Derivatives and Hedge Funds

FIGURE 13.5
Impact of Length of Commitment on Hedge Fund Allocation

commodity pool. The secret to this strategy is to commit a portion of the
hedge fund investment to a zero coupon bond that matures at the full value
of the initial investment some years later. Also, the zero coupon bond must
be placed in a segregated account, preventing possible creditors of the
hedge fund from getting it if the hedge fund loses more than 100 percent of
partner capital.
Zero coupon bonds sell at a discount from face value. The amount of
that discount can be invested in a hedge fund without regard to risk be-
cause, even if the hedge fund loses 100 percent of the money, the zero
coupon bonds will still mature at the full value of the initial investment.
Figure 13.5 shows the allocation to zero coupon bonds at a 5 percent
rate of return for various maturities. Zero coupon bonds trade near par for
short maturities, so little discount is available to invest in the hedge fund
strategy. For a commitment period of five years, only 22 percent can be al-
located to the hedge fund strategy.
At lower levels of interest rates, nearly all the assets are allocated to the
zero coupon bond portion of the strategy. As a result, the blended return on
this portfolio is low. However, when rates are higher, the discount on bonds
is larger and more of the money can be allocated to the hedge fund strategy.
(See Figure 13.6.) As rates rise from 5 percent to 10 percent, the allocation
to hedge funds nearly doubles from 22 percent to 39 percent. Higher mar-
ket returns make it easier to achieve a guaranteed breakeven but the oppor-
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