HEDGE FUND PRODUCTS

Equities

Equities are also known as company shares or stock. It is a form of ownership interest in a company. Equities are the riskiest form of investment as the price can go up or down. If a company goes into bankruptcy the equity holders are paid out last. Hedge funds usually purchase these through an equity broker such as JP Morgan, Goldman Sachs etc.

 

Equities are traded on a stock exchange. An Equity Index is a listing of the total value of a particular segment of a stock exchange. For example, the FTSE 100 is an index of the 100 biggest companies on the London Stock Exchange. An index like the FTSE 100 is a useful indicator of the performance of the equity market as a whole.
 

Equity Swap / Contract for Difference (CFD)

Hedge funds use CFDs to profit from equity markets without having to buy the actual shares. It is an agreement between a buyer and a seller (hedge fund and equity broker) to exchange the difference between the current price of a share and its price at a later date.

 

e.g A Hedge Fund buys a CFD on Microsoft shares when the price is £10. If the price of the share rises above £10 then the hedge fund will make a profit. If, on the other hand, the price falls below £10 then the hedge fund must make a payment to the broker.

 

The main difference between CFDs and equities is that you do not own the share if you have a CFD. There is no upfront cost with a CFD like when purchasing a share. You can build up much larger positions with CFDs than equities because of the low initial cost. This can result in much larger profits or losses. Using CFDs is essentially a form of betting on the price movement of a share.

Bonds

A bond is simply a loan with a few special features. The issuer of a bond is the borrower and the bondholder is the lender. An investor will know the length of the loan (maturity) and the interest rate (coupon rate) prior to purchase. An investor buys a bond and receives a coupon payment each year and the original loan amount is paid back to the bondholder at maturity.

 

The main types of bonds are government bonds and corporate bonds. Government bonds have less risk as they are extremely unlikely to default on any of the payments. Corporate bonds are riskier and therefore investors will receive a higher coupon payment with corporate bonds to compensate for this risk. Agencies such as Moody’s and S&P rate the corporate bonds based on their level of risk.

 

The main difference between bonds and equities is that equity holders own a part of a company and bondholders are lending to the company. Bonds have a fixed time length but shares can be outstanding indefinitely.
 

Derivatives - Futures & Options

A futures contract is an agreement between 2 parties to buy or sell an asset at a certain date in the future at a price agreed now. In a futures contract, the 2 parties have to fulfil the contract on the agreed date.

 

This is different from an options contract. An options contract gives the holder the right but not the obligation to buy or sell an asset on or before a certain date at a specific price. The option holder can exercise the contract if they wish to.

 

Options and futures are beneficial to hedge funds in a number of ways. They can be used to protect or ‘hedge’ against potential losses or to make profits. For example, if a hedge fund owned a large number of shares in a tobacco company and were concerned about an upcoming legal decision which could impact negatively on the company and the share price. They could buy an option to sell the shares at an agreed price. In this way, they would be protected against a fall in the share price. The option holder would not use the option if the decision was in the company’s favour and it would expire worthless.
 

Credit Default Swap (CDS)

A CDS is a form of insurance on corporate bonds. The buyer of a CDS contract buys protection against the bond issuer defaulting. The buyer of the CDS pays a fee to the seller and in return, the seller agrees in the event of credit default to reimburse the buyer for the value of the bond.

 

Interest Rate Swap

An interest rate swap is an agreement where 2 parties agree to swap interest rate payments. The swap is typically an exchange of a fixed interest rate payment for a floating rate payment.

 

It can be useful to an investor who has a loan based on a floating interest rate. They may be concerned about interest rates rising in the future and enter into an interest rate swap to take away this risk. They pay a fixed interest rate to the counterparty and receive a floating rate payment which is used to pay off their existing loan. The floating rate paid and received nets off leaving just a fixed-rate payment.

Commodities

Commodities are goods such as oil, gold, copper and corn that are traded on an exchange. They are bought and sold based on standardised contracts similar to futures contracts. Many hedge funds participate in the commodities market to profit from price movements. They don’t want to receive the good and therefore close out the position prior to the maturity date.

 

e.g A fund may purchase an oil contract for 100 barrels of oil. The delivery date is September 2007. The hedge fund can close out this position by selling the contract just before the delivery date and settle in cash rather than receiving the oil.

 

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