[COMPANY NAME]

[Company address]

[DOCUMENT TITLE]
[Document subtitle]

Contents
1.

Introduction..................................................................................................... 2

1.1.

Hedge Funds................................................................................................ 2

1.2.

Types of Hedge fund..................................................................................... 2

1.3.

Hedge fund portfolio.................................................................................... 3

1.4.

Comparison of 4 indexes from Bloomberg....................................................6

1.4.1.

Total equity analysis...............................................................................6

1.4.2.

Total volume analysis............................................................................. 6

1.4.3.

Moving average..................................................................................... 6

1.4.4.

Relative strength index..........................................................................7

1.4.5.

Rate of change....................................................................................... 7

1.5.

Selected 20 companies................................................................................7

1.5.1.

Performance comparison.......................................................................7

1.5.2.

Share price comparison.........................................................................9

2.

Portfolio theory.............................................................................................. 10

2.1.

International portfolio diversification..........................................................11

2.2.

Return rate................................................................................................. 11

2.3.

Mean efficient frontier................................................................................ 13

3.

Arbitrage....................................................................................................... 13

3.1.

4.

Arbitrage opportunity in selected portfolio.................................................13

3.1.1.

Home index company (Seagate Technology PLC (STX:NASDAQ GS)........14

3.1.2.

Sharp decline in share price.................................................................14

Impact of exchange rate volatility and market risk on portfolio....................15

4.1.

Exchange rate risk (Transaction, Economic and Translated risk).............16

4.1.1.

Transaction risk.................................................................................... 16

4.1.2.

Translation risk..................................................................................... 16

4.1.3.

Economic risk....................................................................................... 16

4.1.4.

Exchange rate volatility.......................................................................17

4.1.5.

Potential effect on portfolio..................................................................17

5.

Fame - French 2 and 3 factor model.............................................................17

6.

Conclusion..................................................................................................... 17

7.

References..................................................................................................... 17

1. Introduction
1.1.

Hedge Funds

Hedge fund is defined as a vigorously managed pool of investment that is open to

only a limited group of investors. Hedge funds performance is measured in absolute
return units. Theoretically hedge funds is defined as purely active component of the
conventional portfolio whose performance is measured against a market benchmark.
Hedge funds are limited to group of investors because of the risks associated with
them. According to Ethan W. Johnson (2006) Hedge funds are alternative
investments which uses various strategies to generate active return or alpha for the
investor. Hedge funds are often made as unregulated investment pool and are
commonly based offshore. Hedge funds required huge investment and sometimes
limits the ability to withdraw investment. Some characteristics of hedge funds include
high management fees, percentage share of management asset and charge
performance fee. However hedge funds are very risky, but they uses a variety of
financial instruments to limit the risk also this minimizes the relationship with bond
and equity markets (Arman Eshraghi and Richard Taffler, 2012). Hedge funds are
mostly based on partnerships, where hedge fund manager or portfolio manager act
as a partner. Hedge fund managers often invest their own money along with the
investors money and have all the control over the investment decisions. Portfolio
managers aims to generate greater returns than other investment opportunities and
they try not to be reliant upon the market. The term Arbitrage is used in defining
hedge fund, arbitrage seeks to generate higher returns from the change in price of
two related assets. There are number of arbitrage strategies also known as hedge
funds types used in hedge fund investment.

1.2.

Types of Hedge fund

Black (2004) provides categorized hedge funds into five styles or categories i.e.
neutral funds, event driven, macro funds, arbitrage and long/short or directional
trading.

Hedge funds based on arbitrage strategy normally have lower standard deviation of
returns as they are openly hedged. According to Timmons (2006) such strategy has
5 to 7% annual standard deviation consequence of which is highest sharp ratios
among other hedge fund strategies. Nevertheless such strategies generate return
slowly but lose funds fast which makes it extremely risky. Long/short hedge funds
take both short and long situations in a hope for good stock selection strategies. The
purpose of this fund is to outperform general market. Neutral funds is a sub-type of
long short fund, in this hedge fund managers try to hedge funds against general
market movements. According to Stulz (2007) in such type hedge fund managers
take zero beta exposure to equity markets. On the other hand the event driven
hedge funds attempts to capture gains from various events within the market e.g.
political turmoil, acquisitions and bankruptcy. Its main purpose is to exploit pricing
inefficiencies which may occur before or after spinoff, earnings call and merger.
Macro funds takes guiding bets on the market as whole. This is either short or long
i.e. based on the funds philosophy or research. The purpose of macro strategies is to
focus on the liquid assets that usually do not involve risks other than credit risk.
1.3.

Hedge fund portfolio

All investment have some sort of risks. According to Sender, H. and Kirchgaessner
(2008) hedge funds invest in derivatives that are very risky because of leverage. As
a UK based portfolio manager I have neutral attitude towards risk. According to Stulz
(2007) portfolio selection is the most important part in the hedge fund investment.
The estimate of the expected mean return is probably the most important input in
portfolio selection. Estimation risk associated with the expected mean returns
contribute more error to portfolio selection then estimation risk of the covariance
matrix (Ozik, G. and Sadka, 2010). The portfolio selection method I am going to
apply is the Marginal VaR (Value at risk). According to Fung, W. and Hsieh (2002)
MVaR is allows portfolio managers to analyse the impact of adding or removing
equities from investment portfolio. As the value at risk is affected by the correlation of
investment equities, it is not enough to consider specific investments value at risk
(VaR) in segregation. According to Fung, W. and Hsieh, D (2002) in MVaR selection
of portfolio the value at risk should be compared against the total portfolio.

A stock market index is a measurement of the value of the selection of the stock
market. Currently there are many stock markets in different part of the world. A good
selection of hedge fund portfolio comes from different stock market indexes (Giraud,
2004). In order to select equity portfolio tax sensitivity is important as non-taxable
portfolios gives portfolio managers more managerial flexibility than taxable portfolios.
According to ( ) non-taxable portfolios gives greater exposure to short-term capital
gain and dividend income than their taxable counterparts. Another important factor in
index selection is market efficiency. Markets are correct most of the times but
sometimes they overreact when a new development is made either positive or
negative within the individual firms. Based on these general principals I am selecting
CAC-40, FTSE-100, NASDAQ-100 and NKY-225 indexes.
FTSE-100 index is the most watched and well-known UK`s market index. It is one of
the biggest index in UK by far and has a value of 1.9 trillion. It tracks the value of
100 biggest corporations in London. FTSE-100 is less instable and is comparatively
cheaper to track. In last 10 years FTSE-100 performed really well as shown in the
figure below.

However FTSE-100 didnt perform well last year due to Brexit (UK leaving EU)
shown in figure below. But have shown tremendous growth after 2006 and have
ability to regain its position again in the coming year. This year on December 5 th
FTSE-100 has performance increased by 13.51%.

CAC-40 in particular is the most widely used indicator of the Paris market and
reflects the performance of 40 largest equities listed in France. For UK based
investors it is the closest market and easy to track as UK and European economy is
always affected in similar way. Similarly CAC has shown good results in last 10
years, however due to recent Brexit issue it has shown downfall.

But this year CAC-40 has shown good results and price has reached 4764 with
2.68% increase in a year with 125.38 million worth shares traded. According to
Trading economics global`s analysis CAC-40 is expected to trade at 4350.00 points
in 12 months time.
Similarly NASDAQ-100 and NKY-225 indexes both have performed really well in this
year. NASDQ-100 in particular has shown 8.39% growth where NKY-225 showed
-0.19% decline this year. However it is forecasted that it will reach 7100.00 points in
12 months time.

1.4.

Comparison of 4 indexes from Bloomberg

1.4.1. Total equity analysis

1.4.2. Total volume analysis

1.4.3. Moving average

1.4.4. Relative strength index

1.4.5. Rate of change

1.5.

Selected 20 companies

1.5.1. Performance comparison

Company

Revenue

Dividend

ROE

ROI

indicated

P/E

EPS

RATIO

Sky Plc (SKY.L)

11.97bn
ITV Plc (ITV.L)
2.97bn
AstraZeneca PLC $5.603

gross yield
3.35%
3.39%
4.72%

20.15%
55.60%
16.21%

5.48%
29.24%
5.70%

25.66
16.07
27.77

0.39
0.12
1.94

(AZN.L)
billion
Smith & Nephew 4.62B

1.97%

8.91%

5.86%

36.91

0.40

plc (SN.L)
Mediclinic

1.15%

24.90

0.30

2.11bn

International

plc

(MDC.L)
VINCI

SA 39.32Bn

3.05%

14.41%

6.26%

16.09

3.88

26.64bn

3.07%

7.48%

4.64%

24.55

2.65

(DG.PA)
Schneider

Electric

SE

(SU.PA)
Legrand

SA 4.81bn

1.39%

15.11%

91.4%

24.89

2.10

(LR.PA)
ENGIE

SA 69.88bn

8.38%

-9.75%

-4.65%

-1.91

2.87%

5.28%

3.82%

42.94

0.81

21.32bn

1.70%

48.16%

30.41%

30.44

1.93

11.16bn

6.40%

22.1%

6.22%

22.83

1.72

4.43bn

--

16.1%

12%

24.56

1.97

--

16%

7.4%

26.36

3.33

408.37bn

0.85%

11.25%

8.72

28.61

131.8

o)
Dentsu

706.47bn

1.52%

10.40%

7.14%

21.09

249.4

Inc (4324:Tokyo)
Terumo

525.03bn

0.99%

8.36%

5.51%

34.48

119.6

1.28%

7.47%

6.06%

29.48

79.3

2.04tn

1.11%

15.22%

9.86%

20.66

524.8

533.75bn

1.18%

6.27%

2.45%

24.50

121.5

(ENGI.PA)
Accor

S.A. 5.58Bn

(AC.PA)
Starbucks
Corp (SBUX:NA
SDAQ GS)
Seagate
Technology
PLC (STX:NASD
AQ GS)
Cerner
Corp (CERN:NA

SDAQ GS)
Dollar
Tree 15.5B
Inc (DLTR:NASD
AQ GS)
Kikkoman
Corp (2801:Toky

Corp (4543:Toky
o)
Ajinomoto

Co 1.19tn

Inc (2802:Tokyo)
Daikin
Industries
Ltd (6367:Tokyo
)
Sapporo
Holdings

Ltd (2501:Tokyo
)
1.5.2. Share price comparison
Company
Sky Plc (SKY.L)
ITV Plc (ITV.L)
AstraZeneca PLC (AZN.L)
Smith & Nephew plc (SN.L)
Mediclinic International plc (MDC.L)
VINCI SA (DG.PA)
Schneider Electric SE (SU.PA)
Legrand SA (LR.PA)
ENGIE SA (ENGI.PA)

Current Share Price

1,034.72
183.28
4,244.66
1,160.03
711.72
62.33
64.93
52.30
11.94

Share Price (2015)

1,112.00
276.60
4,616.50
1,208.00
888.50
62.42
49.11
50.72
14.69

Accor S.A. (AC.PA)

Starbucks

34.84
58.75

35.00
60.77

Corp (SBUX:NASDAQ GS)

Seagate
Technology 39.38

29.05

PLC (STX:NASDAQ GS)

Cerner

48.40

58.01

Tree 87.76

81.32

Corp (CERN:NASDAQ GS)

Dollar

Inc (DLTR:NASDAQ GS)

Kikkoman Corp (2801:Tokyo)
Dentsu Inc (4324:Tokyo)
Terumo Corp (4543:Tokyo)
Ajinomoto Co Inc (2802:Tokyo)
Daikin
Industries
Ltd (6367:Tokyo)
Sapporo

3,765.0
5,260.0
4,125.0
2,335.0
10,840.0

Holdings 2,986.0

4070.0
6630.0
3800.0
2717.5
8361.0
2665.0

Ltd (2501:Tokyo)

2. Portfolio theory

The term portfolio theory is all about finding the balance between minimizing risk and
maximizing return. The main objective of the portfolio theory is to diversify risk by
selecting investments in appropriate manner while not reducing the expected return.
The concept of Modern Portfolio Theory (MPT) was first introduced by Harry

Markowitz in his research paper "Portfolio Selection he developed this theory based
on the idea that non risk taker portfolio managers can create portfolios to maximize
or improve return based on the known market risk. He emphasised that market risk
is an integral part of the greater reward. Moreover Ohlson and Ziemba (1976) argues
that Modern Portfolio Theory assumes that portfolio managers prefer portfolios that
are less risky. A portfolio manager in this sense takes more risk if the expectation of
return is high. With the help of portfolio theory, investors investing in more than one
equities can take the advantage of diversification and thus reducing the risk level of
portfolio. Portfolio theory shows that investment in equities is not about selecting
them, but to select the right combination to reduce the risk level. The Modern
Portfolio Theory uses five different risk measurements to minimize the risk in a
portfolio investment. These includes beta, alpha, R-squared, Standard Deviation and
Sharpe ratio (Stulz, 1995). All these risk indicators intends to help portfolio managers
to determine a potential investments risk-reward profile.
Within this theory a return from a single investment is less significant than how that
investments return moves against overall portfolio values. According to Taksar et al
(1988) by analysing the risk and return base statistical relationship between the
stocks in a portfolio, portfolio managers can raise returns against a taken level of
tolerable risk. Research shows that a constant rebalancing of portfolio can
considerably reduce the risk in any given portfolio. As over the time many stocks in
portfolio can have changes in value because of the fluctuating market conditions.
Such fluctuations can imbalance the portfolio, so in order to ensure the smooth flow
of the portfolio and achieve the financial goals, it is important to rebalance the
portfolio sporadically.

2.1.

International portfolio diversification

Stock market investment is risky, but it also have potential to generate high returns.
Both researchers and practitioners suggest investing in multiple stocks to minimize
risk. Black and Litterman (1992) suggest that international diversification of stocks
reduces the risk even more when compared with local diversified portfolio.
International portfolio diversification does not provide benefit to the investor just

because of holding perfectly correlated stocks. But for another reason, as

international stocks with greater diversification provide less risky investment as their
prices are less interconnected and are anticipated by totally different external and
internal factors.

2.2.

Return rate

Company
Sky Plc (SKY.L)
ITV Plc (ITV.L)
AstraZeneca PLC (AZN.L)
Smith & Nephew plc (SN.L)
Mediclinic International plc (MDC.L)
VINCI SA (DG.PA)
Schneider Electric SE (SU.PA)
Legrand SA (LR.PA)
ENGIE SA (ENGI.PA)

Return
20.15%
55.60%
16.21%
8.91%
14.41%
7.48%
15.11%
-9.75%

Beta
0.6799
1.1886
0.46
0.78
1.0492
0.89
1.39
0.9803
0.8419

Accor S.A. (AC.PA)

5.28%
Starbucks Corp (SBUX:NASDAQ GS)
48.16%
Seagate
Technology 22.1%

0.9975
0.72
2.05

PLC (STX:NASDAQ GS)

Cerner Corp (CERN:NASDAQ GS)
Dollar Tree Inc (DLTR:NASDAQ GS)
Kikkoman Corp (2801:Tokyo)
Dentsu Inc (4324:Tokyo)
Terumo Corp (4543:Tokyo)
Ajinomoto Co Inc (2802:Tokyo)
Daikin Industries Ltd (6367:Tokyo)
Sapporo Holdings Ltd (2501:Tokyo)

0.82
0.64
0.75
1.0988
0.76
0.30
0.99
0.80

16.1%
16%
11.25%
10.40%
8.36%
7.47%
15.22%
6.27%

2.3.

Mean efficient frontier

3. Arbitrage
The concept of Arbitrage plays an important role in the modern finance. According to
Thomas and Jaye (2005) arbitrageurs are the entities which concurrently take short
and long positions in various assets. It helps the investor by enforcing market
efficiency and eliminate relative pricing. The term Arbitrage is used in defining
hedge fund, arbitrage seeks to generate higher returns from the change in price of
two related assets. There are number of arbitrage strategies also known as hedge
funds types used in hedge fund investment. Hedge funds based on arbitrage
strategy normally have lower standard deviation of returns as they are openly
hedged. According to Giraud (2004) such strategy has 5 to 7% annual standard
deviation consequence of which is highest sharp ratios among other hedge fund
strategies. Nevertheless such strategies generate return slowly but lose funds fast
which makes it extremely risky. Long/short hedge funds take both short and long
situations in a hope for good stock selection strategies. The purpose of this fund is to
outperform general market.
3.1.

Arbitrage opportunity in selected portfolio

3.1.1. Home index company (Seagate Technology PLC (STX:NASDAQ GS)

Seagate Technology PLC

Share Price dropped

May 6 2016

19.07

June 27 2016

20.87

November 2 2016

32.65

3.1.2. Sharp decline in share price

Company

Share
dropped

price Share

(1st dropped (2nd dropped

price
(3rd

incident)
September 14
June 27
June 14
Feb 11

incident)
November 21
November 15
November 4
June 17

(SN.L)
Mediclinic International plc Feb 24

May 18

November 11

(MDC.L)
VINCI SA (DG.PA)
Schneider
Electric

Feb 11
SE Jan 18

June 27
Feb 12

November 21
June 27

(SU.PA)
Legrand SA (LR.PA)
ENGIE SA (ENGI.PA)

Feb 12
Jan 21

June 27
Feb 10

November 4
June 27

Accor S.A. (AC.PA)

Starbucks

Jan 20
Jan8

Feb 8
Feb 8

April 6
June 27

March 3

June 17

Nov 11

March 8

May 8

Sky Plc (SKY.L)

ITV Plc (ITV.L)
AstraZeneca PLC (AZN.L)
Smith & Nephew plc

incident)
June 27
Feb 9
Feb 8
Jan 20

price Share

Corp (SBUX:NASDAQ GS
)
Cerner
Corp (CERN:NASDAQ G
S)
Dollar

Tree Jan 14

Inc (DLTR:NASDAQ GS)

Kikkoman

Jan 21

Feb 12

April 5

Corp (2801:Tokyo)
Dentsu Inc (4324:Tokyo)
Terumo

Jan 21

Feb 12

July 8

Co Jan 21

April 1

June 24`

Inc (2802:Tokyo)
Daikin
Industries Jan 20

Feb 12

June 16

Ltd (6367:Tokyo)
Sapporo
Holdings Jan 21

Feb 10

Feb 29

Corp (4543:Tokyo)
Ajinomoto

Ltd (2501:Tokyo)
There is high correlation between CAC-40, FTSE-100 and NKY-225 indexes and
very low correlation with the NASDAQ-100 index. But there is a very high correlation
between Smith & Nephew plc (SN.L) and Daikin Industries Ltd (6367: Tokyo). Smith
& Nephew plc is based in UK whereas Daikin Industries Ltd is located in Tokyo.
Within this portfolio arbitrage opportunity can be availed by setting profit ceiling by
buying shares of Smith & Nephew plc and Daikin Industries Ltd. By buying the
shares of these two companies the demand for their shares will increase which will
ultimately increase the prices of their shares. Once the targeted price is achieved
then selling the shares will generate huge returns. By applying this strategy I can
increase investment return and maximise arbitrage profit, thereby achieving profit
ceiling.
However arbitrage works on the assumption that market expectation do not change,
interests rate remain same, market volatility remains same and are not subjected to
exogenous shocks, inflation rates must be same in order for arbitrage to work.
4. Impact of exchange rate volatility and market risk on portfolio
The foreign exchange rate risk is the integral part in the decisions related to
international portfolio diversification (Allayannis, Ihrig, and Weston, 2001). The
exchange rate risks the hedging strategies and ultimately pose risk towards the
profitability.

4.1.

Exchange rate risk (Transaction, Economic and Translated risk)

The most common definition of exchange rate risks relates to the impact on the
value of the hedge funds by an unexpected exchange rate. It is an indirect or a direct
loss in the cash flow as the anticipated value of the foreign currency changes when
the exchange rate changes. It ultimately affects the assets, liabilities, cash flows and
net profit of the investor. In order to manage such risks hedge fund managers need
to determine this type of risk and hedging strategy and all the available tools to deal
with such issues. Many multinational businesses participate in the international
currency markets because of their multi-country operations. They participate in the
currency markets also to measure the impact of the changes in rate on their firm.
There are three different types of exchange risk a firm or hedge fund manager can
encounter (Madura, 1989). These three basic types include transaction risk,
translated risk and economic risk.
4.1.1. Transaction risk
Transaction risk is the type of risk which is also known as cash flow risk. It deals with
the effect of the change in rates on the transactional account which directly affect the
receivables. According to Jorion and Khoury (1996) it also have negative impact on
payable accounts. Organizations or hedge fund managers who are in need for cash
to smoothly run their cash flow can encounter issues, such has direct impact on the
firms ability to carry out their transactions (Hakala and Wystup, 2002).
4.1.2. Translation risk
Translation risk is a type of exchange risk which is also known as balance sheet
exchange risk. Within multinational firms it has direct impact on the valuation of the
subsidiary in the remote country which has different currency. Transaction risk is
usually calculated by the exposure of the net assets of the subsidiary. In the combine
balance sheet the translation can either be done at the end of the financial period or
can be done periodically. This totally depends on the companys headquarters
accounting regulations.

4.1.3. Economic risk

Economic risk pose direct risk towards the firms present value of the future operating
cash flow because of the fluctuating the exchange risk. In short this types of the risk

is directly applied on the revenues of the firm or profits of the hedge funds investor.
This effects on the operating expenses and international revenues. Identification of
such risks is important in order to avoid and issues with the cash flow. Development
of the strategy is vital for managing such currency risks.

4.1.4. Exchange rate volatility

Alternative exchange rates are the term used to manage exchange rate issues.
These are namely fixed exchange rate or floating exchange rates. Fixed exchange
rates are not supposed to change by definition. Volatility of the exchange rate shows
the degree to which variables change over the time. The larger the magnitude of a
variable change, or the more quickly it changes over time, the more volatile it is.
4.1.5. Potential effect on portfolio
Such exchange rate has huge impact on the proposed portfolio. It has economic risk
involved. As 15 out of 20 stock are foreign stocks.

5. Fame - French 2 and 3 factor model

The Fama and French three factor mode is the asset pricing model which expands
into CAPM by adding value and size factors o the market risk. According to this
model the small cap and value stocks always perform better. This model was
designed by two researcher including Kenneth French and Eugene Fama. They
designed this model to describe stock returns. By including these two additional
factors, the model adjusts for the outperformance tendency, which is thought to
make it a better tool for evaluating manager performance.

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fantasy", Accounting, Auditing & Accountability Journal, Vol. 25 Iss: 8, pp.1244

1265
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Analysts Journal, September-October, 28 - xx.

Elton, E. and G. Gruber (1995). Modern Portfolio Theory and Investment
Analysis, Fifth Edition. New York: Wiley.

Ethan W. Johnson, (2006) "Hedge fund marketing overview", Journal of

Investment Compliance, Vol. 7 Iss: 2, pp.48 51


F. Scott Thomas, John C. Jaye, (2005) "Converting hedge funds into mutual

funds a primer", Journal of Investment Compliance, Vol. 6 Iss: 4, pp.25 34

Fung, W. and Hsieh, D. (2000) Performance Characteristics of Hedge Funds
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Financial Analysis, 35, 291-307.

Fung, W. and Hsieh, D. (2002) Benchmarks of Hedge Fund Performance:
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22-34.
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Contrary

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