Established in January 1999, Pine Street Capital (PSC) was a market-neutral hedge fund that specialized in the technology field, facing market risk and trying to decide whether and which way to use in order to hedge equity market risk. They choose technology sector because the partners of PSC felt that they have enough ability to evaluate this sector and specially be good at picking out-performing stock. Short-selling of NASDAQ and options hedging strategy are the two major hedging choices for PSC. Either strategy has its own advantages in different economic periods and conditions. The fund has just through one of the most volatile periods in NASDAQ's history, and it was trying to decide whether it should continue its risk management program of short-selling the NASDAQ index or switch to a hedging program using put options on the index. The more common hedging strategy they used was a short-sale strategy to eliminate market risk from the fund. Short-sale strategy can be explained in the following model:
Expected PSC Portfolio Return=α+β*(Market return)
α: The amount of return in excess of that due to market risk
β: The response of PSC’s portfolio to changes in the market PSC established relationship between the performance between PSC’s portfolio and the market. PSC adopted the market-neutral strategy because they wanted to eliminate market risk (beta risk) which was hedged from PSC’s portfolio by shorting the market in proportion to the beta of the assets in the portfolio while firm-specific risk (alpha risk) remains. And they believe that it was very specialized in the technology sector and hence be able to evaluate the field and pick up outperforming stocks accurately. The alpha return that PSC was left with in their portfolio after hedging market risk could be negative if they picketed the wrong stocks. But PSC was so confident because their comparative advantage is to select positive alpha stocks in technology field and do profitable investment. The number...