Describe in the detail a major hedge fund trading strategy – Essay Example

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(Capocci, 2013) In case there is a divergence in prices of the securities the trader has to act in a certain way. When one security’s price rises whilst its pair drops, the arbitrage trader will have to short one of the securities and buy the other one. The trader will thereafter close the trade whenever the respective prices converge and in doing so he will lock in a profit. This strategy is most effective when utilized in a range-bound market that is neither falling nor rising due to the need for a correlation of prices between paired securities.

(Gatev, Goetzmann & Rouwenhorst, 1999) 2.0 How the Strategy generates returns This strategy can be viewed as a mixture of a several strategies that are used with a wide range of securities. The main concept of the strategy entails a hedge fund manager buying a security with the expectation that it will gain in price whilst at the same time selling short a similar security that he expects to decline in price. Similar securities in this context refers to the bond and stock of a certain company; stocks of different companies that are operating in the same sector of the economy; bonds that have been issued from the same company but bearing varied coupons and/or maturity different dates.

These types of securities possess an easy to calculate equilibrium value since they are similar but only differ slightly in some of their components. (Nicholas, 2005) The strategy’s way of generating money can be explained in the following way. One can make an assumption that a particular company possesses two bonds that are outstanding. One of them pays 6% whilst the other one 8%.

Both of these bonds have the same expiry dates and have first-lien claims on the assets of the company. The 8% bond will sell at a higher premium than the 6% bond since it has a higher coupon rate. If for example the 6% bond is currently trading at $10,000, the other premium priced 8% bond should be trading at around $12,767 assuming everything else is ideal and constant. However, as is often the cases, the premium amount is usually not in sync with equilibrium thus creating a suitable opportunity to exploit the temporary variation in prices.

(Calamos, 2013) We can make an assumption that in actuality, the 8% bond is transacting at US$11,000 while on the other hand the 6% bond is steady at US$10,000. The hedge fund manager will purchase the 8% bond while at the same time short selling the 6% bond so as to adequately exploit the temporary variation in pricing.

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