s employing this strategy wisely, will not only know everything about the company and its financials but will have know everything about the company and its financials but will have studied the creditors involved in the reorganization as well. studied the creditors involved in the reorganization as well.

Their numbers, their willingness to compromise, and the complexity Their numbers, their willingness to compromise, and the complexity of their claims help indicate how long the reorganization will last, of their claims help indicate how long the reorganization will last, what the asset distributions will be, and whether the expected what the asset distributions will be, and whether the expected returns are worth the wait.returns are worth the wait.

Strategy Overview- Contd.-2Strategy Overview- Contd.-2

Investment Manager will buy up enough of the company’s debt or Investment Manager will buy up enough of the company’s debt or trade claims so as to earn a seat on the creditor committee and trade claims so as to earn a seat on the creditor committee and have an influence in the distribution process. have an influence in the distribution process.

Distressed securities investing allows the investor who has gained Distressed securities investing allows the investor who has gained adequate knowledge through his research and due diligence to limit adequate knowledge through his research and due diligence to limit the downside of his investment by effectively buying $1 for 50 centsthe downside of his investment by effectively buying $1 for 50 cents

Average return 20 percent during the three years (2003-2005)Average return 20 percent during the three years (2003-2005)

How to determine a distressed How to determine a distressed company is worth investing in? company is worth investing in?

Study the events driving down the value of a company’s Study the events driving down the value of a company’s securities.securities.

Do calculations to determine if the purchase price of the Do calculations to determine if the purchase price of the security is below not only its potential value but its bare-security is below not only its potential value but its bare-bones liquidation value.bones liquidation value.

Understanding the different kinds of claims involved in a Understanding the different kinds of claims involved in a reorganization or bankruptcy, as not all are paid back reorganization or bankruptcy, as not all are paid back evenly and at the same time. evenly and at the same time.

ExampleExample El Paso Electric underwent a Chapter 11 reorganizationEl Paso Electric underwent a Chapter 11 reorganization Dickstein Partners, which specializes in distressed investments, Dickstein Partners, which specializes in distressed investments,

bought junior bonds in the utility that had fallen to 50 cents on the bought junior bonds in the utility that had fallen to 50 cents on the dollar, expecting additional profits from shares parceled out as part dollar, expecting additional profits from shares parceled out as part of the reorganization plan.of the reorganization plan.

Companies in the process of reorganizing their debts often issue Companies in the process of reorganizing their debts often issue new shares to the junior creditors when they can’t repay them in full. new shares to the junior creditors when they can’t repay them in full.

Such shares are commonly referred to as orphan equities when the Such shares are commonly referred to as orphan equities when the issuer (the company) has no Wall Street coverage. issuer (the company) has no Wall Street coverage.

First issued at $5 a share, the stock dropped initially as less First issued at $5 a share, the stock dropped initially as less knowledgeable (or less patient) former creditors, stuck with an knowledgeable (or less patient) former creditors, stuck with an unwanted investment, hastily sold their new holdings. unwanted investment, hastily sold their new holdings.

Seeing the opportunity, Dickstein purchased additional equity from Seeing the opportunity, Dickstein purchased additional equity from these sellers and watched as the stock steadily climbed over the these sellers and watched as the stock steadily climbed over the next two years to over $9 a share. next two years to over $9 a share.

Representative Funds - USRepresentative Funds - USTop US Funds – (Source Bloomberg, Hedge Fund Top US Funds – (Source Bloomberg, Hedge Fund Research)Research)Fund NameFund Name Hedge FundHedge Fund 3 Year 3 Year

return(2003-05)return(2003-05)York Credit York Credit OpportunitiesOpportunities

Dinan Mgmt.Dinan Mgmt. 33.10%33.10%

Jolly RogerJolly Roger Pirate CapitalPirate Capital 32.30%32.30%

Highland CrusaderHighland Crusader Highland Capital Highland Capital Mgmt.Mgmt.

31.0%31.0%

Representative Funds - UKRepresentative Funds - UKTop UK Funds (Source Bloomberg, Hedge Fund Top UK Funds (Source Bloomberg, Hedge Fund Research)Research)Fund NameFund Name Hedge FundHedge Fund 3 Year 3 Year

return(2003-05)return(2003-05)VR Argentina VR Argentina RecoveryRecovery

VR Distressed VR Distressed AssetsAssets

42.9%42.9%

Millennium Global Millennium Global High YieldHigh Yield

Millennium Global Millennium Global InvestmentInvestment

38.6%38.6%



32.0%32.0%

Fixed Income ArbitrageFixed Income Arbitrage

Define – Fixed Income ArbitrageDefine – Fixed Income Arbitrage Hedge Funds take offsetting positions in Fixed Income securities Hedge Funds take offsetting positions in Fixed Income securities

and their derivatives in order to exploit mispricings between Interest and their derivatives in order to exploit mispricings between Interest rates securities.rates securities.

Fixed income arbitrage is an investment strategy generally Fixed income arbitrage is an investment strategy generally associated with hedge funds, which consists of the discovery and associated with hedge funds, which consists of the discovery and exploitation of inefficiencies in the pricing of bonds, i.e. instruments exploitation of inefficiencies in the pricing of bonds, i.e. instruments from either public or private issuers yielding a contractually fixed from either public or private issuers yielding a contractually fixed stream of income. stream of income.

Fixed-income arbitrage speculates on the widening or narrowing of Fixed-income arbitrage speculates on the widening or narrowing of a spread between similar or closely related fixed income securities a spread between similar or closely related fixed income securities based on mathematical models of their respective yield curves.based on mathematical models of their respective yield curves.

Most arbitrageurs who employ this strategy trade globally.Most arbitrageurs who employ this strategy trade globally.

Type of securities Type of securities In pursuit of their goal of both steady returns and In pursuit of their goal of both steady returns and

low volatility, the arbitrageurs can focus upon:low volatility, the arbitrageurs can focus upon: Interest rate swaps, Interest rate swaps, US non-US government bond arbitrage, US non-US government bond arbitrage, US Treasury security, US Treasury security, Forward yield curves, Forward yield curves, Mortgage-backed securities.Mortgage-backed securities.

Investment ApproachInvestment Approach Fixed Income Arbitrage strategies vary widely Fixed Income Arbitrage strategies vary widely

followed and include:followed and include: Exploiting anomalies between one issuer debt Exploiting anomalies between one issuer debt

securities securities Exploiting anomalies between debt securities of Exploiting anomalies between debt securities of

different issuers different issuers Exploiting dislocations between emerging market Exploiting dislocations between emerging market

securities and U.S. debt securities securities and U.S. debt securities

GLOBAL MACRO STRATEGYGLOBAL MACRO STRATEGY

Global MacroGlobal Macro

This Strategy aims to make profit from changes in global economies.This Strategy aims to make profit from changes in global economies.

Global macro managers carry long and short positions in any of the Global macro managers carry long and short positions in any of the world's major capital or derivative markets. These positions reflect world's major capital or derivative markets. These positions reflect their views on overall market direction as influence by major their views on overall market direction as influence by major economic trends and/or events.economic trends and/or events.

Focuses on macro-economic opportunities across numerous Focuses on macro-economic opportunities across numerous markets and instruments with the hopes of profiting from macro markets and instruments with the hopes of profiting from macro events.events.

Macro events are changes in global economies and the macro Macro events are changes in global economies and the macro investors anticipate such events and shifts and make profit by investors anticipate such events and shifts and make profit by investing in financial instruments whose prices are most directly investing in financial instruments whose prices are most directly influenced by these trend. Eg: Interest Rate,Inflation,Economic influenced by these trend. Eg: Interest Rate,Inflation,Economic policies etc.policies etc.

Global Macro – Cont.Global Macro – Cont.

Participates in all major markets - equities, bonds, currencies and Participates in all major markets - equities, bonds, currencies and commodities - though not always at the same timecommodities - though not always at the same time..

Uses leverage and derivatives to accentuate the impact of market moves.Uses leverage and derivatives to accentuate the impact of market moves.

If a huge deficit is accompanied by an expansionary fiscal policy (higher If a huge deficit is accompanied by an expansionary fiscal policy (higher government spending and taxation) and tight monetary policy (higher government spending and taxation) and tight monetary policy (higher interest rates to stem borrowing), the theory has it that the country's interest rates to stem borrowing), the theory has it that the country's currency will actually rise. currency will actually rise.

Stanley Druckenmiller went long on the Deutsche mark to the tune of $2 Stanley Druckenmiller went long on the Deutsche mark to the tune of $2 billion after the Berlin Wall came down in 1989. Seeing that West Germany billion after the Berlin Wall came down in 1989. Seeing that West Germany was about to run up a huge budget deficit to finance the rebuilding of East was about to run up a huge budget deficit to finance the rebuilding of East Germany and that the Bundesbank was not going to tolerate any inflation, Germany and that the Bundesbank was not going to tolerate any inflation, Druckenmiller predicted - quite correctly and lucratively - that the price of the Druckenmiller predicted - quite correctly and lucratively - that the price of the Deutsche mark would rise. Deutsche mark would rise.

Global Macro – Cont.Global Macro – Cont. Historical patterns also helps in identifying trends and Historical patterns also helps in identifying trends and

inflection points.inflection points.

For example, in late 1989, Druckenmiller turned bearish For example, in late 1989, Druckenmiller turned bearish on the Japanese stock market in part because the Nikkei on the Japanese stock market in part because the Nikkei index had reached a point of overextension that in all index had reached a point of overextension that in all previous instances had led to sell-offs.previous instances had led to sell-offs.

The speed with which capital is capable of moving The speed with which capital is capable of moving means that any economy can be disrupted by means that any economy can be disrupted by international capital flows due to external considerations. international capital flows due to external considerations. This understanding is a cornerstone of macro investment This understanding is a cornerstone of macro investment strategies.strategies.

MERGER ARBITRAGE MERGER ARBITRAGE (RISK ARBITRAGE)(RISK ARBITRAGE)

Merger Arbitrage(Risk Merger Arbitrage(Risk ArbitrageArbitrage ))

Invest in shares of a company that is in the Invest in shares of a company that is in the process of a merger or acquisition.process of a merger or acquisition.

Involve simultaneous purchase of stock in Involve simultaneous purchase of stock in companies being acquired, and the sale of stock companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread in its acquirer, hoping to profit from the spread between.between.

It starts when a news release appears on a It starts when a news release appears on a trading screen such as Bloomberg or Reuters trading screen such as Bloomberg or Reuters announcing that a bidder wishes to buy the announcing that a bidder wishes to buy the stock in a company. stock in a company.

Merger Arbitrage – Cont.Merger Arbitrage – Cont. After a company announces an intent to acquire another, After a company announces an intent to acquire another,

the price of the target company's stock predictably goes the price of the target company's stock predictably goes up while the acquiring company's stock will sell at a up while the acquiring company's stock will sell at a discount to its value at the merger's closing.discount to its value at the merger's closing.

The merger arbitrageur seeks to lock in this spread.The merger arbitrageur seeks to lock in this spread.

A manager takes a long position in the equity of the A manager takes a long position in the equity of the target company, with the expectation of being able to target company, with the expectation of being able to exchange the stock for cash or securities of the acquiring exchange the stock for cash or securities of the acquiring company when the acquisition is complete. At the same company when the acquisition is complete. At the same time, the manager sells short the stock of the acquiring time, the manager sells short the stock of the acquiring company, expecting it to drop before the deal is finalized. company, expecting it to drop before the deal is finalized.

Merger Arbitrage Strategy: Merger Arbitrage Strategy: Buy 1 share of target Company B at $100; Buy 1 share of target Company B at $100;

Sell short 1 share of acquirer Company A at $105Sell short 1 share of acquirer Company A at $105

Scenarios After Scenarios After MergerMerger

Gain (Loss) Gain (Loss) on Long on Long Position of Posit ion of $100$100

Gain (Loss) Gain (Loss) on Short on Short Posit ion of Posit ion of $105$105

Total Gain Total Gain (Loss(Loss

Rise in Rise in Company A Company A Stock to $120Stock to $120

$20$20 ($15)($15) $5$5

Fall in Fall in Company A Company A Stock to $80Stock to $80

($20)($20) $25$25 $5$5

Merger Arbitrage - cont.Merger Arbitrage - cont. To hedge against collapsed deals, some fund To hedge against collapsed deals, some fund

managers supplement their long positions in the managers supplement their long positions in the target company with target company with puts on the company's puts on the company's stockstock - but only when the spread is such that - but only when the spread is such that the potential profit well offsets the cost of the the potential profit well offsets the cost of the buying the put.buying the put.

Other alternative - Other alternative - To short the target's To short the target's stockstock . Eg:, Paulson Partners shorted the stock . Eg:, Paulson Partners shorted the stock of AEL Industries Inc. on the reports of of AEL Industries Inc. on the reports of acquisition plans to be on shaky ground. acquisition plans to be on shaky ground.

Thank YouThank You

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