You are on page 1of 20

C.S.

Arul kumar

17MIME12016

Risk and Control Strategy

ASSIGNMENT – 1

1. Explain top 7 option strategies which hedge the market risk. Explain each
strategy with suitable example.

# 1 LONG/SHORT EQUITY STRATEGY

 In this type of Hedge Fund Strategy, Investment manager maintains


long and short positions in equity and equity derivative securities.
 Thus, the fund manager will purchase the stocks that they feels is
undervalued and Sell those which are overvalued.
 Wide varieties of techniques are employed to arrive at an investment
decision. It includes both quantitative and fundamental techniques.
 Such a hedge fund strategy can be broadly diversified or narrowly
focused on specific sectors.
 It can range broadly in terms of exposure, leverage, holding
period, concentrations of market capitalization and valuations.
 Basically, the fund goes long and short in two competing companies
in the same industry.

But most managers do not hedge their entire long market value with
short positions.

EXAMPLE OF LONG/SHORT EQUITY

 If Tata Motors looks cheap relative to Hyundai, a trader might buy


$100,000 worth of Tata Motors and short an equal value of Hyundai
shares. The net market exposure is zero in such case.
 But if Tata Motors does outperform Hyundai, the investor will make
money no matter what happens to the overall market.
 Suppose Hyundai rises 20% and Tata Motors rises 27%; the trader
sells Tata Motors for $127,000, covers the Hyundai short for
$120,000 and pockets $7,000.
 If Hyundai falls 30% and Tata Motors falls 23%, he sells Tata Motors
for $77,000, covers the Hyundai short for $70,000, and still pockets
$7,000.
 If the trader is wrong and Hyundai outperforms Tata Motors, however,
he will lose money.
# 2 MARKET NEUTRAL STRATEGY

 By contrast, in market-neutral strategy, hedge funds target zero net-


market exposure which means that shorts and longs have equal
market value.
 In such a case the managers generate their entire return from stock
selection.
 This strategy has a lower risk than the first strategy that we
discussed, but at the same time the expected returns are also lower.

EXAMPLE OF MARKET NEUTRAL STRATEGY

 A fund manager may go long in the 10 biotech stocks that are


expected to outperform and short the 10 biotech stocks that may
underperform.
 Therefore, in such a case the gains and losses will offset each other
inspite how the actual market does.
 So even if the sector moves in any direction the gain on the long
stock is offset by a loss on the short.
# 3 MERGER ARBITRAGE STRATEGY

 In such a hedge fund strategy the stocks of two merging


companies are simultaneously bought and sold to create a riskless
profit.
 This particular hedge fund strategy looks at the risk that the merger
deal will not close on time, or at all.
 Because of this small uncertainty, this is what happens:
 The target company’s stock will sell at a discount to the price that the
combined entity will have, when the merger is done.
 This difference is the arbitrageur’s profit.
 The merger arbitrageurs care only about the probability of the deal
being approved and the time it will take to close the deal.

EXAMPLE OF MARKET ARBITRAGE STRATEGY

Consider these two companies– ABC Co. and XYZ Co.

 Suppose ABC Co is trading at $20 per share when XYZ Co. comes
along and bids $30 per share which is a 25% premium.
 The stock of ABC will jump up, but will soon settle at some price
which is higher than $20 and less than $30 until the takeover deal is
closed.
 Let’s say that the deal is expected to close at $30 and ABC stock is
trading at $27.
 To seize this price-gap opportunity, a risk arbitrageur would purchase
ABC at $28, pay a commission, hold on to the shares, and eventually
sell them for the agreed $30 acquisition price once the merger is
closed.
 Thus the arbitrageur makes a profit of $2 per share, or a 4% gain,
less the trading fees.
# 4 CONVERTIBLE ARBITRAGE

 Convertibles generally are the hybrid securities including a


combination of a bond with an equity option.
 A convertible arbitrage hedge fund typically includes long convertible
bonds and short a proportion of the shares into which they convert.
 In simple terms it includes a long position on bonds and short position
on common stock or shares.
 It attempts to exploit profits when there is a pricing error made in the
conversion factor i.e. it aims to capitalize on mispricing between a
convertible bond and its underlying stock.
 If the convertible bond is cheap or if it is undervalued relative to the
underlying stock, the arbitrageur will take a long position in the
convertible bond and a short position in the stock.
 On the other hand, if the convertible bond is overpriced relative to the
underlying stock, the arbitrageur will take a short position in the
convertible bond and a long position in the underlying stock.
 In such a strategy managers try to maintain a delta-neutral position
so that the bond and stock positions offset each other as the market
fluctuates.
 (Delta Neutral Position- Strategy or Position due to which the value
of the Portfolio remains unchanged when small changes occur in the
value of the underlying security.)
 Convertible arbitrage generally thrives on volatility.
 The reason for the same is that, more the shares bounce, more the
opportunities arise to adjust the delta-neutral hedge and book trading
profits.

EXAMPLE OF CONVERTIBLE ARBITRAGE STRATEGY

 Visions Co. decides to issue a 1-year bond that has a 5% coupon


rate. So on the first day of trading it has a par value of $1,000 and if
you held it to maturity (1 year) you will have collected $50 of interest.
 The bond is convertible to 50 shares of Vision’s common shares
whenever the bondholder desires to get them converted. The stock
price at that time was $20.
 If Vision’s stock price rises to $25 then the convertible bondholder
could exercise their conversion privilege. They can now receive 50
shares of Vision’s stock.
 50 shares at $25 is worth $1250. So if the convertible bondholder
bought the bond at issue ($1000), they have now made the profit of
$250. If instead they decide that they want to sell the bond, they
could command $1250 for the bond.
 But what if the stock price drops to $15? The conversion comes to
$750 ($15 *50). If this happens you could simply never exercise your
right to convert to common shares. You can then collect the coupon
payments and your original principal at maturity.
# 5 CAPITAL STRUCTURE ARBITRAGE

 It is a strategy in which a firm’s undervalued security is bought and its


overvalued security is sold.
 Its objective is to profit from the pricing inefficiency in the issuing
firm’s capital structure.
 It is a strategy used by many directional, quantitative and market
neutral credit hedge funds.
 It includes going long in one security in a company’s capital structure
while at the same time going short in another security in that same
company’s capital structure.
 For example, long the sub-ordinate bonds and short the senior
bonds, or long equity and short CDS.

EXAMPLE OF CAPITAL STRUCTURE ARBITRAGE

An example could be – A news of particular company performing badly.

In such a case, both its bond and stock prices are likely to fall heavily. But
the stock price will fall by a greater degree for several reasons like:

 Stockholders are at a greater risk of losing out if the company is


liquidated because of the priority claim of the bondholders
 Dividends are likely to be reduced.
 The market for stocks is usually more liquid as it reacts to news more
dramatically.
 Whereas on the other hand annual bond payments are fixed.
 An intelligent fund manager will take advantage of the fact that the
stocks will become comparatively much cheaper than the bonds.

# 6 FIXED-INCOME ARBITRAGE

 This particular Hedge fund strategy makes profit from arbitrage


opportunities in interest rate securities.

 Here opposing positions are assumed in the market to take


advantage of small price inconsistencies, limiting interest rate risk.
The most common type of fixed-income arbitrage is swap-spread
arbitrage.
 In swap-spread arbitrage opposing long and short positions are taken
in a swap and a Treasury bond.
 Point to note is that such strategies provide relatively small returns
and can cause huge losses sometimes.
 Hence this particular Hedge Fund strategy is referred to as ‘Picking
up nickels in front of a steamroller!’

EXAMPLE OF FIXED INCOME ARBITRAGE

A Hedge fund has taken the following position: Long 1,000 2-year
Municipal Bonds at $200.

 1,000 x $200 = $200,000 of risk (unhedged)


 The Municipal bonds payout 6% annually interest rate – or 3% semi.
 Duration is 2 years, so you receive the principal after 2 years.

After your first year, the amount that you have made assuming that you
choose to reinvest the interest in a different asset will be:

$200,000 x .06 = $12,000

After 2 years, you will have made $12000*2= $24,000.

But you are at risk the entire time of:

 The municipal bond not being paid back.


 Not receiving your interest.

So you want to hedge this duration risk

The Hedge Fund Manager Shorts Interest Rate Swaps for two companies

that pays out 6% annual interest rate (3% semi-annually) and is taxed at

5%.

$200,000 x .06 = $12,000 x (0.95) = $11,400

So for 2 years it will be: $11,400 x 2 = 22,800

Now if this is what the Manager pays out, then we must subtract this from

the interest made on the Municipal Bond: $24,000-$22,800 = $1,200

Thus $1200 is the profit made.


# 7 EVENT DRIVEN

 In such a strategy the investment Managers maintain positions in

companies that are involved in mergers, restructuring, tender offers,

shareholder buybacks, debt exchanges, security issuance or other

capital structure adjustments.

EXAMPLE OF EVENT DRIVE STRATEGY

One example of Event driven strategy is distressed securities.

In this type of strategy, the hedge funds buy the debt of companies that are

in financial distress or have already filed for bankruptcy.

If the company has yet not filed for bankruptcy, the manager may sell short

equity, betting the shares will fall when it does file.

# 8 GLOBAL MACRO

 This hedge fund strategy aims to make profit from large economic

and political changes in various countries by focusing in bets on

interest rates, sovereign bonds and currencies.


 Investment managers analyze the economic variables and what

impact they will have on the markets. Based on that they develop

investment strategies.

 The Managers analyze how macroeconomic trends will affect interest

rates, currencies, commodities or equities around the world and take

positions in the asset class that is most sensitive in their views.

 Variety of techniques like systematic analysis, quantitative and

fundamental approaches, long and short-term holding periods are

applied in such case.

 Managers usually prefer highly liquid instruments like futures and

currency forwards for implementing this strategy.

EXAMPLE OF GLOBAL MACRO STRATEGY

An excellent example of a Global Macro Strategy is George Soros shorting

of the pound sterling in 1992. He then took a huge short position of over

$10 billion worth of pounds.

He consequently made a profit from the Bank of England’s reluctance to

either raise its interest rates to levels comparable to those of other

European Exchange Rate Mechanism countries or to float the currency.

Soros made 1.1 billion on this particular trade.


2. “Hedging is to provide insurance against adverse fluctuations in the price
movements”. Do you agree? Discuss the statement with the help of the real
time stock example.

A hedge is an investment that protects your finances from a risky situation.


Hedging is done to minimize or offset the chance that your assets will lose
value. It also limits your loss to a known amount if the asset does lose
value. It's similar to home insurance. You pay a fixed amount each month.
If a fire wipes out all the value of your home, your loss is the only the
known amount of the deductible.

Hedging Strategies

Most investors who hedge use derivatives. These are financial


contracts that derive their value from an underlying real asset, such as a
stock. An option is the most commonly used derivative. It gives you the
right to buy or sell a stock at a specified price within a window of time.

Here's how it works to protect you from risk. Let's say you bought stock.
You thought the price would go up but wanted to protect against the loss if
the price plummets. You'd hedge that risk with a put option. For a small fee,
you'd buy the right to sell the stock at the same price. If it falls, you exercise
your put and make back the money you just invested minus the fee.

Diversification is another hedging strategy. You own an assortment of


assets that don't rise and fall together. If one asset collapses, you don't
lose everything. For example, most people own bonds to offset the risk of
stock ownership. When stock prices fall, bond values increase. That only
applies to high-grade corporate bonds or U.S. Treasurys. The value of junk
bonds falls when stock prices do because both are risky investments.

Hedges and Hedge Funds

Hedge funds use a lot of derivatives to hedge investments. These are


usually privately-owned investment funds. The government doesn't
regulate them as much as mutual funds whose owners are public
corporations.

Hedge funds pay their managers a percent of the returns they earn. They
receive nothing if their investments lose money. That attracts many
investors who are frustrated by paying mutual fund fees regardless of its
performance.

Thanks to this compensation structure, hedge fund managers are driven to


achieve above market returns. Managers who make bad investments could
lose their jobs. They keep the wages they've saved up during the good
times. If they bet large, and correctly, they make tons of money. If they
lose, they don't lose their personal money. That makes them very risk
tolerant. It also makes the funds precarious for the investor, who can lose
their entire life savings.

Hedge fund use of derivatives added risk to the global economy, setting the
stage for the financial crisis of 2008. Fund managers bought credit default
swaps to hedge potential losses from subprime mortgage-backed
securities. Insurance companies like AIG promised to pay off if the
subprime mortgages defaulted.
This insurance gave hedge funds a false sense of security. As a result,
they bought more mortgage-backed securities than was prudent. They
weren't protected from risk, though. The sheer number of defaults
overwhelmed the insurance companies. That's why the federal government
had to bail out the insurers, the banks, and the hedge funds.

The real hedge in the financial system was the U.S. government, backed
by its ability to tax, incur debt and print more money. The risk has been
lowered a bit, now that the Dodd-Frank Wall Street Reform Act regulates
many hedge funds and their risky derivatives.

Stock analysis of Dish TV India Ltd on BSE


Add to watchlist

12 Feb,15:45 Prev Day's H/L 52wk H/L Mkt Cap


Volume
close (Rs.) (Rs.) (Rs. Cr)
33.55
+3.95 +13.34%
34.70 - 81.70 -
3,279,330 29.60 6,177.56
29.45 19.25

Company details for Dish TV India Ltd


Report Card
PE Ratios : 164.86

EPS (Rs.) : 0.18

Sales (Rs. Cr) : 983.12

Face Value (Rs.) : 1


Net Prof
Margin (%) : 1.16
Last Bonus
Last Dividend(%) : 50
Return on
Average Equity : 0.4

Conclusion:
If a investor had invested Rs.1000 before one week ago now he would had
got position Rs.1,474.73
3. Explain the Basel norms I, II and III in detail.

History:
On 26 June 1974, a number of banks had released payment of
Deutsche Marks (DEM - German Currency at that time) to Herstatt
(Based out of Cologne, Germany) in Frankfurt in exchange for US
Dollars (USD) that was to be delivered in New York. Because of time-
zone differences, Herstatt ceased operations between the times of
the respective payments. German regulators forced the troubled
Bank Herstatt into liquidation .The counter party banks did not receive
their USD payments. Responding to the cross-jurisdictional
implications of the Herstatt debacle, the G-10 countries, Spain and
Luxembourg formed a standing committee in 1974 under the
auspices of the Bank for International Settlements (BIS), called the
Basel Committee on Banking Supervision. Since BIS is
headquartered in Basel, this committee got its name from there. The
committee comprises representatives from central banks and
regulatory authorities.
Basel I:

In 1988, the Basel Committee on Banking Supervision (BCBS) in Basel,


Switzerland, published a set of minimum capital requirements for banks.
These were known as Basel I. It focused almost entirely on credit risk
(default risk) - the risk of counter party failure. It defined capital
requirement and structure of risk weights for banks.

Under these norms: Assets of banks were classified and grouped in five
categories according to credit risk, carrying risk weights of 0%(Cash,
Bullion, Home Country Debt Like Treasuries), 10, 20, 50 and100% and no
rating. Banks with an international presence are required to hold capital
equal to 8% of their risk-weighted assets (RWA) - At least, 4% in Tier I
Capital (Equity Capital + retained earnings) and more than 8% in Tier I and
Tier II Capital. Target - By 1992.

One of the major role of Basel norms is to standardize the banking practice
across all countries. However, there are major problems with definition of
Capital and Differential Risk Weights to Assets across countries, like
Basel standards are computed on the basis of book-value accounting
measures of capital, not market values. Accounting practices vary
significantly across the G-10 countries and often produce results that
differ markedly from market assessments.
Other problem was that the risk weights do not attempt to take account of
risks other than credit risk, viz., market risks, liquidity risk and operational
risks that may be important sources of insolvency exposure for banks.

Basel II:

So, Basel II was introduced in 2004, laid down guidelines for capital
adequacy (with more refined definitions), risk management (Market Risk
and Operational Risk) and disclosure requirements.

- use of external ratings agencies to set the risk weights for corporate,
bank and sovereign claims.

- Operational risk has been defined as the risk of loss resulting from
inadequate or failed internal processes, people and systems or from
external events. This definition includes legal risk, but excludes strategic
and reputation risk, whereby legal risk includes exposures to fines,
penalties, or punitive damages resulting from supervisory actions, as well
as private settlements. There are complex methods to calculate this risk.
disclosure requirements allow market participants assess the
capital adequacy of the institution based on information on the scope
of application, capital, risk exposures, risk assessment processes, etc.
Basel III:

It is widely felt that the shortcoming in Basel II norms is what led to the
global financial crisis of 2008. That is because Basel II did not have any
explicit regulation on the debt that banks could take on their books, and
focused more on individual financial institutions, while ignoring
systemic risk. To ensure that banks don’t take on excessive debt, and that
they don’t rely too much on short term funds, Basel III norms were
proposed in 2010.

- The guidelines aim to promote a more resilient banking system


by focusing on four vital banking parameters viz. capital, leverage, funding
and liquidity.

- Requirements for common equity and Tier 1 capital will be 4.5% and 6%,
respectively.

- The liquidity coverage ratio(LCR) will require banks to hold a buffer of


high quality liquid assets sufficient to deal with the cash outflows
encountered in an acute short term stress scenario as specified by
supervisors. The minimum
LCR requirement will be to reach 100% on 1 January 2019. This is to
prevent situations like "Bank Run".

You might also like