SUMMARY
The introductory chapter presented a definition of hedge funds, despite the
lack of clear divisions between hedge funds and other types of investment
accounts. This chapter on investment techniques reflects the grayness of
that definition. All the techniques described in this chapter are used by
other types of investors as well as hedge funds. Notably, many of the tech-
niques were developed by proprietary traders within broker-dealers.
Hedge funds have adopted these techniques along with conventional
investment techniques to create desirable returns for their investors. The
techniques described are more sophisticated and often require trading that
is either prohibited or untypical of mutual funds, trust accounts, and con-
ventional investment advisory accounts. Because the techniques create a
pattern of returns that don't track stock and bond returns closely, they pro-
vide a way for the hedge fund investor to improve the return and risk char-
acteristics of a traditional portfolio.
QUESTIONS AND PROBLEMS
4.1
A hedge fund manager claims to have a "black box." None of the in-
vestment decisions are left to the discretion of the hedge fund traders.
Is the black box a technical trading strategy?
4.2
A hedge fund hears a rumor that Company X is considering making a
takeover bid for Company Y. The hedge fund buys shares in Com-
pany Y, hoping to profit from a run-up in price when the bidding is
announced. Is this a merger arbitrage trade?
4.3
Suppose Company X announces a bid for Company Y to be paid in
cash. Should the merger arbitrage trader sell Company X shares to
hedge a purchase of Company Y shares?
4.4
A trader estimates that he can make $5 per share after financing costs
and commissions if the merger is completed at $105. However, if the
deal is not completed, the position could lose $10. Explain why the
trader might justify risking a 10 percent loss to try to capture a 5 per-
cent gain.
4.5
XYZ L.P. operates as a merger arbitrage hedge fund. Is it likely that
the manager of XYZ prefers to enter into takeover events where the
acquiring company has a high dividend and the target company has a
low dividend?
4.6
Why is a hedge fund a good structure for investing in bankruptcy-
prone companies?
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