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Hedge Fund Insurance

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I had a meeting yesterday with an investor, an old friend named Dave from my Lehman days. He started a Fund of Funds a few years back and now runs a few billion.

He asked me the following question: what are the implications of these secured notes that several large banks are offering on hedge fund portfolios?

First let me explain. A Fund of Funds acts as a fiduciary for investors like pension funds, endowments, banks, and wealthy individuals that are less sophisticated about hedge funds. They gain access to hedge funds by pooling their investors' money and then they build a diversified portfolio of hedge funds of various types to reduce risk.

For some this risk reduction through diversification is not enough. So investment banks step in and offer "insurance" on the performance of their specific portfolio of hedge funds: they guarantee for a fee that the Fund of Funds will not lose more than a specified amount over some period of time. I have heard terms such as 1.5% annual fee with a 7% deductible (they will not lose more than 7%) over four years.

This insurance, like all insurance, is a put option, and can be priced and hedged as such. As far as the price goes, if this deal sounds expensive to you I would say that you are right. The annual fee makes the premium paid expensive relative to the strike (7% out of the money) of the put.

As far as hedging their risk, the investment bank gains control of the Fund of Funds right to redeem. If the portfolio begins to lose money, the investment bank begins to redeem the various hedge funds so that the portfolio is liquidated before or around the strike. This "dynamic" hedging methodology I have described before and is similar to what occurred for portfolio insurance of the 1987 crash and what exists today in any put option.

The only difference in this case is liquidity. Normally hedge funds allow redemptions only once a quarter (and can have further restrictions), so it is difficult to align the dynamic hedging unless the Fund of Funds (and therefore the investment bank) has "managed accounts" where they can redeem at any time.

Offsetting this difficulty in hedging is the price the investment bank collects for the put. A high price makes the gamma very low, so re-edging is less than that of an option cheaper in price.

If this option is so expensive, then why do some Fund of Funds buy it? (We estimate that $50 to 100 billion of this insurance is out there.) The answer is simple: the Fund of Funds doesn't pay the price, the ultimate investor does.

There is nothing fishy here because it is normally the ultimate investor who demands it. So in answer to my friend Dave's question, I told him that the price investors are paying takes much of the "negative gamma" risk out of the trade for the investment brokers. In normal conditions the contingent risk presented by this derivative activity does not present too much danger to the system.

But I do believe that in an abnormal situation this just adds to the huge convexity risk that is out there from the vast derivatives market and the historically high amounts of debt.
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