ALTERNATIVE FUND STRATEGIES CLASS 4 NOTES

Relative Value Strategies

Relative value strategies (Use of significant leverage) 1. Equity (done earlier). 2. Using Fixed income and convertible securities-to be done here. Why relative value differences? On account of changes in credit quality, liquidity and volatility. When this strategy does becomes successful? During normal market conditions. When does this strategy fail? During crisis periods. 1. Fixed Income

Why the word arbitrage? Because it seeks to exploit pricing inefficiencies arising due to variation in duration, credit quality, liquidity and optionality. What does it involve? Taking long/ positions in a range of debt securities- buy relatively undervalued and sell relatively overvalued securities. Characteristics: Case 1: Lower credit quality (Sec. A)-Yield 7.4% Higher credit quality (Sec. B)-Yield 6.2% Credit spread-1.2% Historical range-0.45-1% Hence we expect yield spread to narrow. Hence we buy A and sell security B expecting mean reversion. Case 2: Of the run security (Sec. A) On the run security (Sec. B) Same story. 1 Case 3: Volatility is expected to rise- Go long on putable bond and short on callable bond. Case 4: Lower issue size (Sec. A) Higher issue size (Sec. B) Same story. Case 5: 10 year Treasury yield 2 yr treasury yield Same story... Here we are exploiting the net positive relative carry. Case 6: Yield curve expected to become steep or flat-accordingly one can take long/short positions. Types- 1. Exploiting small pricing differences within sovereign debt securities-Less risky. 2. Long/short credit trading-acceptance of certain relative credit risk across different issuers. Interest rate risk: 1. Duration neutral positions. 2. Taking on desired yield curve exposure. Of course duration neutral strategies are a hedge only against a one time small parallel shift in the yield curve. In order to hedge against large change in yield or change in shape of the yield curve-Fixed income derivatives need to be used. Sovereign risk and currency risk-These can also be hedged via derivatives. Taking positions in ABS and MBS will bring exposure to credit risk and prepayment risk which can also be hedged via derivatives. How efficient are fixed income developed capital markets? Quite efficient such that pricing inefficiencies are very small (ofcourse correlation issues are present)- Given low pricing inefficiencies, high levels of leverage are used - This can be specially dangerous during stressed times. Structured financial products by way of trenched securities (Sequential pay CMO, PAC tranches, IO & PO Tranches, credit trenching via senior and subordinate debt).These compound the risk of fixed income arbitrage strategies. Risk relate to negative convexity of MBS, sudden unexpected rise in default rates, balance sheet leverage of hedge funds and redemption process.

2 Differences in liquidity between treasury and non-treasury and also between on the run and off the run securities... create arbitrage strategies for hedge fund manager.

Risk Profile and Liquidity

Risk Profile depends on correlation, yield spread, diverse universe, credit quality and convexity aspects, structured financial products. High liquidity for yield curve and carry trade involving US securities. Attractiveness: A function of correlations between different securities, the yield spread available, and the high number and wide diversity of debt securities across different markets. Leverage and usage

High leverage usage except when it involves complex structures. Also leverage made available via repo transactions through prime brokers.

Strategy Implementation

Yield curve strategy : Right now inverted yield curve. Yield curve is going to steepen. Buy short term fixed income and sell long term fixed income. Case 1: of the same issuer Case 2: of different issues. Carry trade strategy : Buy high yield and sell low yield. Enjoy positive carry and profit from spread narrowing. Its duration and credit neutral but exposed to liquidity risk. Hope normal market conditions. There could be substantial loss if there is crisis and you have used substantial leverage. The payoff profile resemble short put.

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