Hedge funds come in many shapes and sizes. They operate many diverse investment strategies that seek to generate returns that are less dependent on the direction of traditional equity, bond, commodity and currency markets. This makes them useful in diversifying traditional risk factors in an investment portfolio. There are a number of well established hedge fund strategies.

Equity long short investing is one of the most common and well known strategies. It is an extension of traditional long only equity investing but adds the ability to sell short and to use leverage. The basis of equity long short investing is to seek good companies or undervalued companies to buy on the long side, and poorly run or overvalued companies to sell short. Buy balancing long and short exposures market risk can be hedged to the desired level. Most equity long short funds run a net long bias. Some equity long short funds are market neutral in that they seek to hedge out all their market exposure. The risk they run is idiosyncratic company specific risk.

Credit long short investing is another hedge fund strategy. It is less common than equity long short investing, however, the main principles are similar. The manager seeks good and undervalued companies to buy long and poorly run or overvalued companies to sell short. In this case, however, instead of trading in the equity of these companies, the manager buys and sells the debt of the companies. This includes bonds, convertible bonds, bank debt, trade receivables and credit default swaps.

A special case of credit long short is capital structure arbitrage. This is a more sophisticated form of credit long short and more often than not involves buying and selling the equity or debt instruments issued by the same company. Very often capital structures of companies are not properly valued because the investors who trade equities and the investors who trade bonds are different and have different objectives. Examples of capital structure arbitrage are long senior debt versus short subordinated debt. In case of default or reorganization the recovery value in the senior security is higher than in the subordinated security.

Convertible arbitrage is a very interesting form of hedge fund investing because it combines elements of equity, credit and volatility trading. The typical trade in convertible arbitrage is to hold the convertible long, short a delta amount of equity, and hedge out the credit risk with CDS or an asset swap. Convertible arbitrage can take advantage of mispriced equity optionality where the manager consistently re-hedges the convertible with a delta amount of equity as the equity price fluctuates. Convertibles can also be used to create high carry levered positions with little equity risk. Convertibles also feature in distress or stressed investing.

Fixed income arbitrage refers to non-credit related bond and bond derivative trading and is usually expressed in sovereign issues. There are two main schools which include Macro and Arbitrage. Macro fixed income investing is based on the premise that pricing in fixed income markets reflect macro conditions and economic policy. Managers seek to make money by having a macro view and expressing it by trading sovereign fixed income securities and derivatives. Arbitrage strategies are predicated on the thesis that relationships between different securities tend to a no-arbitrage position over time. Managers seek inefficiently priced securities and bet that they converge to efficient pricing.

Distress investing involves investing in the securities of companies in distress or bankruptcy. This can range from equity to debt, bank debt, CDS, trade claims, options et al. Often these securities are incorrectly valued and priced and often holders of such securities are forced to dispose of them at uneconomic prices. Sometimes the manager will be an activist in steering the outcome of the bankruptcy process. Distress investing brings together business valuation, legal understanding of bankruptcy processes, trading ability and an understanding of the motivations of incumbent stakeholders from shareholders to creditors to management.

Merger arbitrage invests in situations where one company is taking over another. It usually involves buying the target company and selling the acquiring company (in a stock offer) or just the target (in a cash offer.) The strategy has evolved to include investing in any hard catalyst (announced deal) situation to include de-mergers or spin offs, asset sales and other special corporate actions. The strategy seeks to make money by deciding if a situation will evolve as announced or not. More evolved strategies also opine on the path of a situation playing out to completion or deal break.

Global Macro is one of the oldest and most well known hedge fund strategies. Broad types of macro strategies include Fixed Income, the most common type, which avoids the idiosyncratic risk inherent in equities or corporate credit, Commodities, which are very much driven by demand and supply and thus correlated to industrial production, FX, which is an extension of fixed income macro with elements of inflation and rates and finally Equities, which is a less common expression of global macro as it contains the idiosyncratic risk inherent in companies’ financial performance and outlook.

Merger Arbitrage (sometimes referred to as Risk Arbitrage) is a strategy that invests in the securities of companies that are party to a merger or takeover transaction.

In a cash offer where the arbitrageur expects the merger to be successful, they will buy the target company. In the case of a stock exchange the arbitrageur will sell the acquirer and buy the target in the ratio of the exchange.

A couple of examples are helpful:

1. Company B announces a cash offer for Company A for 10 usd. Company A was trading at 6 usd before the announcement. The arbitrageur is happy to pay up to but not more than 10 usd for Company A since they can sell it to Company B for 10 usd. If they are able to buy Company A for anything less than 10 usd they are able to realize a profit by selling it to Company B for 10 usd. Upon announcement, the price of Company A will typically trade up close to the cash offer price. It will usually not trade at precisely the cash offer price since there is always a chance that the deal will break.

2. Company B announces a share exchange offer for Company A at a rate of 2 shares of A for 1 share of B. The arbitrageur will buy 2 shares of A for every share of B that it sells short. It is the intention when the deal closes to exchange the 2 shares of A for 1 share of B to deliver into the short. Upon announcement, the share price of A will typically trade up close to the half the share price of B. It will not trade at exactly half the value of B since there is always some non-zero chance that the deal will not go through. The spread between the market price and the implied price is the deal spread and is what the arbitrageur seeks to lock in.

Merger arbitrage payoffs are not symmetrical. Typically, the potential profit is small relative to the potential downside. As an example, a stock trading at 30 may trade to 50 if the cash offer is 55. The potential upside is 5 if the deal is completed and the potential loss should the deal fail is 20 as the stock may trade back to pre-announcement levels. The relative upside and downside magnitudes are usual of many deals. Why then engage in such a trade?

The arbitrageur typically tries to ascertain the probability of the deal failing. If the probability is 10% in our example above, then the expected return of the trade is 90% X 5 + 10% X (-20) = 2.50 a positive expectation. A positive expected value means that the trade is a viable one. In friendly deals the probability of deal break is circa 3-5%.

By diversifying the portfolio over a number of deals, the probability of achieving the average expected value of the deals is enhanced. The correlation between deals tends to be low since deal risk is idiosyncratic and not systemic. Exceptional circumstances can introduce systemic deal failures such as 2008 when the leverage which is endemic to LBOs was withdrawn by banks while primary liquidity in the leveraged loans market dried up. Absent such catastrophic liquidity conditions, a portfolio approach to a collection of positive expectation, albeit negatively skewed and leptokurtic trades is defensible and indeed efficient.

It is crucial therefore that the arbitrageur quantifies the risk of deal break. Apart from a deal failing to close, it may be delayed or repriced or may face competing bids.

A deal may fail to close if it fails to satisfy the conditions of the merger, if it fails to obtain requisite shareholder approval, if it fails to receive anti-trust and other regulatory approvals, if the acquirer is unable or unwilling to complete, if the target is unwilling or unable to complete or if the financing for the transaction is or becomes unavailable, among other things.

The risk to the arbitrageur includes:

The Merger Agreement, which specify the terms and conditions of the transaction and govern the rights and obligations of the parties involved to consummate or terminate the transaction.

The acquirer becoming a target, which can happen when M&A activity is elevated, and can result in a loss in both the long and short positions as the acquirer’s shares rise and the target’s shares fall.

Material changes to the financial condition of the target or the acquirer. The acquirer may terminate a deal if there are material adverse changes to the target. The financing banks may withdraw their support if the solvency or viability of the combined entity is in question.

Market Risk, where market conditions may affect credit conditions for financing a deal or where deal spreads may exhibit significant volatility.

Legal and regulatory risk, where a transaction may require the approval of anti trust authorities or other regulations. Political risk is material in strategic industries or in cross border transactions whic
h may involve mercantilist domiciles.

Alternative expressions of Merger Arbitrage.

To be clear, Ivan Boesky’s unique style of merger arbitrage which he perpetrated in the 1980s, that of trading preemptively prior to an announcement on material, non-public information, is patently illegal.

There are many other completely legal and equally exciting and lucrative expressions of merger arbitrage.

Options. The asymmetry of returns to the individual trade present a problem to the arbitrageur which can sometimes be corrected through the use of options. Long positions in the target company can be protected with put options. Or the long cash long put position can be equally expressed through a long call option. This is an expensive strategy but it compensates for the asymmetry of the trade expressed solely in the equity of the companies in question. It is expensive because post announcement, implied volatilities tend to surge as arbitrageurs rush to hedge their short volatility returns profiles. Not only do implied vols tend to rise, they tend to flatten and sometimes invert the term structure. If an arbitrageur goes beyond ascertaining or ascribing probabilities of closure, to establishing an expectation for the path to closure, the options markets offer excellent opportunities. Anti trust and other regulatory decision dates are opportunities for the arbitrageur to buy or sell options depending on their view on specific outcomes. An example is instructive. If the arbitrageur expects an anti trust hearing to delay the closure of a deal they might sell volatility to the initial expected closing date to fund the buying of longer dated options.

Path dependent strategies extract more value and return from a merger event than the garden variety trade expressions.

Credit. When one of the companies in a merger, especially if it is the target, has no listed or traded equities, vanilla arbitrage strategies are confounded. The impact of a merger on the condition of the companies in question range beyond the impact on their equity. The entire capital structure can and often is impacted. The arbitrageur who is able to express the trade across the capital structure, from equity to debt, is often well placed to profit from less crowded trades. An example might involve a company buying an unlisted company which has bonds or bank debt in issue. Differential treatment of claims under change of control can cause different claims to price differently creating arbitrage or trading opportunities.

Activism is an exciting area of merger arbitrage and involves the arbitrageur actively engaging with the management of one or both of the companies in a transaction. Encouraging and facilitating a higher competing bid is one of the ways of creating value. Helping or facilitating a potentially failing deal to close is another strategy sometimes pursued.

On 14 October 2011 I wrote that the the Seeds of a US Economic Recovery had been sown and that it lay in the export sector. The robust trend in US exports and the trade balance continues to take hold.

In September, exports improved from 178 billion USD to 180 billion USD and the trade balance strengthened to -43 billion USD against a prior -45 billion USD and a forecast -46 billion USD. The numbers were the result of slightly improved exports but significantly slower imports. Exports to Canada and Mexico were mostly unchanged to slightly weaker. Exports to the European Union were sightly stronger. Exports to the UK were significantly stronger. Exports to the Pacific Rim continue to rise significantly in an encouraging trend.

Its still early days yet but clearly the weak USD is beginning to do the job. Manufacturing is gradually being brought back onshore and it is a matter of time before this manifests itself in employment data. Job vacancies grew over 7% in September.

The threat to the recovery lies in emerging market growth since this is also the current source of strength. The US does most trade within its own time zone, to the North and South. The current recovery is therefore sensitive to the prospects for Canada, South, Central and Latin America. While the direct trade with China is not as large as the importance many economists or investors place on it, the Americas are exposed to China through its voracious appetite for natural resources. A slowdown in China would threaten the Americas and indirectly as well as directly US exports. So far this is more a risk than a current reality, but it bears close monitoring.

In the meantime, flagging inflation numbers in China may provide the Chinese room for looser policy which would support the export driven US recovery. Balanced against this is the fact that food price inflation remains persistently high while the rest of the CPI basket is flat to deflating. Policy may be more sensitive to the specific components of the CPI than headline numbers.  Anecdotal evidence of credit and liquidity shortages are also ominous signs that China’s tight fiscal and monetary policies may have overshot their mark.

Perversely, while European economies struggle with keeping the Euro together and the banking industry solvent, and this persistently spooks markets, it may have positive substitution effects for US products and services.

Since the 1980s US companies began to ‘offshore’ their operations either directly or through engaging foreign suppliers. The result was not only a chronically high and increasing trade deficit but also an increasing share of corporates’ share of GDP at the expense of labour’s share of GDP. Until 2008 this trend has been intact. With the financial crisis and a repricing of the USD as well as reduced availability of trade finance, this dynamic is being thrown into reverse. As manufacturing is brought back onshore the labour’s share of GDP will rise relative to corporate’s. It is still early days.

For now the tactical position is to be long US exporters and short domestics. This will change in future as the export recovery broadens to the rest of the economy.

As a unifying currency the Euro has been pretty divisive. The comprehensive plan that Sarkozy and Merkel devised only a couple of weeks ago has fallen apart.

It fell apart because it was held together by wishful thinking. For Greece, the alternative to default today is default tomorrow. The alternative to leaving the Euro today is leaving the Euro tomorrow. Currency forecasters would do better than fiddling with their charts and come up with some estimate for the value of a new Drachma. Good job all those old currency tickers haven’t been reassigned. We might need them soon.

Everything is possible, at a price. Holding the Euro together is also possible, at a price. There will be winners and losers and there will always be an incentive to cheat and be subsidized by the collective. Policing the deadbeats, as we can now see, is difficult.

Some countries lived beyond their means, others within. Only the fiscally responsible or the lucky can help the profligate or unfortunate.

There are always solutions, but human beings are not always rational, reasonable, just or honorable. In certain emerging markets, driven by a weak economy, for whatever reason that economy is weak, the people leave to seek employment elsewhere. Not every brain surgeon or rocket scientist will find employment in their chosen field, but find employment they do.

Given the culture of entitlement, the over-developed sense of self worth, and generous welfare benefits, some countries will take longer to adjust to the new reality. They may face protracted depression. Or they may feel they have been treated unfairly. When people feel they have been done an injury, it usually matters little who is the cause of that injury.

The Europeans need to be very careful. This is no longer a problem of economics. There is no greater force than a bad idea whose time is up.

The latest plan for the Euro, for the European banking system, for Greece, Italy, Portugal and for the union itself, is unlikely to work.

Here’s why.

Some economies require lower interest rates, some higher. Some need a stronger currency, some a weaker one. Some countries will need to run temporary deficits and some, surpluses. These fundamentals have been ignored in favour of a narrow solution to a particular symptom for a small group of countries. The Eurogroup has suggested that the fate of the Euro is directly related to the unity of the region, a broad and unsubstantiated claim.

The EFSF’s modus operandi is as yet unclear. What we do know is that we intend to establish and maintain a large scale cash flow CLO with the EFSF providing credit enhancement. It is hoped that surplus countries will step in to provide senior financing. The implied leverage will have serious consequences for the financial risks assumed by the EFSF. This is the main risk. Compounding this are credit correlation effects within the term structure of a single sovereign’s securities as well as across sovereigns. Such correlation effects could lead to unexpected losses even if average spreads in the underlying pool are unchanged. The risk management of the EFSF needs special attention. This is a technical issue that has escaped even some of the most sophisticated structured credit traders and the EFSF is at risk of overlooking it.

The credit rating of the EFSF must be questioned if it is providing first loss or subordinated debt to a levered structure. Depending on the implied leverage, small variations or haircuts in the underlying securities could decimate the EFSF’s balance sheet. Member countries’ implicit guarantees to the EFSF will be called and tested.

The 50% haircut negotiated with the banks holding Greek debt still require confirmation. Non-bank claim holders may not cooperate. There is no Chapter 11 process applicable to sovereign distress. The reorganization is therefore not analogous to a prepackaged petition and could be contentious. This is just in the cash securities. The situation in the synthetics is opaque since the quantity of side bets in bilateral credit derivatives is not fully quantified. It is not clear whether the proposed exchange is voluntary or not, and thus if it would represent a credit event under ISDA.

The recapitalization plan for the banking system contained a number, 9% and a date, 9 months down the road. The nature of the recapitalizations have not yet been articulated although bank recaps are known processes. Bank balance sheets remain opaque and or poorly understood and thus cannot be relied upon. Recapitalization to provide for current asset quality is hardly encouraging of bank’s propensity for the credit expansion Europe needs to revive economic growth.

For now at least, the measures are insufficient and not well defined. They are therefore far from a comprehensive solution. Expect failure within weeks.


Recommendations for the future:

Dismantle the Euro, or at least amputate the distressed bits. Free up exchange rates and interest rates as policy tools. Allow additional degrees of freedom for price discovery and resource allocation.

Establish an international Chapter 11 process for sovereign issuers. After centuries of sovereign defaults it is time to establish a process for orderly restructurings.

Create richer sovereign capital structures. The assets of the sovereign are not well defined, mainly because cash flow generation derives from taxes based on potentially fluid corporate and personal taxpayers. As a result, it is not easy to define an ordinal priority of claim against assets. It is, however, possible to define an ordinal claim on cash flows. Such cash waterfall structures resemble CLO structures. Such structures can be complex, as mentioned above, and need careful risk management. But by tranching the immediate liabilities of the sovereign rather than tranching the liabilities of an SPV owning the liabilities of a sovereign, some of the risks are mitigated. Or at least transformed to a less volatile (even if for reasons of serial correlation) form.

Cut marginal tax rates. Countries are basically purveyors of domicile. The elasticity of demand for domicile in a pre Globalized world was low. Today it is high. Reducing marginal tax rates will very likely raise tax revenues. Governments are cognizant of the impact of exchange rates on a country’s competitiveness, they have not yet come to the same realization on taxation.

Social security and welfare reform. Defined benefit schemes of healthcare, unemployment insurance, and pensions need to be reformed in favour of defined contribution schemes. It is beyond the scope of this discussion to delve into the details but the overriding concepts are to instill a greater sense of responsibility for one’s own economic fate, and to discourage the culture of entitlement.


The idea that a common currency implies common goals and aspirations, economic unification, strategic alignment and a common fate is not justified. The efforts of the Euro group have, if anything, exposed the deep differences and fissures within Europe. German pragmatism has clashed with French egalitarianism. Even the tenuous French and German bargain sparked irritation among the Italians. British meddling was warded off curtly by the French. Sometimes it is common ground that is most vigorously disputed.