Derivatives are mostly used by hedge funds for arbitrage, speculation or hedging. If we compare hedge funds to mutual funds we can see that they have the same similarity – they invest money on behalf of clients. Contrary to mutual funds they do not publicly offer their securities and accept funds only from financially sophisticated individuals. Hedge funds have much greater freedom because they are not restricted to a certain regulations insisting that there would not be any short positions taken, or limitations of leverage and etc. Of course, these conditions are used to develop new highly sophisticated, unconventional, and proprietary investment strategies. However, fees charged by hedge funds are maintained at a high level at around 1 – 2% of the amount invested plus 20- 30% of the profits. Nowadays hedge funds have an amount of $1trilion invested throughout the world. In order to set up speculative or arbitrage positions hedge fund managers use derivatives for a certain trading strategies. These strategies involve:
1) Evaluation of risks
2) Choosing between acceptable and hedged risks
3) Devise strategies for unacceptable risks
There are several different strategies employed by fund managers:
1) Investments in emerging markets: search for developing countries or companies and invest in their debt or equity.
2) Distressed securities: search for companies that are close to bankruptcy and buy their securities
3) Long/short equities: search for securities considered to be undervalued and short those deemed as overvalued in such a way that the effect on the entire trend of the market is minor.
4) Global macro: fulfill trades that mirror foreseen macroeconomic trends.
5) Merger arbitrage: trade after merger or acquisition is announced so that a profit is made only if the deal is being approved.
6) Convertible arbitrage: fund manager takes a long position in a convertible security united with the short position in the underlying equity.