Hedge Funds

Some investors use hedge funds to reduce risk in their portfolio by diversifying into uncommon or alternative investments like commodities or foreign currencies. Others use hedge funds as the primary means of implementing their long-term investment strategy.

Hedge Funds

Hedge funds are not registered as publicly traded securities.
For this reason, they are available only to those
fitting the Securities and Exchange Commission definition of
“accredited investors”—individuals with a net worth exceeding
$1 million or with income greater than $200,000
($300,000 for couples) in each of the two years prior to the
investment and with a reasonable expectation of sustainability.

Institutional investors, such as pension plans and limited
partnerships, have higher minimum requirements.
The SEC reasons that these investors have financial advisers
or are savvy enough to evaluate sophisticated investments
for themselves.

Hedge Funds

A “hedge fund” is a private partnership
aimed at very wealthy investors. It can use
strategies to reduce risk. But it may also use
leverage, which increases the level of risk
and the potential rewards.

Hedge funds can invest in virtually anything anywhere.
They can hold stocks, bonds, and government securities
in all global markets. They may purchase currencies,
derivatives, commodities, and tangible assets. They
may leverage their portfolios by borrowing money against
their assets, or by borrowing stocks from investment
brokers and selling them (shorting). They may also
invest in closely held companies.

Combined Derivative Products

The range of derivative products is limited
only by the human imagination. Therefore, it is
not unusual for financial derivatives to be
merged in various combinations to form new
derivative products.

For instance, a company may find it
advantageous to finance operations by issuing
debt, the interest rate of which is determined
by some unrelated index. The company may have
exchanged the liability for interest payments
with another party. This product combines a
Structured Note with an interest
rate Swap.

Rights of Use

A type of swap is represented
by swapping capacity on networks
using instruments called
“indefeasible rights of use”, or IRUs.
Companies buying an IRU might book the
price as a capital expense,
which could be spread over a number of
years. But the income from IRUs could
be booked as immediate revenue,
which would bring an immediate
boost to the bottom line. 

Technically, the practice is within
the arcane rules that govern financial
derivative accounting methods, but only
if the swap transactions are real
and entered into for a genuine
business purpose.

Swaps

Interest rate swaps occur generally
in three scenarios. Exchanges of a fixed rate
for a floating rate, a floating rate for a
fixed rate, or a floating rate for a
floating rate.

The "Swaps market" has grown dramatically.
Today, Swaps involve exchanges other than
interest rates, such as mortgages, currencies,
and "cross-national" arrangements. Swaps may
involve cross-currency payments
(U.S. Dollars vs. Mexican Pesos) and
crossmarket payments,
e.g., U.S. short-term rates vs. U.K. short-term rates.

Swaps

A Swap is a simultaneous buying
and selling of the same security or obligation.
Perhaps the best-known Swap occurs
when two parties exchange interest payments
based on an identical principal amount,
called the "notional principal amount."

Think of an interest rate Swap as follows:
Party A holds a 10-year $10,000 home equity loan
that has a fixed interest rate of 7 percent,
and Party B holds a 10-year $10,000 home equity
loan that has an adjustable interest rate that
will change over the "life" of the mortgage.
If Party A and Party B were to exchange
interest rate payments on their otherwise
identical mortgages, they would have
engaged in an interest rate Swap.

Structured Notes

Structured Notes are debt instruments where
the principal and/or the interest rate is indexed
to an unrelated indicator. A bond whose interest
rate is decided by interest rates in England or
the price of a barrel of crude oil
would be a Structured Note,

Sometimes the two elements of a Structured Note
are inversely related, so as the index goes up,
the rate of payment (the "coupon rate") goes down.
This instrument is known as an "Inverse Floater."

With leveraging, Structured Notes may
fluctuate to a greater degree than the underlying index.
Therefore, Structured Notes can be an extremely
volatile derivative with high risk potential
and a need for close monitoring.

Structured Notes generally are traded OTC.

Stripped Mortgage-Backed Securities

Stripped Mortgage-Backed Securities,
called "SMBS," represent interests in a pool of
mortgages, called "Tranches", the cash flow of
which has been separated into interest and principal
components.

Interest only securities, called "IOs",
receive the interest portion of the mortgage
payment and generally increase in value as interest
rates rise and decrease in value as
interest rates fall.

Principal only securities, called "POs",
receive the principal portion of the mortgage
payment and respond inversely to interest rate movement.
As interest rates go up, the value of the PO
would tend to fall, as the PO becomes less attractive
compared with other investment opportunities
in the marketplace.

Financial Derivatives - Futures

A Future is a contract to buy or
sell a standard quantity and quality of an
asset or security at a specified date and price.

Futures are similar to Forward Contracts,
but are standardized and traded on an exchange,
and are valued daily. The daily value provides
both parties with an accounting of their financial
obligations under the terms of the Future.

Unlike Forward Contracts,
the counterparty to the buyer or seller
in a Futures contract is the clearing corporation
on the appropriate exchange.

Futures often are settled in cash or
cash equivalents, rather than requiring physical
delivery of the underlying asset.