Hedge Fund

default. Then, the hedge fund makes money over time, as long as yield
spreads remain steady or narrow to smaller spreads.
Fixed income hedge funds may also buy and sell combinations of se-
curities, hoping to profit from changes in the relationship between the
long positions and the short positions. For example, a fund might buy
short-term securities and sell short long-term securities, hoping that the
yields on the short instruments will decline relative to the yields on the
longer issues. This trade is called "buying the curve." Although these
trades may be constructed to be neutral to a general rise or decline in
rates, the positions make or lose money based on the performance of the
individual sectors.
Mortgage/Asset-Backed Arbitrage
Fixed income arbitrage hedge funds may use mortgage-backed securities or
asset-backed securities to construct market neutral portfolios. Mortgage-
backed securities are securities that are created from pools of mortgages.
Most of these securities are issued as pass-through securities by Freddie
Mac and Fannie Mae, although many have been reissued as collateralized
mortgage obligations (CMOs), interest-only (IO), and principal-only (PO)
notes, and other mortgage derivatives. Mortgage-backed securities present
a challenge in constructing and maintaining a market neutral portfolio be-
cause these securities reflect the prepayment option granted to the home-
owner on the underlying mortgages.
Asset-backed securities are created from a wide variety of loans, al-
though most asset-backed securities are created from consumer loans, such
as credit card receivables and automobile loans. Asset-backed securities do
not present the hedging challenge of mortgage-backed securities. Instead,
the investor faces the risk of default.
Several hedge funds have faced challenges running mortgage-backed
strategies, including the well-publicized bankruptcy of the Granite Fund
and financing challenges at Ellington
3
and MKP Capital. The first essen-
tial ingredient needed to run either mortgage-backed or asset-backed ar-
bitrage strategies is to have a robust valuation model. If the valuation
model is sound, then the hedge fund can measure the sensitivity of the
positions to changes in interest rates, credit spreads, volatility, and other
factors. The second essential ingredient is having a strategy for surviving
periods when these types of securities go out of favor with investors. It is
important for hedge funds to maintain some borrowing capacity for
times when these assets are subject to distress pricing and lenders raise
margin requirements.
68
HEDGE FUND COURSE
ccc_mccrary_ch04_59-72.qxd 10/6/04 1:42 PM Page 68