Pine Street Capital is a market-neutral hedge fund in the technology field and is facing market risk and has to decide which way to use in order to hedge the risk. It can either use short selling of NASDAQ or options hedging strategy. Each strategy has its own advantage in different economic conditions. As the fund has just gone through a volatile period in NASDAQ’s history, PSC has to choose between two choices. Choice 1: Continuing to hedge market risk by short selling Choice 2: Switching to using put option on the index
Hedge Fund VS Mutual Fund
The number of hedge funds increased a lot in the late 19th century. Hedge funds are private group investments that offer equity pooling advantages similar to mutual funds. But for hedge funds, they are not publicly owned, so are less regulated than mutual funds. This advantage gives hedge funds the flexibility they need in investment strategies and risk management that cannot be found in mutual funds and it seems to result in a higher return. Moreover, mutual funds cannot use leverage like hedge funds. The advantage of using leverage to finance a portion of the assets in a portfolio is that it may result in a higher return on equity when compared with all-equity financed portfolio. Hedge funds also enjoy other additional privileges but the main differences lie in the ability for hedge fund to use leverage and to hedge by shorting or using options to limit the overall risk of their investments. Hedging Strategy of PSC
PSC adopts the market-neutral strategy which means market risk(beta risk) is hedged away while firm-specific risk(alpha risk) remains. PSC adopts this strategy because it believes that it is very specialized in the technology sector and hence be able to evaluate the field and pick up outperforming stocks accurately. The alpha return would be negative if PSC is unable to choose the good stocks. However, PSC felt that its comparative advantage is picking up positive alpha stock. On the...