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10 Business Snapshot 1.1 Hedge Funds

CHAPTER 1

Hedge funds have become major users of derivatives for hedging, speculation, and arbitrage. A hedge fund is similar to a mutual fund in that it invests funds on behalf of clients. However, unlike mutual funds hedge funds are not required to register under U.S. federal securities law. This is because they accept funds only from ®nancially sophisticated individuals and do not publicly o€er their securities. Mutual funds are subject to regulations requiring that shares in the funds be fairly priced, that the shares be redeemable at any time, that investment policies be disclosed, that the use of leverage be limited, that no short positions be taken, and so on. Hedge funds are relatively free of these regulations. This gives them a great deal of freedom to develop sophisticated, unconventional, and proprietary investment strategies. The fees charged by hedge fund managers are dependent on the fund's performance and are relatively highÐtypically 1 to 2% of the amount invested plus 20% of the pro®ts. Hedge funds have grown in popularity with over $1 trillion being invested throughout the world. ``Funds of funds'' have been set up to invest in a portfolio of other hedge funds. The investment strategy followed by a hedge fund manager often involves using derivatives to set up a speculative or arbitrage position. Once the strategy has been de®ned, the hedge fund manager must: 1. Evaluate the risks to which the fund is exposed. 2. Decide which risks are acceptable and which will be hedged. 3. Devise strategies (usually involving derivatives) to hedge the unacceptable risks. Here are some examples of the labels used for hedge funds together with the trading strategies followed: Convertible Arbitrage: Take a long position in a convertible bond combined with an actively managed short position in the underlying equity.

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