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Many investors are not interested in assuming low levels of risk

11.2 Probabilistic risk models allow the risk manager to measure risk even when there is no arbitrage relationship or other inherent set of mathematical relationships linking positions in a portfolio. Although the probability-based models may not be able to answer exactly the same questions that bond mathematics or option hedging allows, these models can still provide valuable measures of risk. This information can be used by traders and risk managers to influence risk-taking decisions.

.3 Many investors are not interested in assuming low levels of risk. Generally, higher returns are associated with higher levels of risk in a portfolio. Risk management includes the choice of the level of risk as well as the measurement of risk to manage the match between risk tolerance and the risk in the portfolio. Further, risk management usually includes an analysis of whether the risks assumed in a portfolio provide the best chance for reward in light of those risks.

11.4 The prices of many bonds track key interest rates very closely.

Within this large subset of bonds, the specific price sensitivity of a bond can be fairly precisely predicted relative to another bond or other bonds.

11.5 The full price or dirty price is the price of the bond including accrued interest. In the bond pricing formula, the dirty price is the present value of the coupons and final maturity. For the net price or price generally used in trading, quotations, and position reporting, this present value is reduced by the accrued interest.

11.6 The average life is a measure of the time between the settlement date and each of the cash flows. It is a measure of risk because longer bonds generally have more risk than bonds with shorter maturities. Duration, however, adds the additional refinement of valuing each cash flow at its present value, so that payments in the distant future that have little value also have less impact on the duration than the same cash flows have on average life.

11.7 The largest advantage of hedging the currency exposure is the liquidity of the U.S. dollar exchange rates. In addition, the peso exposure might be netted with other dollar or dollar proxy positions, reducing the size of the required hedge. The largest disadvantage comes if the Argentine peso decouples from the U.S. dollar. Such a proxy hedge is an unhedged bet that the Argentine peso remains tied to the dollar.

11.8 Aside from several operational problems like beta not being stable over time, it really isnt the right measure of risk for securities unless the correlation between the assets is very high. In other words, the risk of a stock in a portfolio can be much lower than the risk of the stock as a freestanding investment when diversification offers substantial risk reduction.

11.9 A long straddle consists of a long call plus a long put position. The straddle benefits from substantially higher prices (because the call becomes valuable) or substantially lower prices (because the put becomes valuable). The hedged call closely resembles this payoff. In a declining market, the call becomes worthless and the hedge becomes an outright short position similar to the long put position in a straddle. In a rally, the call begins to gain value 1 for 1 with the underlying future and appreciates more than a ratioed short position similar to the call in a straddle.

11.10 The delta of an option is the hedge ratio between an option and the underlying instrument. Because the option confers the right but not the obligation to buy or sell, it can gain or loss money more slowly than an outright position in the underlying instrument. Under most circumstances, an option will move no faster than the underlying instrument from which it derives its value. For deep-in-the-money European options, the maximum hedge ratio is the present value of the delta (hedge ratio) 1.00 because any payoffs on the option are received only in the future.

11.11 You could overweight the five-year by 25 percent. If the relationship between the two-year and five-year follows the past pattern, your positions will not show gain or loss from changes in the yields of the underlying instruments. Alternatively, you could underweight the two-year position by 20 percent because the the unadjusted five-year, at 100 percent of the duration-based weighting, is 125 percent of the two-year that represents only 80 percent of the unadjusted amount.

11.12 Modified duration represents the percent change in value for the position for a change in yield. The formula for modified duration was derived from the present value formula before accrued interest is subtracted. Modified duration will underestimate price changes if applied to the net price instead of the full or dirty price, which includes accrued interest. When applied to trade weightings, the price sensitivity of both the long and short positions will be too low.

Whether that error affects the long position more than the short position depends on the amount of accrued interest on the long position in comparison to the amount of accrued interest on the short position. The error could create a hedge ratio that is not neutral to changes in interest rates particular strategies and those speakers typically list the names of the funds they manage in their credentials. If the presentation resembled a marketing presentation, an unhappy investor might try to argue that the speech was a prohibited solicitation.

12.2 Probably not. The marketing manager must talk about the convertible arbitrage strategy generally, not about XYZ Hedge Fund. The marketing manager is able to discuss XYZ to potential investors who approach the speaker during the conference.

12.3 The speech by the third-party marketer probably would be considered a general advertisement for XYZ Hedge Fund. The marketer would be in violation but the hedge fund would not be in violation unless it could be shown that the hedge fund was involved in preparing the presentation and knew that the third-party marketer would be making a prohibited general solicitation.

12.4 The investor has no restrictions on her ability to contact hedge funds. She can contact as many funds as she wishes with or without having any relationship prior to the contact. Once contacted, the fund managers can reply and solicit her for an investment.

12.5 The manager pays the third-party marketer out of the fees that are paid to the management company. Typically, the investor is charged no more but the manager shares part of the fees with the third-party marketer. Investors should always read the documentation when investing. It is permissible to construct a different fee structure as long as the fees are disclosed to investors.

12.6 The restrictions on advertising were designed to straddle a line between maintaining laws to protect most investors and also allow exceptions for investors that need no protection. The restrictions limit the exempted investments to wealthy investors with a fair degree of investment experience. The advertising ban in particular limits the breadth and scale of a private placement.

Securities laws do not specifically prohibit hedge funds from advertising. The prohibition exists because of an exception built into the laws affecting securities registration. In most cases, hedge funds issue shares in a limited liability corporation or partnership interests in a limited partner as a private placement. That private placement is exempt from registration requirements but the hedge fund manager must not make a general solicitation or a general advertising appeal.

Registered hedge funds and registered funds of hedge funds are being created. These registered investment products can be sold to individuals who would not qualify to invest in a traditional hedge fund. It may be possible to advertise these investments.

Hedge funds in many jurisdictions outside the United States can advertise.

12.7 This fee structure is very simple. The marketer receives 20 percent of all management and incentive fees collected, not just the fees associated with the $10 million raised for the fund. The gross profit of the fund is 10 percent of $15 million or $1.5 million, so the fund is worth $16.5 million before assessing the management fee. A 1 percent management fee is $165,000. The return on the fund after the management fee is $1.5 million less $165,000 or $1,335,000. The management company collects 20 percent of $1,335,000 or $267,000. The third-party marketer collects 20 percent of both the $165,000 fee and the $267,000 incentive fee or $86,400.

12.8 Of the $15 million in assets, $5 million existed before the third-party marketer started to work with the hedge fund. Therefore, one-third of the fees paid to the marketer reflect fees not attributable to the thirdparty marketers efforts.

prime broker likely will not participate in the fees. However, based on the inclusive provision, the third-party marketer would be paid 20 percent of the fees collected on returns attributed to the $1 million investment.

Many hedge funds provide returns comparable to stock returns but with substantially lower risk. For many hedge funds, a leveraged investment would be no more risky than an investment in the S&P 500 and may provide substantially higher returns.

Investors may be able to improve the diversification of their portfolios by adding leveraged hedge fund returns to traditional portfolios. Suppose a portfolio manager allocated 10 percent of the portfolio to alternative assets. If the 10 percent is invested in a single hedge fund, the portfolio may gain some benefits from diversification but could get even more benefit by investing the money in hedge fund derivatives that would replicate an investment of 20 percent of the portfolio in hedge funds. The additional commitment to the alternatives plus the possibility of including multiple hedge funds means that the total risk of the portfolio might be lower than the portfolio with 10 percent invested directly in hedge funds.

In additional to creating leverage, derivatives that are tied to hedge fund returns can offer downside protection. For example, an investment in calls or swaptions tied to hedge fund returns might have twice the upside potential of a direct investment but no additional downside.

Finally, if hedge fund derivatives can provide tax advantages over direct investment, the derivate alternative may offer higher after-tax returns in a wide range of possible outcomes. This higher after-tax return may justify taking a higher risk profile. Although leverage inherently increases the chance of loss, the higher average return reduces the chance of loss.

.2 If it is imprudent for an investor to invest directly in a particular hedge fund, it would likely be imprudent for the investor to invest in derivatives based on that hedge fund. If the investor does not have sufficient investment experience or risk tolerance to invest in hedge fund, that investor probably lacks the investment experience or risk tolerance to invest in similar derivatives. However, the derivative may be less risky because of optional characteristics it may have. The derivative may not exactly replicate the return of the hedge fund. Instead, the derivative may be based on an index of hedge fund returns that offers some benefit of diversification over the direct investment in a single fund.

13.3 When there are tax advantages of one investment over another, the taxpayer is permitted to consider the tax treatment as part of an investment decision. However, tax savings cannot be the entire motivation for the derivative trade. It is important to show that there was a business purpose in making the investment and the investor felt there was a reasonable chance to make money with the investment. The results of past court cases have depended on the particular facts, and there have been almost no cases dealing specifically with the tax treatment of hedge fund derivatives.

13.4 The IRS does ask the courts to look through the business structure of sham transactions as if the structures did not exist. It is plausible that the IRS might argue that an investment in a derivative was an artificial way to avoid having to report interest expenses that could require the investor to pay UBIT.

For several reasons, the tax-free investor could argue that a hedge fund derivative was not a sham trade. First, the tax-exempt investor is permitted to consider taxes in making investment decisions and could argue that there was a business purpose and an economic motive for investing in the instrument. Second, the derivative investment could differ materially from a direct investment in terms of downside protection, leverage, or even in the extent that the derivative replicated the direct investment. Third, the tax-free investor can invest in offshore hedge funds that do not pass through interest expense. Tax-free investors can invest in banks that also have large interest expenses. Although the tax code can trigger a UBIT situation, the IRS doesnt view the hedge fund industry and the tax-exempt investors as abusive tax shelters. Finally, tax-exempt investors do invest in a variety of other derivatives and the IRS does not methodically look through these derivatives to see if they can find a way to tax otherwise tax-exempt investors.

On a notional investment of $10 million, this means you receive 80 percent of 5.25 percent on $10 million or $420,000. You pay LIBOR on $10 million at 5 percent (1.25 percent per quarter) or $125,000. You net the two payments and receive $295,000.

13.6 Because the gross return is given, it is not necessary to make calculations involving the management and incentive fees. The investor receives a payment of 80 percent of -2 percent on a notional balance of $10 million (a loss or negative receipt of $160,000). The investor also pays the $125,000 interest calculated in the answer to question 13.6. Therefore, the investor makes a payment of $285,000.

13.7 The swap agreement would appear to create infinite leverage because the $10 million notional position was created with no out-of-pocket cash commitment. The investor is much more limited in the overall leverage possible. Entering into a total return swap with the counterparty was acceptable to the swap counterparty because the hedge fund investor had sufficient capital to convince the counterparty that it could make the swap payments even if the returns turned significantly negative.

Six months later, if rates are still at 12.32 percent, the zero will be worth $583,883 (58.39 percent of face value). The hedge fund portion of the investment is worthless, so the investor is down about 42 percent.

If the investment was structured properly, none of the creditors can access the value of the zero coupon bonds to cover obligations of the hedge fund. However, the investor may not be able to withdraw the guaranteed $1 million for four and a half more years. Perhaps the investor may withdraw the $583,883 value of the zero coupon bonds.

13.9 The call seller may own a call option or a payoff that closely resem

bles a call option. The incentive fee is approximately the same as a call option on a percent of the hedge fund. A manager of a $100 million hedge fund that receives an incentive fee equal to 20 percent of returns has a call option on $20 million of the hedge fund (in fact, 20 percent of the gross return before incentive fees but after management fees).

Although a hedge fund manager could sell a call on the performance of that fund, it might create conflicts of interest for the manager to sell the incentive fee in advance because this mitigates any motivation the investors are paying for. Other parties that receive part of the incentive fee (third-party marketers, early investors, etc.) might sell calls on the fund that match their incentive payments if they dont make decisions that impact fund performance.

Investors and dealers can sell calls and carry positions in the underlying hedge fund assets as a hedge. For example, an investor might buy into a hedge fund and write calls against the position, much like stock and bond investors write covered calls on traditional assets. Dealers buy and sell options and maintain a tightly hedged position of options and the underlying assets to control risk. The limited liquidity available to hedge fund investors complicates the problem of maintaining a hedge over time, but dealers have been willing to trade options on hedge fund returns despite the challenges.

13.10 Hedge fund operators do not receive fees that resemble a put option.

In fact, in most stock, bond, and commodity markets, there are few natural sellers of put options. Similarly, dealers may have a hard time selling and hedging puts on hedge fund performance because the appropriate hedge for a sale of a put option is a short sale of the underlying asset, and selling short the performance of a particular hedge fund is difficult, at least at this stage of development of the hedge fund derivatives market. At least in principal, the seller of a put option on hedge fund performance could hedge the option by selling short assets held in the hedge fund. This hedging alternative is possible only if the hedge fund grants complete transparency. Because the option hedger is likely to be selling all the assets held by the hedge fund whenever fund performance is poor, it is not likely that the hedge fund would continually cooperate with the option market maker.

13.11 The portfolio of individual call options is worth at least as much as a call option on the hedge fund index and is probably worth more than the call option on the index. The difference depends on the extent the hedge funds move together. If hedge fund returns overall are flat to down, the call on the index would be worthless but individual hedge funds might have had profits that make a call option valuable for the individual hedge fund.

13.12 The value of most options should never be less than zero because the owner can simply let the option expire. While it is possible to imagine options that carry costs to abandon them, this is not a common structure.

13.13 Some of the premium payments must go toward providing a death benefit for the insurance policy to gain the tax treatment of insurance. The death benefit has economic value but may not be highly valued by a hedge fund investor.

Also, insurance policy transfers the hedge fund assets to beneficiaries. The purchaser of the policy (i.e., the hedge fund investor) cannot be a beneficiary and the purchaser cannot redeem the cash value of the policy without paying tax on the hedge fund returns. Nevertheless, the policy purchaser can borrow the cash value back if the need arises, but the amount lent reduces the payout to beneficiaries.

13.14 Hedge fund returns are taxed at higher tax rates than long-term investments in common stock because a large part of the stock return is taxed as long-term capital gains. Of course, bond income is a major component of bond returns and this income is also taxed at the higher ordinary income rate.

For example, ignoring the additional benefit possible from postponing capital gains tax or the avoidance of capital gains tax altogether at death, the difference in tax rate (here assumed to be 40 percent on ordinary income and short-term gains and 20 percent on long-term capital gains) means that a hedge fund must provide a return of 20 percent before tax to match the after-tax return on stocks making 15 percent if all of the stock return is long-term capital gain and all of the hedge fund return is taxed as ordinary income. Furthermore, if hedge fund returns escape taxation as part of a universal life insurance policy, the hedge fund need earn only 12 percent to match the after-tax return of a taxable investment earning 15 percent subject to capital gains tax or 20 percent subject to ordinary income tax.

13.15 The insurance policy accumulates $2 million (1 + 10%)10 = $5,187,485. The after-tax return on the hedge fund is 10% (100% 35%) = 6.5%. The hedge fund outside the insurance policy would accumulate $2 million (1 + 6.5%)10 = $3,754,275.



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Previous Issues

200605-27The hedge fund will likely mark the positions to market regularly and associate the gain or loss to the investors

200605-26Hedge funds that do not use leverage will not generate much interest expense

200605-25The multistrategy hedge fund produces a nominal return

200605-24Some hedge funds are designed to provide very high returns and may accept high degrees of risk to attain those returns

200605-23Hedge fund investments can be structured as notes that pay a coupon equal to the return of the underlying hedge fund assets

200605-22Hedge funds face very few restrictions on their use of derivatives in their portfolios

200605-21Marketing and Hedge Fund Regulations in the United States

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