Pine Street Capital

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Pine Street Capital
Discussion and Analysis

1

PINE STREET CAPITAL – WHAT RISK TO HEDGE & WHAT TO BEAR?

Hedge: market related risks

1. Currently managing a market neutral fund ($32 AUM)
In the past the market risk was hedged by shorting or short-selling representative shares of the market index In the past the market riskunder was The alternative hedged by shorting hedging the consideration was or shortselling representativehelp of put market risk with the shares of the market the market index options on index

Ready to Bear: individual security related risk; leverage

1. The fund deals with technology driven companies due to the expertise of its fund manager in that area; comfortable in prediction of individual stock related risk/ return 2. Use leverage to maximize returns 2

HEDGE FUND STRATEGIES
Option Based Short-Selling Leverage

• Extreme volatility in the • Used to eliminate
market

• By using debt
to finance a portion of assets, RoE is greater

general market risk from the fund

• Beta of portfolio dynamic,
changing rapidly in high volatility market

• Expected Return =
α + β ( Market Return)

• Options can better
immunize against market fluctuations

• Removes market
return component, leaving only alpha return in the portfolio

• However, if
assets lose value, then high leverage works against the investor

• Instead of shorting, buy
PUT options

• Return on hedged
portfolio = guaranteed α, whether up or down movement

• Keep utilizing leverage and
protect against large negative movements
3

BALANCE SHEET EFFECTS OF LEVERAGE

Unlevered Portfolio Assets Equity Assets Equity 50 50 100 100 ROE = 100%

Levered Portfolio Assets Debt Assets Debt 100 50 200 50 Equity Equity 50 150 ROE = 200%

4

SHORT SELLING STRATEGY

1. In normal circumstances the risk was reasonably hedged by using short selling strategy 2. High proficiency of the fund managers in predicting the portfolio beta; systems in place to achieve the exact amount of short selling required

3. Expected PSC portfolio return = α + β*(Market Return)
4. With the help of exact prediction of market risk (β), they were successful in mitigating the whole market related risk to make the portfolio “market neutral” However, due to extreme volatility in the markets, especially in technology driven shares the prediction of beta became very difficult 5

SHORT SELLING STRATEGY EXAMPLE

Long Portfolio Short NASDAQ Total

Initial Value $100 $150 $250

Tomorrow NASDAQ (+10%) NASDAQ (-10%) $116 $86 $135 $165 $251 $251 1% 1%

Return on Hedged Portfolio

As NASDAQ increases by 10%, using α + β*(Market Return), where α = 1% and β = 1.5, we get 1 + 1.5(10) = 16% and 1 + 1.5(-10) = -14% As NASDAQ increases by 10%, shorting it results in a 10% decrease ($15 decrease) and vice versa 6

BLACK SCHOLES MERTON MODEL

Call Option

Cgen = Se
Put Option

b-r T

N  d1  - Ke-rTN  d2 
b-r T

Pgen = Ke N  -d2  - Se
-rT

N  -d1 

d1 

ln(S/K)  (b   2 /2)T

 T
 d1   T

d2 

ln(S/K)  (b   2 /2)T

 T

7

OPTION GREEKS

The “Greeks” are sensitivities of option price to model inputs* First Order 1. 2. 3. 4. Delta Theta Vega Rho

Second Order 1. Gamma
Each measures a different dimension to the risk in an option position *Black Scholes Merton model
8

DELTA

Delta is the rate of change of the option price with respect to the price of the underlying asset Delta indicates the number of shares of stock required to mimic the returns of the option for Call = N(d1) C c  S

Option price

for Put = N(d1) - 1 P p  S

Slope =  B A Stock price

9

PUT OPTION BASED HEDGING EXAMPLE
Un-hedged Portfolio S&P (+5%) Assets Equity (Stock) $107.5 $107.5 ROE = 7.5% Hedged Portfolio (PUT Options) S&P (+5%) Assets Equity (Stock) $95.77 (S&P Puts) $5.60 $101.37 ROE = 1.37%

(Stock)

Today Assets $100

Equity $100

S&P (-5%) Assets Equity (Stock)...
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