Before delving into the various hedging strategies that make hedge funds such a popular investment, one needs to consider the different types of risk out there that can be impacted by hedging. These risks also determine which type of hedging strategy will be used.
- Commodity risk: This is the risk associated with a change in the price of a commodity (production input such as metals, energy related goods and agricultural products among many others). The risk is generated from fluctuation in the possible movements of commodity contracts.
- Credit risk: This is the risk associated with a loss in terms of the principal or the financial reward emanating from a certain borrowers inability to pay back a loan or fulfill a contractual stipulation. This risk arises when the borrower is hoping to use future potential cash flows to repay the current debts.
- Currency risk: This risk occurs when there is a potential change in the movement of prices related to one currency against another. All investors who have assets in a foreign country face this risk unless they are hedged.
- Interest rate risk: This is another common type of risk and stems from the fact that the relative value of an interest bearing liability (loan or bond) will deteriorate if the absolute value of the interest rate rises.
- Equity risk: This is the risk associated with equity investment depreciation, due to stock market dynamics leading the investor to lose money.
- Volatility risk: This type of risk is associated with bond options. This is the risk that accompanies exchange rate movements and how they impact the investment portfolio in foreign currency terms.
Hedging strategies are countless in number, and they depend on the type of risk, market conditions and the managers expertise. As mentioned above, the hedging strategies involve a combination of financial instruments and leverage. These financial instruments are derivatives, mainly options (a contract sold by an option writer to another party, and entails the right of the buyer to sell or buy a particular security or financial asset at a predetermined price) and futures (a financial contract that imposes on the buyer to buy an asset at an agreed-upon date and price).
The hedge fund strategies are broadly divided into event-driven, equity, global macro, relative value arbitrage, and directional.
- Equity Hedge: This type of strategy is also called the long/short equity and is one of the earliest and simplest of strategies. It entails a combination of strategies:
- Long/short: Hedge fund managers have an option to purchase stocks that they think are undervalued or sell short the stock they feel are overvalued. Usually, the funds will have a positive exposure to the equity markets, such as 70 percent of the invested funds into long stocks and 30 percent of the funds into shorting of the stocks. Hence, as per this example, the general net exposure to the market would be 40p percent and the fund would be devoid of using leverage, implying that the gross exposure would be a complete 100 percent. This can be tweaked around if the fund manager increases their current long position to an 80 percent, while still maintaining the 30 percent short position, which would increase the market exposure to a 110 percent. The additional 10 percent would be the leverage.
- Market neutral: In this strategy, the fund manager aims to generate profits by the increasing and decreasing prices in the market(s). The manager seeks to minimize the general exposure to the market. This can be achieved in two ways:
- If the manager invested an equal 50 percent each in both the long and short stocks, which would make the net exposure zero percent, while the gross exposure would be 100 percent.
- The second way to achieve market neutrality is by having zero exposure beta. The goal that managers want to achieve with this strategy is to remove the volatility exhibited via market movements.
- Global Macro: This hedging strategy aims to derive profits from changes in the global economies that are brought about by changes in the government policies that impact the interest rates, which then affect the currency, bond and stock markets. These strategies generally garner the greatest risk/return risk profiles of any hedge fund strategy. These funds invest largely in stocks, bonds, currencies, futures, options and other forms of derivative securities. Global macro funds place certain directional bets on prices of underlying assets and they are typically highly leveraged. The reason for the name is that most of these have a global perspective and the wide diversity of investments, and the size of markets in which they invest ensure that the investment can proliferate before being challenged by any possible capacity problems.
- Relative Value Arbitrage: These strategies exploit the relative discrepancies in price between certain securities. The main concept is that the manager will purchase a security that is anticipated to appreciate whilst, at the same time, selling short a related security that is anticipated to depreciate. These securities can be bonds or stocks. The discrepancies are usually related to the mispricing of securities as opposed to relative securities or the overall market. To estimate this mispricing, the managers undertake a variety of sophisticated mathematical, technical and/or fundamental techniques. The various relative value arbitrage strategies include:
- Fixed income arbitrage: The pricing inefficiencies between fixed income securities are exploited by fund managers.
- Convertible arbitrage: This involves taking positions in both the convertible bonds and stocks of a specific organization.
Other important types of relative value arbitrage strategies include asset-backed securities, credit long/short, risk arbitrage and volatility arbitrage.
- Distressed securities: These are hedge fund strategies when they invest in distressed securities. These securities are financial instruments of organizations that are on the brink of bankruptcy or currently undergoing it. Thus, these securities have a highly reduced value. In such a case, the hedge fund can be embroiled in the loan workings or restructurings of the bankrupt company. The strategy entails purchasing low value distressed securities as the company nears bankruptcy or buying these securities when the company is coming out of its bankruptcy phase. The intuition is that the low valued securities would be traded at extremely discounted values that it may generate attractive risk-adjusted returns.
- Event-driven securities: Strategies associated with trading securities, investment opportunities, and the risk underlying the securities as per a particular event.
There are many more hedging strategies that are used; however, these are the main and most popular ones.