Topics in Hedge Fund Strategies
Syllabus Spring 2010
Lasse H. Pedersen
John A. Paulson Professor of Finance and Alternative Investments
The class describes some of the main strategies used by hedge funds and proprietary traders and provides a methodology to analyze them. In class and through exercises and projects (see below), the strategies are illustrated using real data and students learn to use “back testing” to evaluate a strategy. The class also covers institutional issues related to short selling, liquidity, margin requirements, risk management, and performance measurement. The strategies’ returns are adjusted for illiquidity and their risks are evaluated, including the risk forced liquidation due to margin constraints.
The class is highly quantitative. As a result of the advanced techniques used in state-of-the-art hedge funds, the class requires the students to work independently, analyze and manipulate real data, and use mathematical modeling.
The students must form groups of up to 5 members and analyze either (i) a hedge fund strategy or (ii) a hedge fund case study. Below you will find ideas for strategies or case studies, but the students are encouraged to come up with their own ideas. Each group must document its findings in a written report to be handed in on the last day of class.
Each group analyzing a strategy must study the economic rationale behind the strategy (what property of the market makes it inefficient in a way that you can exploit?), the relevant evidence from the academic literature (if any), the strategy’s past returns using real data, estimate the associated transactions costs and use of capital (margin), and describe its success (or failure) using several performance measures.
Each group analyzing a case study must describe the involved parties and the events, analyze the underlying economic mechanisms at play, discuss the general lessons that can be learned, and are encouraged to try to estimate the returns and capital use of a strategy that corresponds to that used by the involved hedge fund(s) to verify anecdotal evidence.
The class evaluation will be based on the written group projects, class participation, and the homeworks.
Esben Hedegaard: firstname.lastname@example.org
i. Convertible bond arbitrage: long converts, hedge equity, credit, fixed income; gamma, busted, high-money
ii. Dedicated short bias: identifying frauds, forensic accounting
iii. Emerging markets: emerging stock selection; country selection; currencies
iv. Equity market neutral: value, B/M, P/E; size; momentum; reversals; convergence trades, pairs trading; statistical arb; high frequency trading; index arbitrage
v. Event driven: mergers; distressed; carve outs; spinoffs, splitoffs, when-issued; IPOs, SEOs; SPACs
vi. Fixed income arb: swap spread; yield curve, butterfly; mortgage; CDS-bond basis; on-the-run/off-the-run
vii. Global macro: carry trade (uncovered interest parity); devaluation; thematic; yield curve; country selection; tactical asset allocation
viii. Long/short equity: value, growth; earnings quality; management quality; industry rotations; sector specialists; capital structure arb
ix. Managed futures: trends, countertrends, overextended trends
x. Multi-strategy: several different styles in one fund
a. Fung and Hsieh (1999), “A primer on hedge funds,” Journal of Empirical Finance, vol. 6, pp. 309-331.
b. Malkiel and Saha (2005), “Hedge Funds: Risk and Return,” Financial Analysts Journal, vol. 61, no. 6, 80-88.
a. De Bondt and Thaler (1985), “Does the Stock Market Overreact?,” vol. 49, no. 3, pp. 793-805. Read only pages 793-800.
b. Jegadeesh and Titman (1993), “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” The Journal of Finance, vol. 48, no.1, pp.65-91. Read only pages 65-70.
c. Asness, Friedman, Krail, and Liew (2000), “Style Timing: Value versus Growth,” Journal of Portfolio Management, vol. 26, no. 3, pp 50-60.
Background reading, not required:
d. Asness, Moskowitz, and Pedersen (2008), “Value and Momentum Everywhere”.
e. Fama and French (1992), “The Cross-Section of Expected Stock Returns,” The Journal of Finance, vol. 47, no. 2, pp. 427-465.
f. Fama and French (1993), “Common Risk Factors in the Return on Stocks and Bonds,” Journal of Financial Economics, vol. 33, pp. 3-56.
g. Lakonishok, Shleifer, and Vishny (1994), “Contrarian Investment, Extrapolation, and Risk,” The Journal of Finance, vol. 49, no. 5, pp. 1541-1578.
a. Asness, Krail, and Liew (2001), “Do Hedge Funds Hedge?,” Journal of Portfolio Management, vol. 28, no. 1, pp 6-19.
b. Perold (1988), “The Implementation Shortfall: Paper Versus Reality,” Journal of Portfolio Management, Spring 1988, vol. 14, no. 3.
c. Acharya, and Pedersen (2005), “Asset Pricing with Liquidity Risk,” Journal of Financial Economics, vol. 77, pp. 375-410. Read pages 375-378, and skim pages 378-384.
Background reading, not required:
d. Garleanu and Pedersen (2008), “Dynamic Trading with Predictable Returns and Transaction Costs.”
a. Brunnermeier and Pedersen (2007), “Market Liquidity and Funding Liquidity,” The Review of Financial Studies, 22, 2201-2238. Read only introduction and Appendix A.
b. Shleifer and Vishny (1997), “The Limits of Arbitrage,” The Journal of Finance, vol. 52, no. 1, pp. 35-55. Read only the introduction, Section III, IV, and V.
c. Mitchell, Pedersen, and Pulvino (2007), “Slow Moving Capital,” The American Economic Review, 97, 215-220.
d. Pedersen (2009), “When Everyone Runs for the Exit,” The International Journal of Central Banking, 5, 177-199.
Background reading, not required:
e. Brunnermeier and Pedersen (2005), “Predatory Trading,” The Journal of Finance, vol. 60, no. 4, pp. 1825-1863.
Garleanu and Pedersen
(2009), “Margin-Based Asset Pricing
and Deviations from the Law of One Price.”
a. Black and Litterman (1992), “Global Portfolio Optimization,” Financial Analysts Journal, September/October.
c. Mitchell and Pulvino (2001), “Characteristics of Risk and Return in Risk Arbitrage,” The Journal of Finance, vol. 56; no. 6, pp. 2135-2176.
Ideas For Projects on Trading Strategies (see also outline)
You could study strategies based on
1.a. A valuation ratio (B/M, P/E, etc.),
1.b. net stock issues, or
See e.g. the papers in class 2 and
Fama and French (2006), “Dissecting Anomalies,” working paper.
Study the profits of momentum or reversals in equity, industries, commodities, FX, or another market.
See papers in class 2. There are many others, e.g. Chan, Jegadeesh, and Lakonishok (1996), “Momentum Strategies,” The Journal of Finance, vol. 51, no. 5., pp. 1681-1713.
Get data on convertible bond prices and stock prices of the same companies and implement a backtest of the strategy. See also
Agarwal, Fung, Loon, and Naik, “Risk and Return in Convertible Arbitrage: Evidence from the Convertible Bond Market,” working paper.
Get data on interest rates and exchange rates for a number of countries and consider the return on the carry trade. Is the risk symmetric, i.e. equal size of upside and downside returns? See also
Burnside, Eichenbaum, Kleshchelski, and Rebelo (2006), “The Returns to Currency Speculation,” working paper.
Brunnermeier, Nagel, and Pedersen (2008) “Carry Trades and Currency Crashes,” NBER Macroeconomics Annual, 23, 313-348.
Some securities “should” follow each other, but sometimes diverge. What is a good trading strategy to exploit this. Look e.g. at Royal Dutch/ Shell and similar pairs and see also
Gatev, Goetzmann, and Rouwenhorst (2006), “Pairs Trading: Performance The Review of Financial Studies, vol. 19, no. 3, pp. 797-827.
Profit from the difference
between two virtually risk free rates, the Treasury rate and the swap rate. See
Make a strategy of risk free
securities of various maturities. See
It might be difficult to get data on mortgage backed securities, so you should only do this if someone in the group has access to such data. See
If traders trade “too much” and “push prices around excessively”, then how do you profit from this? Get inspiration from e.g.
Consider index option strategies, such as selling at the money straddles. When is the strategy most profitable? See e.g.
Amin, Coval, and Seyhun (2004), “Demand for Portfolio Insurance and Index Option Prices,” Journal of Business 77, no. 4.
Is it profitable to buy companies with good earnings news and short those with bad news, after the news is released? See e.g.
Bernard and Thomas (1989), “Post-Earnings-Announcement Drift: Delayed Price Response or Risk Premium?” Journal of Accounting Research, vol. 27, pp. 1-36.
How do you identify opportunities among distressed bonds? How to evaluate default risk and recovery in case of default? Can bond holders be active investors? What is return to a diversified portfolio of distressed bonds (i.e. with no attempt of security selection) and does this capture most of the risk premium?
How can you identify short-selling ideas? Are there ways of identifying frauds or does forensic accounting help? Is certain behavior of management a tell-tale sign of trouble?
How do some of the investment strategies mentioned above work in emerging markets? What special considerations (e.g. costs, barriers, and risks) must be taken into account when investing in emerging markets? What are the special opportunities? How much of emerging market hedge fund returns can be explained by simply being long emerging market equity indices?
How do you select hedge funds? How should you analyze return data, and what other data is available (e.g. 13F, 13D, etc.), and how can this be used to cross-validate managers? How do you combine hedge funds into a portfolio? What is the best way to allocate capital across styles?
Ideas for Projects on Hedge Fund Cases:
How did Paulson and co. structure their trade? What was the downside risk and the upside potential? How did house prices evolve before and after the trade, and how do you think that Paulson and co. anticipated that house prices would stop rising? What might have been the rationale by the institutional investors that traded aggressively on the other side?
See book by Arvedlund (2009), “Too Good to Be True: The Rise and Fall of Bernie Madoff.”
How did hedge funds do during the recent crisis? Which styles suffered the most, and which styles benefited and why? Did hedge funds provide diversification relative to equities? What type of risk management worked, and what were the main sources of trouble?
Look at the press, e.g. WSJ 1/30/2007, and try to get data on oil futures and see what happened around the Amaranth blow up. How does Amaranth’s loss compare to the dollar loss for someone who had the entire open interest on NYMEX?
HBS Cases 9-200-007, 9-200-008, 9-200-009.
What happened and what do we learn about currency trading? Look at data on exchange rates and discuss the risk and return of a currency attack.
The specific references used in class are mention above. Below you find additional material which is useful background reading for your general education, but not required.