RISK MANAGEMENT IN BANKING REPORT ON

HEDGE FUNDS FUNDSPPPAKISTANTIMEMANAGEMENT

SEC-A

Table of Contents
Page | 1

S.N o
1 2 3 4 5 6 7 8 9 10 11 12 13 14

PARTICULARS
Letter Of Transmittal Acknowledgement Executive summary Definition of Hedge Fund Goal of hedge fund Key characteristics of hedge fund Facts about hedge fund industry Hedge fund styles Strategies of hedge fund Fund of hedge fund Benefits of fund of hedge fund Structure of hedge fund Benefits of hedge fund References

PAGE NO.
03 04 05 06 06 07 08 09-11 12-14 15 15 16-17 18 19

SP08-BB-0063

Page |

ACKNOWLEDGMENT

First of all thank to whom who is most merciful and kind to all of his creations with out any discrimination and who make us able to prepare this report.

AND

Page |

We, the group members present special thanks to our parents and teachers specially Mr. Jawed Hussain Baloch i.e. our RISK MANAGEMENT IN BANKING INSTRUCTOR whose unlimited efforts are there to provide us an opportunity to write about such enthusiastic topic and provided us knowledge and information about the topic.

EXECUTIVE SUMMARY
Hedge fund strategies vary enormously -- many hedge against downturns in the markets especially important today with volatility and anticipation of corrections in overheated stock markets. A hedge fund is a private investment fund which may invest in a diverse range of assets and may employ a variety of investment strategies to maintain a hedged portfolio intended to protect the fund's investors from downturns in the market while maximizing returns on market upswings. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year. Because hedge fund managers make speculative investments, these funds can carry more risk than the overall market. Hedge funds can be very risky investments and many investors have been burned by huge hedge fund blow-ups. Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets. Many hedge funds are flexible in their investment options. Many hedge funds have the ability to deliver nonmarket correlated returns. Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent. Hedge funds benefit by heavily weighting hedge fund managers remuneration towards performance incentives, thus attracting the best brains in the investment business. In addition, hedge fund managers usually have their own money invested in their fund. Long/Short In this strategy, hedge fund managers can either purchase stocks that they feel are undervalued or sell short stocks they deem to be overvalued. In most cases, the fund will have positive exposure to the equity markets for example, having 70% of the funds invested long in stocks and 30% invested in the shorting of stocks. The strategies that have the highest risk/return profiles of any hedge fund strategy. Global macro funds invest in stocks, bonds, currencies, commodities, options, futures, forwards and other forms of derivative securities. some hedge funds simply invest in convertible bonds, a hedge fund using convertible arbitrage is actually taking positions in both the convertible bonds and the stocks of a particular company. Hedge funds that invest in distressed securities are truly unique. A fund of hedge fund is a diversified portfolio of generally uncorrelated hedge funds. Provides more predictable returns than traditional investment funds. Allows for easier administration of widely diversified investments across a large variety of hedge funds. Hedge funds also differ
Page | 4

quite radically from mutual funds in how they charge fees. The management fee for a hedge fund is for the same service that the management fee covers in mutual funds. Most if not all hedge funds charge an incentive fee of anywhere between 10-20% of fund profits, and some hedge funds have even gone as high as 50%. Hedge funds do not have daily liquidity like mutual funds do. The terms of each hedge fund should be consistent with the underlying strategy being used by the manager. Requiring redemption notices allows the hedge fund manager to efficiently raise capital to cover cash needs.

DEFINITION OF HEDGE FUND

A hedge fund is a fund that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. Hedge fund strategies vary enormously -- many hedge against downturns in the markets -especially important today with volatility and anticipation of corrections in overheated stock markets. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions. A hedge fund is a private investment fund which may invest in a diverse range of assets and may employ a variety of investment strategies to maintain a hedged portfolio intended to protect the fund's investors from downturns in the market while maximizing returns on market upswings. It is an aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year.

GOAL OF HEDGE FUND

It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is
Page | 5

mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market. Hedge funds can be very risky investments and many investors have been burned by huge hedge fund blow-ups. On many occasions, investors follow the herd mentality of chasing returns, plunging more and more money into a high-performing fund, without regard for how the performance was obtained and more important whether the performance can be repeated in the future.

KEY CHARACTERISTICS OF HEDGE FUNDS

Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets. Many hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.).

Hedge funds vary enormously in terms of investment returns, volatility and risk. Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded.

Many hedge funds have the ability to deliver non-market correlated returns.

Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns.

Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent.

Page |

Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns.

Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage.

Hedge funds benefit by heavily weighting hedge fund managers remuneration towards performance incentives, thus attracting the best brains in the investment business. In addition, hedge fund managers usually have their own money invested in their fund.

FACTS ABOUT THE HEDGE FUND INDUSTRY

Estimated to be a $1 trillion industry and growing at about 20% per year with approximately 8350 active hedge funds.

Includes a variety of investment strategies, some of which use leverage and derivatives while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or through the use of derivatives.

Most hedge funds are highly specialized, relying on the specific expertise of the manager or management team.

Performance of many hedge fund strategies, particularly relative value strategies, is not dependent on the direction of the bond or equity markets -- unlike conventional equity or mutual funds (unit trusts), which are generally 100% exposed to market risk.

Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much capital they can successfully employ before returns diminish. As a result, many successful hedge fund managers limit the amount of capital they will accept.

Page |

Their returns over a sustained period of time have outperformed standard equity and bond indexes with less volatility and less risk of loss than equities.

Beyond the averages, there are some truly outstanding performers.

Investing in hedge funds tends to be favored by more sophisticated investors, including many Swiss and other private banks, that have lived through, and understand the consequences of, major stock market corrections.

An increasing number of endowments and pension funds allocate assets to hedge funds.

HEDGE FUND STYLES

The predictability of future results shows a strong correlation with the volatility of each style. Future performance of strategies with high volatility is far less predictable than future performance from strategies experiencing low or moderate volatility.

Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share. Generally high P/E ratios, low or no dividends; often smaller and micro cap stocks which are expected to experience rapid growth. Includes sector specialist funds such as technology, banking, or biotechnology. Hedges by shorting equities where earnings disappointment is expected or by shorting stock indexes. Tends to be "long-biased." Expected Volatility: High

Distressed Securities: Buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Profits from the markets lack of understanding of the true value of the deeply discounted securities and because the majority of institutional investors cannot own below investment grade securities. (This selling pressure creates the deep discount.) Results generally not dependent on the direction of the markets. Expected Volatility: Low - Moderate

Emerging Markets: Invests in equity or debt of emerging (less mature) markets which tend to have higher inflation and volatile growth. Short selling is not permitted in many emerging markets, and, therefore, effective hedging
Page | 8

is often not available, although Brady debt can be partially hedged via U.S. Treasury futures and currency markets. Expected Volatility: Very High

Fund of Funds: Mixes and matches hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Returns, risk, and volatility can be controlled by the mix of underlying strategies and funds. Capital preservation is generally an important consideration. Volatility depends on the mix and ratio of strategies employed. Expected Volatility: Low - Moderate

Income: Invests with primary focus on yield or current income rather than solely on capital gains. May utilize leverage to buy bonds and sometimes fixed income derivatives in order to profit from principal appreciation and interest income. Expected Volatility: Low

Macro: Aims to profit from changes in global economies, typically brought about by shifts in government policy which impact interest rates, in turn affecting currency, stock, and bond markets. Participates in all major markets -- equities, bonds, currencies and commodities -- though not always at the same time. Uses leverage and derivatives to accentuate the impact of market moves. Utilizes hedging, but leveraged directional bets tend to make the largest impact on performance. Expected Volatility: Very High

Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer. For example, can be long convertible bonds and short the underlying issuers equity. May also use futures to hedge out interest rate risk. Focuses on obtaining returns with low or no correlation to both the equity and bond markets. These relative value strategies include fixed income arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund arbitrage. Expected Volatility: Low

Market Neutral - Securities Hedging: Invests equally in long and short equity portfolios generally in the same sectors of the market. Market risk is greatly reduced, but effective stock analysis and stock picking is essential to obtaining meaningful results. Leverage may be used to enhance returns. Usually low or no correlation to the market. Sometimes uses market index
Page | 9

futures to hedge out systematic (market) risk. Relative benchmark index usually T-bills. Expected Volatility: Low

Market Timing: Allocates assets among different asset classes depending on the managers view of the economic or market outlook. Portfolio emphasis may swing widely between asset classes. Unpredictability of market movements and the difficulty of timing entry and exit from markets adds to the volatility of this strategy. Expected Volatility: High

Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids, and other event-driven opportunities. May utilize several of these investing styles at a given time and is not restricted to any particular investment approach or asset class. Expected Volatility: Variable

Multi Strategy: Investment approach is diversified by employing various strategies simultaneously to realize short- and long-term gains. Other strategies may include systems trading such as trend following and various diversified technical strategies. This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Expected Volatility: Variable

Short Selling: Sells securities short in anticipation of being able to rebuy them at a future date at a lower price due to the managers assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments often due to accounting irregularities, new competition, change of management, etc. Often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle. High risk. Expected Volatility: Very High

Special Situations: Invests in event-driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buy outs. May involve simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread between the current market price and the ultimate purchase price of the company. May also utilize derivatives
Page | 10

to leverage returns and to hedge out interest rate and/or market risk. Results generally not dependent on direction of market. Expected Volatility: Moderate

Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may be out of favour or underfollowed by analysts. Long-term holding, patience, and strong discipline are often required until the ultimate value is recognized by the market. Expected Volatility: Low - Moderate

HEDGE FUNDS: STRATEGIES

Hedge funds use a variety of different strategies, and each fund manager will argue that he or she is unique and should not be compared to other managers. However, we can group many of these strategies into certain categories that assist an analyst/investor in determining a manager's skill and evaluating how a particular strategy might perform under certain macroeconomic conditions. The following is loosely defined and does not encompass all hedge fund strategies, but it should give the reader an idea of the breadth and complexity of current strategies.

Equity Hedge:
The equity hedge strategy is commonly referred to as long/short equity and although it is perhaps one of the simplest strategies to understand, there are a variety of substrategies within the category.

Long/Short In this strategy, hedge fund managers can either purchase stocks that they feel are undervalued or sell short stocks they deem to be overvalued. In most cases, the fund will have positive exposure to the equity markets for example, having 70% of the funds invested long in stocks and 30% invested in the shorting of stocks. In this example, the net exposure to the equity markets is 40% (70%-30%) and the fund would not be using any leverage (Their gross exposure would be 100%). If the manager, however, increases the long positions in the fund to, say, 80% while still maintaining a 30% short position, the fund would have gross exposure of 110% (80%+30% = 110%), which indicates leverage of 10%. Market Neutral In this strategy, a hedge fund manager applies the same basic concepts mentioned in the previous paragraph, but seeks to minimize
Page | 11

the exposure to the broad market. This can be done in two ways. If there are equal amounts of investment in both long and short positions, the net exposure of the fund would be zero. For example, if 50% of funds were invested long and 50% were invested short, the net exposure would be 0% and the gross exposure would be 100%. There is a second way to achieve market neutrality, and that is to have zero beta exposure. In this case, the fund manager would seek to make investments in both long and short positions so that the beta measure of the overall fund is as low as possible. In either of the market-neutral strategies, the fund manager's intention is to remove any impact of market movements and rely solely on his or her ability to pick stocks. Either of these long/short strategies can be used within a region, sector or industry, or can be applied to market-cap-specific stocks, etc. In the world of hedge funds, where everyone is trying to differentiate themselves, you will find that individual strategies have their unique nuances, but all of them use the same basic principles.

Global Macro:
Generally speaking, these are the strategies that have the highest risk/return profiles of any hedge fund strategy. Global macro funds invest in stocks, bonds, currencies, commodities, options, futures, forwards and other forms of derivative securities. They tend to place directional bets on the prices of underlying assets and they are usually highly leveraged. Most of these funds have a global perspective and, because of the diversity of investments and the size of the markets in which they invest, they can grow to be quite large before being challenged by capacity issues.

Relative Value Arbitrage:

This strategy is a catchall for a variety of different strategies used with a broad array of securities. The underlying concept is that a hedge fund manager is purchasing a security that is expected to appreciate, while simultaneously selling short a related security that is expected to depreciate. Related securities can be the stock and bond of a specific company; the stocks of two different companies in the same sector; or two bonds issued by the same company with different maturity dates and/or coupons. In each case, there is an equilibrium value that is easy to calculate since the securities are related but differ in some of their components.

Convertible Arbitrage:
Page | 12

This is one form of relative value arbitrage. While some hedge funds simply invest in convertible bonds, a hedge fund using convertible arbitrage is actually taking positions in both the convertible bonds and the stocks of a particular company. A convertible bond can be converted into a certain number of shares. Assume a convertible bond is selling for $1,000 and is convertible into 20 shares of company stock. This would imply a market price for the stock of $50. In a convertible arbitrage transaction, however, a hedge fund manager will purchase the convertible bond and sell the stock short in anticipation of either the bond's price increasing, the stock price decreasing, or both.

Keep in mind that there are two additional variables that contribute to the price of a convertible bond other than the price of the underlying stock. For one, the convertible bond will be impacted by movements in interest rates, just like any other bond. Secondly, its price will also be impacted by the embedded option to convert the bond to stock, and the embedded option is influenced by volatility. So, even if the bond was selling for $1,000 and the stock was selling for $50 which in this case is equilibrium the hedge fund manager will enter into a convertible arbitrage transaction if he or she feels that 1) the implied volatility in the option portion of the bond is too low, or 2) that a reduction in interest rates will increase the price of the bond more than it will increase the price of the stock. Even if they are incorrect and the relative prices move in the opposite direction because the position is immune from any company-specific news, the impact of the movements will be small. A convertible arbitrage manager, then, has to enter into a large number of positions in order to squeeze out many small returns that add up to an attractive risk-adjusted return for an investor. Once again, as in other strategies, this drives the manager to use some form of leverage to magnify returns.

Distressed:
Hedge funds that invest in distressed securities are truly unique. In many cases, these hedge funds can be heavily involved in loan workouts or restructurings, and may even take positions on the board of directors of companies in order to help turn them around. That's not to say that all hedge funds do this. Many of them purchase the securities in the expectation that the security will increase in value based on fundamentals or current management's strategic plans.In either case, this strategy involves purchasing bonds that have lost a considerable amount of their value because of the company's financial instability or investor expectations that the company is in dire straits. In other cases, a company may be coming out of
Page | 13

bankruptcy and a hedge fund would be buying the low-priced bonds if their evaluation deems that the company's situation will improve enough to make their bonds more valuable. The strategy can be very risky as many companies do not improve their situation, but at the same time, the securities are trading at such discounted values that the risk-adjusted returns can be very attractive.

WHAT IS A FUND OF HEDGE FUNDS?

A diversified portfolio of generally uncorrelated hedge funds. May be widely diversified, or sector or geographically focused. Seeks to deliver more consistent returns than stock portfolios, mutual funds, unit trusts or individual hedge funds. Preferred investment of choice for many pension funds, endowments, insurance companies, private banks and high-net-worth families and individuals. Provides access to a broad range of investment styles, strategies and hedge fund managers for one easy-to-administer investment. Provides more predictable returns than traditional investment funds. Provides effective diversification for investment portfolios.

BENEFITS OF FUND OF HEDGE FUND

Page | 14

Provides an investment portfolio with lower levels of risk and can deliver returns uncorrelated with the performance of the stock market. Delivers more stable returns under most market conditions due to the fund-offund managers ability and understanding of the various hedge strategies. Significantly reduces individual fund and manager risk. Eliminates the need for time-consuming due diligence otherwise required for making hedge fund investment decisions. Allows for easier administration of widely diversified investments across a large variety of hedge funds. Allows access to a broader spectrum of leading hedge funds that may otherwise be unavailable due to high minimum investment requirements. Is an ideal way to gain access to a wide variety of hedge fund strategies, managed by many of the worlds premier investment professionals, for a relatively modest investment.

HEDGE FUNDS: STRUCTURES

Structurally, a hedge fund has some similarities to a mutual fund. For example, just like a mutual fund, a hedge fund is a pooled investment vehicle that makes investments in equities, bonds, options and a variety of other securities. It can also be run by a separate manager, much like a sub-advisor runs a mutual fund that is distributed by a large mutual fund company. That, however, is basically where the similarities end. The range of investment strategies available to hedge funds and the types of positions they can take are quite broad and in many cases, very complex. Fee Structure Hedge funds also differ quite radically from mutual funds in how they charge fees. Their fee structure is one of the main reasons why talented money managers decide to open their own hedge funds to begin with. Not only are the fees paid by investors higher than they are for mutual funds, they include some additional fees that mutual funds don't even charge. Management Fee The management fee for a hedge fund is for the same service that the management fee covers in mutual funds. The difference is that hedge funds typically charge a management fee of 2% of assets managed and in some cases even higher, if the manager is in high demand and has had a very good track record. This fee alone makes managing a hedge fund attractive, but it is the next fee that really makes it a profitable endeavor for good fund managers.
Page | 15

Incentive Fee Most if not all hedge funds charge an incentive fee of anywhere between 1020% of fund profits, and some hedge funds have even gone as high as 50%. The idea of the incentive fee is to reward the hedge fund manager for good performance, and if the fund's performance is attractive enough, investors are willing to pay this fee. For example, if a hedge fund manager generates a 20% return per year, after management fee, the hedge fund manager will collect 4% of those profits, leaving the investor with a 16% net return. In many cases, this is an attractive return despite the high incentive fee, but with more mediocre managers entering the industry in search of fortune, investors have more often than not been disappointed with net returns on many funds. There is one caveat to the incentive fee, however. A manager only collects an incentive fee for profits exceeding the fund's previous high, called a highwater mark. This means that if a fund loses 5% from its previous high, the manager will not collect an incentive fee until he or she has first made up the 5% loss. In addition, some managers must clear a hurdle rate, such as the return on U.S. Treasuries, before they collect any incentive fees. Hedge funds often follow the so-called "two and twenty" structure where managers receive 2% of net asset value managed and 20% of profits, though as mentioned, these fees can vary among hedge funds. (For tips on paying fewer fees, see Stop Paying High Mutual Fund Fees.) Term Structure The terms offered by a hedge fund are so unique that each fund can be completely different from another, but they usually are based on the following factors: Subscriptions and Redemptions Hedge funds do not have daily liquidity like mutual funds do. Some hedge funds can have subscriptions and redemptions monthly, while others accept them only quarterly. The terms of each hedge fund should be consistent with the underlying strategy being used by the manager. The more liquid the underlying investments, the more frequent the subscription/redemption terms should be. Each fund also specifies the number of days required for redemption, ranging from 15 days to 180 days, and this too should be consistent with the underlying strategy. Requiring redemption notices allows the hedge fund manager to efficiently raise capital to cover cash needs. Lock-Ups Some funds require up to a two-year "lock-up" commitment, but the most common lock-up is limited to one year. In some cases, it could be a hard lock, preventing the investor from withdrawing funds for the full time period, while in other cases, an investor can withdraw funds before the expiration of the lockup period provided they pay a penalty. This second form of lock-up is called a soft lock and the penalty can range from 2-10% in some extreme cases.
Page | 16

BENEFITS OF HEDGE FUNDS

Many hedge fund strategies have the ability to generate positive returns in both rising and falling equity and bond markets. Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and volatility and increases returns. Huge variety of hedge fund investment styles many uncorrelated with each other provides investors with a wide choice of hedge fund strategies to meet their investment objectives. Academic research proves hedge funds have higher returns and lower overall risk than traditional investment funds. Hedge funds provide an ideal long-term investment solution, eliminating the need to correctly time entry and exit from markets.

Page | 17

 Adding hedge funds to an investment portfolio provides diversification not otherwise available in traditional investing.

Hedge funds are extremely flexible in their investment options because they use financial instruments generally beyond the reach of mutual funds, which have SEC regulations and disclosure requirements that largely prevent them from using short selling, leverage, concentrated investments, and derivatives.

Flexibility, which includes use of hedging strategies to protect downside risk, gives hedge funds the ability to best manage investment risks.

REFERENCES: http://www.investopedia.com/university/hedgefund http://www.magnum.com/hedgefunds/abouthe dgefunds.asp http://www.hedgeworld.com/ http://www.mamma.com http://www.investopedia.com/terms/h/hedgefun d.asp

Page | 18

http://www.hedgefundresearch.com/ http:// www.starkresearch.com

Page | 19