Stale Pricing

A stale price determines the current value of a security based on the price of a past trade and reflects no new information, which may have surfaced in the meantime. Hence, stale pricing can serve as a trading strategy and also smooth fund returns. The time lag mentioned, in combination with newly available information, enables a relatively precise prediction of the security price for the next trade.

The reason for the predictability of mutual fund returns is based on the industry standard to fix the net asset value (NAV) of a fund only once every day at 4 pm eastern time. The fund evaluates its portfolio positions with the last available market price, which may have been observed long before 4 pm when dealing with illiquid positions or non-US exchanges.

There are a number of hedge funds that specialize in exploiting this time lag advantage also called "market timing". In order to restrict or at least limit the use of stale prices, which is harmful for long-term investors, the Securities and Exchange Commission (SEC) executes pressure on the mutual fund industry to calculate their NAV via "fair prices", or to relate their fees to the holding period of fund investors—short-term investment, higher fees.

Hedge funds as well as private equity funds invest in illiquid and irregularly priced securities, which contribute only via estimated values and not as marked-to-market positions to fund performance.

An investigation of the returns has shown that the corresponding volatility, the correlation with traditional asset classes, the autocorrelation, and therefore the risk of the investment are positively distorted. This also influences the shape of the efficient border of a risk/return optimized portfolio.

Neutralizing the stale pricing ef ect results in a substantial increase in risk connected with alternative assets; however, this does not harm the importance of hedge funds and private equity concerning their diversification effect on traditional asset classes. Only the respective weighting of the portfolio constituents is shifted toward risk minimization.

Stale Pricing

Statistical Arbitrage

Statistical arbitrage portfolios are long/ short portfolios (i.e., self financing) that attempt to create profits from the statistical properties followed by a particular group of assets. If prices deviate from the estimated historical relationship, an arbitrage portfolio is created.

Statistical arbitrage strategies attempt to benefit from empirical regularities without the need for a strong theoretical underpinning in economic theory. Consequentially, most techniques employed in this field work with daily (or higher frequency) price data and much less with other economic or financial data. The techniques involved employ sophisticated statistical algorithms.

The most well-known examples are pairs trading and volatility pumping. The first strategy attempts at identifying a pair of two securities that are glued together by a statistical relationship (cointegration) that results into a mean reverting spread between both securities.

The investor takes a long position in a high-frequency (intraday) rebalanced equal-weight portfolio and a short position in a low-frequency (dai ly) rebalanced equal-weight portfolio. While both portfolios should have the same expected average return, the difference in geometric return should grow over time as the continuously rebalanced portfolio remains more diversified and as such suffers from a lower variance drain.

Statistical Arbitrage

Sterling Ratio

The Sterling ratio provides comparative information for a risk-adjusted assessment of drawdown analysis. Created by commodity fund operator Dean Jones of Reno, Nevada, the Sterling ratio is similar to the Sharpe and Sortino ratios in that it measures return relative to risk. However, in the case of the Sortino ratio, risk is measured by maximum drawdown.

The Sterling ratio is the annualized return for the last 3 years divided by the average of the maximum drawdown in each of the preceding 3 years, plus an arbitrary 10 percent. Jones added the extra 10 percent to the drawdown as he believed that all maximum drawdowns would be exceeded in the future.

To calculate this average yearly drawdown, the latest 3 years (36 months) is divided into three separate 12-month periods and the maximum drawdown is calculated for each. Then these three drawdowns are averaged to produce the average yearly maximum drawdown for the 3-year period. If 3 years of data are not available, the available data is used.

Average drawdown = (D1 + D2 + D3) ÷ 3
Sterling ratio = compound annualized ROR ÷ ABS (average drawdown − 10%)
Sterling ratio = average ROR (last 3 years) ÷ absolute (average drawdown − 10%)

Where D1 = Maximum drawdown for first 12 months;
D2 = Maximum drawdown for next 12 months;
D3 = Maximum drawdown for latest 12 months.

Much like other comparative, risk-adjusted statistics, the higher the Sterling ratio, the better. A high Sterling ratio means that the fund generates a higher return relative to its downside risk.

Sterling Ratio

Stress Testing

In risk management, the notion of "stress test" refers to some extraordinary situation occurring very rarely but whose consequences would be dramatic for a given portfolio. Such situations are usually outside the scope of normal market conditions, but they need to be envisaged and their consequences need to be understood.

Stress testing therefore helps hedge fund managers to determine how their portfolio would react in stylized scenarios. It gives them a better understanding of where extreme risks lie in their portfolios, and allows them to prepare so that they are able to act more decisively and more quickly if the worst-case takes place unexpectedly.

Measuring the volatility and/or value at risk (VaR) of a portfolio provides objective measures, which are usually based on some statistical observation of the past. By contrast, stress testing is a subjective risk-measurement approach that depends mainly on human judgment and experience.

At its simplest, a stress test will show the sensitivity of a portfolio to a certain change in some underlying risk factors. These changes (called "scenarios") can be based on historical data (October 1987, summer 1998, etc.) or can be hypothetical and entail large movements considered being possible.

Stress tests are helpful for evaluating the ef ects of large movements in key variables. Hedge funds ot en use them as a complement to statistical models such as VaR to capture the impact on a portfolio of exceptional but plausible large loss events, understand the overall risk proi le of a fund, set limits, and take capital allocation decisions. However, one should also be aware of the limits of stress test models.

In particular, they usually assume that the portfolio stays unchanged over the stress test period, and are often not able to capture the entire spectrum and interplay of risk exposures (such as operational risk, legal risk, liquidity risk, etc.). As an illustration, many hedge funds run a summer 1998 scenario on their portfolio but they do not model the lack of liquidity associated with this crash.

Stress Testing

Stressed Markets

The occurrence of periods of stress in international financial markets has been a challenge to economists and i nancial researchers for long. Academic interest in exploring underlying economic forces goes back, at least, to the great depression of the 1920s.

More recent prominent examples of periods of stressed markets include the crash of 1987, the so-called 1989 mini-crash, the 1997 Asian currency crisis, and the 1998 Russian debt crisis, which caused the collapse or near collapse of several financial intermediaries worldwide. Also, a purely exogenous event such as September 11, 2001 caused substantial market stress.

Furthermore, various other recent cases of market stress and related cases of individual financial distress add to a growing interest in understanding periods for stressed markets. Sometimes, although less frequently, stressed markets may also relate to run-ups in prices; a large stock market run-up with the start of the Gulf War in January 1991 may serve as an example.

Also, market stress may sometimes not at all be obvious from overall period price changes; a typical example would be frequently observed trading patterns such as so-called "one-day reversals". These tend to occur under high intraday volatility as well as hectic trading but typically do not end with large overall price movements on a market close-to-close basis.

Th e above observations led to the concept of "stressed markets", which is assigned to situations during which unusual economic circumstances prevail. One then distinguishes related market behavior from what is otherwise assumed to be "normal". This concept makes the analysis of markets under stress a separate and relatively recent research topic.

A central characteristic of stressed markets is heavy intraday trading activity that goes along with high intraday price volatility. Such periods are obviously of particular relevance for risk management as well as financial engineering applications.

During recent decades, important advances have been made in the area of economic models, which aim at an explanation of market stress and the occurrence of crashes. Stress dynamics critically depend on the nature and diversity of market participants, their motives for entering the market, and the extent of consistency in their response to worsening conditions.

While economic models make assumptions about the underlying market structure, the potential diversity in the economic background also calls for empirical methods in the study of market stress. Such methods include quantitative approaches in finance, which take care of the special stress circumstances as well as frequent approaches based on extreme value theory.

How do securities behave in situations of market stress? Important empirical observations of market behavior under stress, which is dif erent from normal behavior, include two main areas: nonlinear crosssectional dependence between and liquidity and nonlinear dependence between asset returns.

Consider the following first point: nonlinear cross-sectional dependence between assets returns relates to a typical observation under periods of market stress in that asset return correlations seem to be different than under normal market conditions.

In particular, correlations during strong market downturns seem to be higher than otherwise. This "diversification meltdown" may partly explain increased risk and the sharp movements in overall market indices. However, there is evidence that behavior is stable in a statistical sense.

In other words, it is a standard feature of a complex asset return dependence structure, which is nonlinear and not fully described by a linear dependence concept such as correlation. The feature obviously affects risk-management decisions and also indicates that standard methodologies would underestimate risk during market stress.

The second point is even more involved since we commonly assume that market volatility under normal market conditions is driven by information arrival and trading activity. However, under market stress, the patterns may not hold. Liquidity, which is a constant side variable under normal market conditions, starts to play a dominant role under market stress.

As such, nonlinear asymmetric relationships appear. The Bank for International Settlement’s Quarterly Report for the year 2000 commented that: "The illusion of permanent market liquidity is probably the most insidious threat to liquidity itself".

While markets, typically, become more liquid as prices rise and more participants enter, they become sticky when many participants want to exit at the same time. Risk management is af ected by potential market stress, which implies that common assumptions on market mechanics are violated. Such assumptions include that the liquidation of a position would have no ef ect on the market, that positions can be liquidated in a relatively short time period, and that the bid-offer spread remains stable.

As such, empirical evidence indicates that during times of stress, bid-offer spreads widen and market depth may become asymmetric between the buy and the sell side. Also, the ef ect of order flows on price movements becomes stronger. At the same time, no single measure so far seems fully appropriate to capture market liquidity or liquidity risk.

Stressed Markets

Strike Price

Strike price is the prespecified price that a buyer or a seller of a derivative contract agrees to use to purchase or sell an asset. It is also known as the exercise price. For example, in a call option for an XYZ company stock, the buyer of the contract has the right to purchase the XYZ company stock on or before delivery date for the strike price of X, but not the obligation.

If at the expiration, strike price is above the existing spot/market price, this option contract becomes out-of-the-money and the holder of the contract prefers to y let the contract expire. On the other hand, if the strike price is below the existing market price at the expiration, the contract becomes in-the-money and exercising the contract creates a positive gain for the holder.

For a put option, the holder of the contract has the right, but not the obligation, to sell the stock at the strike price on or before the expiration date. If the existing market price of the stock is below the strike price, put option contract becomes in-the-money and the holder of the contract prefers to exercise it. However, if the strike price is below the market price, the holder of the contract lets the contract expire without exercising it.

Strike Price

Strong Hands

The term "strong hands" refers to the ability/willingness of futures market participants to hold on to market positions in the face of adverse price moves. Since the margin requirements for the purchase or sale of a futures contract represent only a tiny fraction of the value of the futures contract, on average approximately 5% of the value, it is possible for market participants to obtain very signii cant leverage in the futures markets.

And although the leverage would act as a multiplier to increase returns if the participant correctly anticipates the direction of the price movement, either up or down, of the commodity or financial instrument that is represented by the futures contract, an adverse price move can result in significant losses due to this same multiplier effect. Many small investors are quickly forced to liquidate their positions during an adverse price move.

However, there is a class of market participant that is well capitalized, has a long-term view with respect to the direction of price and the conviction/ability to sustain temporary losses in pursuit of greater rewards. This group of investors is usually described as having "strong hands".

Strong Hands

Structured Products

Structured products are complex synthetic products designed to give exposure to assets or investment strategies via a single instrument. Structured products are generally listed and tend to be issued through private placements to professional investors or via public offering to general investors subject to local regulation. Structured products often span different asset classes and often embed derivatives.

Structured products have at least one of four characteristics:

• Access provision — the structure gives investors exposure to assets they might otherwise find impractical to trade. Let us consider a retail investor who would like to invest in a particular fund of hedge funds. h e fund has a minimum investment of $250,000, but the retail investor only has $50,000 available, so the retail investor has no direct access to the fund. However, it may be possible to get access via a structured product that offers identical performance to the fund. To achieve this, the structurer invests a large sum in the fund on wholesale terms and repackages it into units small enough to allow the retail investor to buy. 
• Principal protection or loss limitation — the product provides directional exposure to an underlying asset in one direction only. A simple example would be a note linked to an equity index, which, at maturity, pays back at least the initial investment, and also a large fraction of the performance of the equity index if positive. h is can be achieved in a number of ways, but a simple way would be to buy a zero coupon bond that pays 100% of the principal at maturity at a discount. The remainder is then invested in a call option on the equity index struck at today’s price. Whatever happens, the bond matures to pay back the original investment. If the index rises, the call option also pays out the performance of the equity index. h e actual exposure depends on the relative costs of zero coupon bonds and options on the underlying and is commonly called the "participation rate". 
• Leverage — the structure provides leveraged access to an underlying asset, that is, it pays a multiple of the return on the underlying asset. Structures with leverage usually embed a mechanism to limit losses to the amount of principal invested. 
• Algorithmic trading rule products — structures that invest in assets according to a specified rule set. There may be one or many underlyings, and the algorithm could define the constituents of an index forming the underlying asset depending on prevailing market conditions, or it could define buy or sell points of underlying assets according to the trading rules.

Systemic Risk

Nowadays, structured products are usually carefully constructed with market impact as well as risk control in mind. However, historically they have set up unexpected feedback loops in the underlying market. An early structured product, the portfolio insurance note, is now widely believed to have contributed to the 1987 stock market crash.

In mid-October 1987, 2%–3% of the market capitalization of the Standard & Poors 500 (S&P) was covered by portfolio insurance. Portfolio insurance is an algorithm, which calls for selling of the underlying asset if it falls to a predefined level and repurchase it if it subsequently rises. As the market started falling on Thursday, October 15, 1987, a few sell orders were generated as a result of portfolio insurance.

On Friday, the S&P fell further, triggering many more sell orders and the futures market closed with a large backlog of sell orders. h e 20.4% drop in the S&P on Monday was inevitable. Market participants had failed to fully analyze the mechanism, size, and uniformity of portfolio insurance.

The crash of 1987 was an especially severe case, and serves as a lesson in proper construction of structured products, not a blanket warning against the use of structured products. The basic lesson, not to allow the market to become too concentrated in one risk or another, is now well understood in the context of structured products. Nowadays, structurers usually consider market impact as part of internal risk assessment while creating structured products.

Common Examples

Because they are customized solutions, the possible variety of structured products is almost endless. However, some common examples include:

• Delta-one notes — a note that provides the same returns as an underlying product. These are pure access products. 
• Principal protected note (PPN) — protects the initial investment while giving some level of participation in the upside returns of a risky asset. A PPN may comprise a zero coupon bond and a call option on the risky asset, giving constant participation in the upside of the risky asset regardless of its subsequent path. A PPN may also take the form of a portfolio insurance strategy that starts with full (or higher) participation in the underlying, and reduces participation should the underlying fall. In other words, participation and eventual pay of is path dependent. h e expected outcome of these two PPN variants is the same if initial conditions are the same and leverage is not allowed. If leverage is allowed, the expected outcome of portfolio insurance-based PPNs is generally better than that of option-based PPNs because in portfolio insurance strategies leverage is only employed if the path of the underlying is upward. h e cost of leverage is not incurred when the underlying performs badly. 
• Autocallable note — allows investors to profit from a range-bound underlying, paying a coupon provided the underlying remains below a specified threshold level. However, should the underlying trade down to a predetermined, the holder only receives the actual performance of the underlying. 
• Reverse convertible note — protects the investor’s principal and pays a high coupon as long as the underlying remains below a predetermined level. However, if the product falls to a lower predetermined level, the coupons fall and could become negative. h is is equivalent to being long a zero coupon bond and short a down-and-in put.
• Airbag — protects the investor from a small crash in markets, but not a large one. Airbags are equivalent to a long at-the-money put and short more than one out-of-the-money puts.

Structured Products

Survivorship Bias

Survivorship bias refers to the bias that is introduced when returns are calculated from a pool of live investment funds only. Funds that die usually do so with poor returns. Since a cohort of live funds includes funds that would eventually die, it is more realistic to calculate historical returns from a pool that includes both live and dead funds. Using only live funds—namely, surviving funds—would produce historical returns that are artificially high.

There are many ways to calculate survivorship bias, the simplest being the difference between the returns of live and dead funds. It is sometimes preferable, however, to calculate survivorship bias using three different portfolios:

1. the surviving portfolio,
2. the observable portfolio, and
3. the complete portfolio.

Returns can be raw returns, returns in excess of a benchmark, risk-adjusted returns, or excess returns from a factor model. Failing to adjust for survivorship bias can lead to returns that are unduly inflated. Most studies of hedge fund survivorship bias, estimate the bias at two to four percent per year.

Survivorship Bias

Sweat Equity

Sweat equity refers to the value added by entrepreneurs in a new venture through their unpaid labor. It reflects the value created by the owners of a company as a result of the time, talent, and effort they contribute. The term "sweat equity" refers, in general, to the noncash contribution of an entrepreneur without a link to accounting.

However, in some countries entrepreneurs are able to account for their sweat equity in their balance sheet. Entrepreneurs can then receive additional share of ownership for their added value. In contrast to sweat equity, financial equity refers to the monetary contribution to a company by its owners.

In the context of a venture capital financing round the sweat equity of the entrepreneur may lead to conflicts in negotiating the deal. The entrepreneur and the venture capital investor are likely to have conflicting perspectives on the share of ownership the entrepreneur should keep due to his noncash contributions.

The entrepreneur expects to be compensated for the sweat equity he has contributed in the past. In contrast, venture capital investors base the venture valuation purely on the future growth potential. For them, it is relevant whether the past efforts of the entrepreneur result in a basis for future profits that would enable them to realize a successful exit.

Only then they would be willing to compensate the entrepreneur for his past efforts. Ineffective or irrelevant contributions by the entrepreneur can be considered sunk costs for the entrepreneur.

Sweat Equity

Syndicate

Syndicate is a group of venture capitalists, private equity investors, underwriters, and so on, who temporarily work together on one project. A syndicate is led by the lead investor (lead underwriter, lead venture capitalist, etc.).

Syndicate Bid

The "syndicate bid" describes two prices. The first definition of the term refers to a climate of competition between various syndicates. It describes the price a syndicate consisting of different (investment) banks
offers to the issuer of a security. In order to win the deal each syndicate might choose a high bid, but also faces the risk of not being able to place the issue in the market in case of an overpricing.

During the so-called "price meetings", which take place before announcing their syndicate bid the members of an underwriting syndicate try to reach consensus about bid and of er prices. After winning the deal, the corresponding syndicate starts selling the issue at the agreed offer price.

As soon as the syndicate is dissolved each underwriter is allowed to sell at an arbitrary price. In this context, the syndicate may also be formed by two or more venture capitalists or buyout companies, which jointly try to acquire a target company. Therefore, the syndicate bid is the price the syndicate is willing to pay for their target.

Th e second price described by the term "syndicate bid" refers to the single price of a security agreed upon by the syndicate members. In this context, the Securities and Exchange Commission (SEC) allows the syndicate manager and all other syndicate members to stabilize the market by increasing the demand of the issued security (mostly shares in an IPO) during the offering period.

This activity aims at keeping the price stable, which is of importance, especially during periods of rather weak demand. Under Regulation M of the Securities Act of 1934, stabilization is allowed as an appropriate mechanism in order to distribute securities. Further legal sources governing stabilization in the United States can be found in Regulation K, Rule 104, which replaced Rule 10b-7.

Syndicate Bid

Syndicate Manager

Syndicates of at least two different entities have the function to diversify risks among their members. Quite often they consist of investment banks or venture capitalist and buyout companies, respectively. In public offerings of securities the investment banks face, for example, underwriting risks.

Historically, relative to total risk, their capital accounts were very small, which led to one of the earliest syndicated underwritings—Pennsylvania Railroad in 1870. Another reason for forming syndicates is the combined distribution capability of all members. Banks of different sizes and dif erent expertise organized in syndicates can draw upon their combined know how.

Due to different strengths and weaknesses of each participant most often they have different functions within the syndicate, which might bring to mind a "pyramid structure": The syndicate manager is placed on top—he is also referred to as lead underwriter, managing underwriter, or lead manager. In the area of venture capital and private equity, the term "lead investor" is encountered most often.

The syndicate manager organizes the syndicate itself as well as the issuance of bonds and securities. For this purpose, he has to i nd further underwriters and organizations and invite them to form a syndicate. The syndicate manager negotiates terms and conditions as well as pricing questions within the syndicate and, as spokesman of the syndicate, with the issuer.

Furthermore, he has to assess. In accordance with the other syndicate members, the syndicate manager executes stabilizing transactions during the of ering period. Some syndicates may have several syndicate managers.

Together they form a so-called management group in which the above-mentioned management functions are split up and coordinated. The decision for or against implementing a management group depends on the security type of the issuance, possible relationships between issuer and investment banks, and the perceived abilities of the corresponding banks.

Usually, one bank of the management team is lead manager or book-runner. The remaining nonmanaging banks of the syndicate are also hierarchically placed structures, starting with the bulge bracket, followed by the major bracket, and finally by the submajor bracket. Between major and submajor bracket a mezzanine bracket may be found.

The syndication of venture capital or buyout investments in privately held companies differs from public offerings of stocks. The Securities and Exchange Commission (SEC) does but slightly regulate the manner in which shares are sold from private companies to venture capitalists and buyout funds.

This fact facilitates cooperation between investment companies. Furthermore, the venture capitalists and buyout funds invest forthright into their target companies and are willing to hold their investments for several years, and they are even obliged to do so for a period of more than 2 years.

Since usually the asymmetric information between investors and target companies is by far higher in venture capital and buyout funds than in public offerings, the investment decision is more complex. Syndication is one mechanism to reduce lacking information about potential target companies.

The conduct of negotiations, especially prior to first-round financings as well as in the following rounds, is one of the lead investor’s exclusive tasks. Furthermore, the organization of funding is part of the lead investor’s business. He is also responsible for continuous monitoring combined with hands-on assistance with respect to all business matters of the portfolio company.

Syndicate Manager

Syndicated Sale

A syndicated sale refers to two types of transactions. In the field of venture capital and buyout, it describes the joint acquisition of a portfolio company by a syndicate of at least two investors under guidance of one lead investor.

Sometimes, this kind of transaction is also referred to as coinvestment. This approach is characterized by the joint action of the participants who face tremendous information uncertainties, that is, the investment decision is reached unanimously and the venture capitalists or buyout firms are united by the common purpose to increase their portfolio company’s value.

In the context of investment banking, a syndicated sale describes a transaction in which a bank underwrites the issuance of a specified security and passes parts of these securities to the other syndicate participants in order to sell them at a previously negotiated single price.

Sometimes, there are also banks involved, which are not part of the syndicate; they form the selling group. The syndicated sale allows the involved investment banks to share their risks. All syndicate participants and members of the selling group are compensated for selling securities to the final investors, the so-called spread between the price paid by the investors, and the price paid to the issuer of the security.

The syndicate manager, potential further managers, syndicate participants, and the members of the selling group share this spread because of their readiness put up with risks and distribute the securities to the investors.

Generally, the syndicate manager and the other managers receive an additional compensation for executing their management function and coordinating the syndicate and, in the case of the book-running manager, for the technical efforts.

Three forms of contracts are used in an underwriting. In a "firm-commitment" contract, the underwriter guarantees the issuer the sale of the securities at a price negotiated beforehand, and the risk is borne by the underwriter.

The "best-efforts" contract is the agreement in which the underwriter commits himself to sell at the negotiated price as many of the securities as possible, whereas in the "all-or-none" contract the underwriter sells either the whole issuance or exercises his right to cancel the transaction.

Syndicated Sale

Syndication

Syndication is a joint investment of several investors in one company. Syndicated deals are common in venture capital or private equity industries. There are several reasons for which investors syndicate their deals.

First, syndication improves the portfolio diversification and risk sharing of the investors as each of the investors can, with a limited amount of resources, participate in more projects. Second, information sharing may be another reason for cooperation among investors.

Syndication may already be important during the selection process because a syndicate of investors may reduce the asymmetries of information more efficiently and be able to select the best quality projects better than a single investor. In practice, the decision to put money into a project is ot en made conditional upon the finding of another partner who is willing to cofinance the firm.

Third, multiple investors may generate a higher value added for their portfolio firms compared to deals financed by a single investor (stand alone deals). Multiple investors may of er an improved managerial support for their portfolio firms through their complementary skills and through a larger variety of contacts than a single investor.

Fourth, syndication may be a means of mitigating competition. Instead of competing for deals, the investors cooperate. Fifth, when reciprocity works properly, syndication can be a means of assuring deal flow. Sixth, investors may learn from each other during the investment process.

However, syndication also incurs costs. The single investor has to take into account that—when he decides to syndicate a deal— he would have to share the profits with his partners. For this reason, experienced investors who would not profit a great deal from information sharing, value adding, and learning from their potential partners may not be willing to syndicate their best deals.

Moreover, some agency problems may be aggravated in syndicated deals compared to stand-alone deals because more participants with different preferences and information sets are involved. However, reputational mechanisms, repeated relationships, and reciprocity are expected to diminish potential agency conflicts among the syndicate partners.

Syndication

Systematic CTA

A systematic commodity trading advisor (CTA) trades futures contracts according to a computer-generated pricing model. Many CTAs are trend followers, who strive to take long positions in upward trending markets and short positions in downward trending markets.

A CTA may trade in a wide variety of markets worldwide, perhaps following over 150 futures contracts in agricultural, energy, precious and industrial metals, bonds and interest rates, and currencies and stock index futures. CTAs are subject to the regulation of the Commodity Futures Trading Commission (CFTC).

h e proi ts generated by a systematic CTA are largely earned in the markets with the largest and most steady trends. A volatile, nontrending market would cause losses for systematic CTAs, who have solely implemented trend following models. Some CTAs may choose to mix trend following and counter-trend models, which bet on mean reversion rather than trends.

This diversification between trend following and counter-trend models allows the CTA to produce more consistent profits, especially in times of volatile, range-bound markets characterized by large price movements in both directions. Systematic traders are trained to understand that the largest profits come from sticking with a very long-term trend. This tendency can lead to volatile performance, with large drawdowns often following the largest gains, as long-lasting trends may reverse.

Systematic CTAs are oft en called technical traders as many fund managers simply focus on volume, volatility, and price formations. An example of a simple technical analysis rule is a moving average crossover system, where the trader takes a long position when a short-term (perhaps 5 day) moving average crosses above a long-term (perhaps 30 day) moving average.

A short position is initiated when the short moving average crosses below the long-term moving average. Ideally, all trading models are thoroughly tested before implementation, as discretionary trades are often less successful than the systematic trades, especially when that discretion leads the trader not to implement the trades requested by the system.

Many systematic CTAs trade a variety of models—each optimized for a different market condition. Perhaps a CTA may have four models including those that perform well in high- and low-volatility trending markets, and others that profit in high- and low-volatility trendless markets. Most systematic CTAs do not attempt to quantify the fundamentals of futures markets such as the supply and the demand factors facing commodities, or how interest rate or inflation expectations may impact currency or bond markets.

The funds offered by CTAs are often called managed futures funds. These funds tend to have excellent diversification characteristics when added to an equity portfolio, as the largest gains to managed futures funds often come during the time when equity markets are posting their largest losses.

Systematic CTAs typically have return profiles that have a very low, or even a negative, correlation to traditional long stock and bond market indices. Funds that trade a wide variety of markets, including commodities, are more diversifying to a portfolio of traditional investments while CTAs that solely trade financial futures are less diversifying.

Systematic CTA

Systematic Trading

Systematic trading is an investing discipline that involves quantitative research and technical market data. An analyst inputs the market conditions into a software application that would initiate a trade program once certain market conditions or parameters are met. An example of a parameter would be if two moving averages cross each other, it would indicate a technical signal to initiate the trades.

The trade programs are based on a set of well-defined rules that tells you when and what to buy or sell. There are various software vendors with special applications that monitor technical market data and alert the analyst or kick of these trade programs automatically. Proponents of this type of analysis believe that historical market conditions repeat over time; therefore, they trade on these conditions.

Systematic Trading

Takedown

Takedown is referred to in the case of security issuance and payments into a venture capital or private equity fund. In the first complex, one meaning of takedown is the price underwriters pay the issuer for a specific security that afterwards is offered to the investors.

In this context, takedown might also describe the commission the (investment) bank keeps for the various services offered by the different banks, for example, managing the syndicate, taking risk, arranging the security issuance, and distributing the securities to the public. As already mentioned, the compensation between the banks differs.

The lead manager may approximately receive 15–20%, and the underwriters between 50 and 75% of the total compensation for an underwriting. If the lead manager is also an underwriter (as is usually the case), and belongs to the selling group, he participates in all revenue segments of a syndicate.

The second meaning of takedown related to security issuance is the proportion (absolute amount) or quota (percentage) of the security a (investment) bank is going to distribute in a syndicated sale or an IPO. Furthermore, it refers to a "takedown transaction" if, during the first trading day of a new security, an underwriter or syndicate manager sells transaction securities below the list offering price in a primary market sale.

Takedown is also relevant in the context of managing venture capital and private equity funds. Here takedown is the amount of money an investor transfers to the fund. To find attractive target companies and to concentrate on only a few deals at a time, the fund managers refrain from collecting all the money the investors promised to invest into the fund, the so-called committed capital, at one point in time. Another reason for not paying all the funds prematurely is that the interest paid by the bank is significantly lower than the rate of return the investments of the fund are expected to achieve.

The partnership agreements, which the limited and the general partners enter into, usually contain a takedown schedule as a specification of the way and the timing the funds are paid in. Typically, an initial payment (set amount) of up to 33% of the committed capital is arranged.

For the subsequent payments either fixed dates for the takedowns are set in the agreement or are let to the discretion of the general partner. In the latter case, a minimum and a maximum time period is fixed. One year, or at the latest 3 years, at er a fund’s inception all funds are drawn from the limited partners.

Takedown

Tender Offer

A potential purchaser of a large number of shares in a company can put a request to all shareholders to determine those willing to of er their shares for purchase. Such a request to purchase shares from a large number of investors is a tender offer. A tender offer may be used by a company to repurchase some of its shares as a way of returning cash to share-holders.

A tender of er by a company to repurchase some of its shares would specify the number of shares to be bought and when the of er would expire. The same price will be paid for all shares acquired in a tender offer. This compares with the company buying back shares in an open market repurchase where sellers would receive different prices based on when the transaction occurred on the stock market.

A tender of er may also be used by an outside investor or company to acquire a large proportion or a controlling interest in another company. In acquisitions, a tender of er is usually used to acquire enough voting control to enable the takeover to succeed.

Tender offers made for the purpose of acquisitions would normally pay a premium over the prevailing price on the stock market. As a method of achieving a business combination, when a tender of er is used in a hostile acquisition, there is empirical evidence that there are long-term wealth gains for acquiring company shareholders compared to friendly mergers.

Tender Offer

Term Sheet

In venture capital investing, a term sheet refers to a letter written by an investor, typically a venture capital firm, to a start-up company outlining the basic terms of the investment agreement. These financial terms would include the investment amount, the stake to be taken up by the investor, and the implied pre-money valuation and post-money valuation for the investor.

Other terms include preemptive rights by the investor to invest in future rounds or to acquire additional stakes if some of the existing investors decide to sell their shares in the company, antidilution and rachet provisions to protect the investment value of the investor, as well as the rights of the investor in such matters as hiring of senior people in the company, representation at the company board, and consent before the company can file for public listing or sell the company.

Once the term sheet is agreed upon by both the investor and the company, the investment agreements are then prepared in accordance to the agreed terms; although if market conditions change and/or one or both parties change their mind, the terms may be amended before the legal documents are entered into.

Term Sheet

Third-Stage Financing

At this stage, the firm is experiencing success in terms of sales, with clientele purchasing the product. At the third stage, capital for financing operations is used to expand or increase the existing plant capacity, fine tune marketing, as well as increase the quality of the product via product improvements.

Capital is now provided for i rm expansion to meet the growing demand for the product because the firm, at this stage, is closing in on its break-even point and beginning to show signs of some profitability.

Third-Stage Financing

Tick

Tick is the smallest possible movement, up or down, in the price of a financial asset. Until the end of the 1990s, the system used in the United States to determine the tick was through the use of fractions of 1/8, which was most likely introduced from the traditional predecimal division of the British pound into quarters and eighths. Currently, the shares negotiated on the New York Stock Exchange are negotiated with movements of $0.01 instead of the system using fractions.

In some countries, the size of the tick is determined on the basis of the price level of the share, although the common way is a single value for all the securities negotiated. Although the size of the tick in a market may be nominally fixed, a company can influence the percentage of the price of its securities that it represents, modifying the number of securities negotiated by means of splits or share repurchases.

In this method, the obligatory size of the ticks can describe a major percentage of variation in the prices of the securities between the different markets. In the specific case of the adoption of the decimal system in the United States, Dyl et al. (2002) found that it led to lower prices (due to the splits) for the securities, without this leading to a substantial change in the volume negotiated in monetary terms.

Tick

To-Arrive Contract

A to-arrive contract is the first known futures-type contract that was developed in the middle of the nineteenth century at the Chicago Board of Trade (CBOT). The CBOT was established to bring farmers and merchants together and to standardize the quantities and qualities of the traded grains. These standardized contracts are called to-arrive contracts.

It allows the farmer to sell the grain for a fixed price, the so-called futures price, and to deliver the grain to a specified futures date. For example, a wheat farmer expects to have 100,000 bushels of wheat to sell in 4 months. The price of wheat is volatile so there is a price risk. To hedge this risk the farmer can agree to deliver the bushels of wheat in 4 months at a price that is set today.

The definition "to-arrive" is referred to the delivery of the traded commodity. In the nineteenth century and earlier, a lot of goods were brought by ship. h e price, quantity, and quality of the commodity were fixed before delivery. The main part of trading, that is, delivery and payment, took place when the ship arrived in the harbor. This type of contract is still used today, but not as much as it was in the past.

To-Arrive Contract

Tombstone

A tombstone is an advertisement in newspapers and other publications that is used by financial firms to announce significant underwriting, fundraising, or personnel developments. For example, investment banks will use tombstones to announce a public offering of securities that have successfully completed the underwriting process.

Investment banks will also take out tombstone advertisements to announce a private placement of securities for a particular client or to high-light their role in a strategic transaction such as a corporate merger or acquisition. Private equity firms will place a tombstone to announce the launch of a new fund or to notify of a significant closing. Financial firms will sometimes use a tombstone to announce a significant personnel change.

Tombstones are most commonly used to announce newly registered securities by an investment banking firm. In this instance, the tombstone will contain details about the issue including the name of the issuing company, the security type, the offering price, the total value of the offering, and the names of the investment bankers associated with the deal.

In addition, there is an established protocol to the format of this type of tombstone. Specifically, there is a particular order in which the investment bankers are listed in the tombstone. Listed at the top are the lead and colead investment banks for the issue.

They are followed by the "major bracket" investment banks, an industry determined categorization that is based upon reputation and national focus. Next in line are the "mezzanine bracket" investment banks, which are typically smaller firms that operate nationally. Finally, at the bottom of the list are the regional investment banks.

Tombstone

Top-Down Investing

Top-down investing targets investment opportunities along with a three-step selection process based on a macroeconomic analysis (e.g., strategic or tactical asset allocation).

First, the impact of the business cycle and financial market conditions are assessed across major asset classes (i.e., equities, fixed-income securities such as bonds, money market assets, and currencies).

This analysis level is achieved in the light of geography, region, and country dimensions while considering leading economic fundamentals (e.g., GDP, interest rates, production, market indexes, consumer anticipations, inflation, and employment). Second, once the most interesting market place(s) is(are) selected, related sectors are classified according to their attractiveness and competitiveness.

Winning sectors are identified as industries exhibiting the best return prospects. Third, the most attractive securities are selected within the most competitive sector(s) on an individual basis (expected outperforming securities). For this purpose, issuing companies are analyzed in the light of corresponding firm-specific fundamentals.

For example, stock-based top-down investing attempts to select expected outperforming stocks in the light of issuers’ size (e.g., small caps) and related style (e.g., value or growth stocks). Finally, top-down investing allows for portfolio diversification across leading financial markets all over the world and across related winning sectors.

Top-Down Investing

Tranche

"Tranche" (sometimes traunche) is originally a French word, meaning slice or cutting. In the private equity context, it is a partial financing round, also known as milestone round. If a company does not receive all of the capital of a financing round upfront, it will receive the capital in several cash injections.

At each financing round, the investor makes a decision whether or not to invest and continue the relationship. At each tranche of a financing round, the investor has the option to stop financing, but only if the agreed milestones are not met; otherwise the investor is usually obliged to finance all tranches until the present financing round is completed.

Slicing the total amount of each financing round into smaller cash injections gives the investor more control over how the capital is allocated. The option to provide just enough cash to the company, given its development needs, enforces a more disciplined focus to reach mutually agreed upon goals.

Terms and conditions, which include estimates of company valuation, shares, and nonparticipation rights, are usually negotiated at each financing round but stay the same for each tranche, which represents only a financing fraction, payable upon completion of an agreed milestone. Cash injections may be given to a portfolio company as a bridge in anticipation of the next financing round, or on top of the financing round to maintain liquidity.

Tranche

Transparency

Transparency refers to the degree of disclosure an investment manager provides to their investors. Investors may require transparency regarding the actual trading positions and leverage of the fund, the trading strategies employed by the fund, and the pricing, accounting, and risk management processes of the fund.

A completely transparent hedge fund may manage separate accounts, where all assets are held in the investor’s trading account. This allows investors to see all positions and trading activity in real time.

The transparent fund will clearly answer detailed questions about their trading strategy and allow investors to audit their trading and risk management processes and settlement procedures.

A partially transparent hedge fund may prefer not to manage separate accounts, and may only offer investments in commingled funds. The manager of this fund may describe the spirit of the trading strategy, while concealing the exact details of the process that generate the trades. The fund may offer investors aggregated data rather than the specific positions and trading activity of the fund.

These aggregated risk reports will typically include statistics regarding the size and diversification of positions and the distribution of assets by market. Risk statistics within each market may also be disclosed, such as the average beta, sector weights, and the distribution of market capitalization for an equity portfolio.

The manager will typically allow investors to view their operations if that is a requirement of receiving a new investment, but the exact algorithms used to generate trades or risk management processes will not be disclosed. Performance is disclosed only on a monthly basis, and the returns of the fund are audited on an annual basis .

In order to reduce operational risks , it is important that these performance estimates and aggregated risk statistics come from the prime broker or the third party vendor of a risk management system. Should a manager have fraudulent intentions, performance or position data disclosed by the fund may be changed to conceal the true risks or performance of the fund.

An opaque fund is one that offers little to no transparency to investors. This fund manager will only disclose monthly performance, and sometimes may not pay for an annual audit. Trading strategies and positions are only discussed in broad terms, and are never disclosed in full.

These funds, especially when there is a quantitative nature to the process, are often called "black box" funds, as it is difficult to see inside the manager’s process. Institutional investors are often uncomfortable with funds that lack transparency, as it is difficult to ascertain the risk of the strategy and the skill of the manager.

Investors require transparency of their hedge fund managers to become comfortable with the manager’s strategy during the due diligence process. Ideally, the manager will disclose enough about their trading process for the investor to determine the skill level of the manager before an investment is made. Transparency is also valuable to investors during the risk management and portfolio construction processes.

Investors desire that their hedge fund portfolios have a low correlation to traditional investments, as well as a low correlation between the hedge funds in the portfolio.

Access to position level, or aggregated risk statistics, for the fund allows investors to clearly see the correlation between the fund managers in their portfolio. Once an investment is made in a hedge fund, transparency allows the investor to continue to monitor the progress of the fund.

Should the fund manager choose to increase risk or leverage or modify the types of securities traded, an investor with a reasonable level of transparency would notice this divergence quickly, which allows them to have a timely conversation with the fund manager if they are concerned by these changes.

At that time, the investor may ask the fund manager to reduce risk or return to the original trading style. If the investor is not satisi ed with the response of the fund manager, the investor may choose to reduce the investment in that hedge fund to reduce the risk.

A fund of funds manager may wish to have complete transparency of the underlying positions to aggregate all of the positions of the fund to see the exact portfolio.

This helps the fund of funds reallocate capital between their hedge fund managers. Some funds of funds may implement hedges at the port folio level when the aggregated risk of their fund investments exceeds a predetermined level.

Hedge fund managers may wish to limit the degree of transparency to investors for many reasons. The most common reason cited by managers is that their positions and their trading processes are proprietary, and that disclosure would reduce the value of the hedge fund management company.

Should this information be disclosed to active traders or those who wish to profit at the hedge fund’s expense, position level data in an illiquid market can, indeed, reduce the returns of the fund by increasing trading costs.

However, the vast majority of investors and funds of funds do not have any interest in replicating the strategy of the fund or increasing the trading costs of the fund.

Fund managers may be more wary of sharing their positions with their prime broker, especially if there is not a clear separation from the proprietary trading desk. Hedge funds may also decline to offer full transparency, as the amount of information may be over whelming to investors.

If a fund executes thousands of trades each month and holds hundreds of positions at a time, this information may be difficult for an investor to interpret. Partial transparency, including a monthly summary of portfolio risks, may allow investors the information they need, while reducing the privacy concerns of the hedge fund manager.

Transparency

Trend Following

Trend following commodity strategies attempt to derive future expected performance from past historical performance. This involves two steps. We first need to identify whether a trend has been established and secondly for how long it will continue.

In essence, a trade follower will always be late to hop on a trend and will almost invariably be surprised when the trend ends (often as the result of an exogenous, i.e., unforecastable shock). Only if the trend continues for long enough to cover the costs from a trend reversal, will the strategy be profitable.

Return momentum strategies are the most common strategies in the commodity universe. They come in the form of either simple momentum (buy winners and sell losers) or crossover momentum (buy a commodity if the short run performance exceeds the long run performance).

Generically we can express a trend following strategy as mom (h, s, l), where h denotes the holding period horizon, s the short-run moving average, and l the long-run moving average.

For example, mom (3, 6, 12) denotes a momentum strategy that will invest into a commodity, if the 6 months moving average exceeds the 12 months moving average and vice versa. As the strategy is good for the next 3 months, the question arises, "what do we do after 1 month?" After all, a new signal arrived.

Do we want to create an entirely new portfolio, throwing out our old 3 month view? Given that our holding period assumption is 3, we will for each period build a portfolio that is a mixture of the past three momentum portfolios.

Equal weighting stacked portfolios implicitly assumes that there is linear decay in information ratio. While this is not necessarily true, it seems to be a robust assumption.

What are the economic foundations of trend following strategies? We start with behavioral finance models. Suppose we have a market with two types of investors, both exhibiting bounded rationality.

One type of investors only reacts to fundamental information, disregarding the information in price changes, while the second type of investors disregards fundamental information and only reacts to price changes. If fundamental information spreads slowly, we will see commodity prices to initially underreact to the arrival of new information.

This will kick-start momentum traders that have observed past prices to rise. Sitting on a self-accelerating strategy, momentum traders continue buying in an attempt to arbitrage the slower fundamental investors. Effectively this will lead to a market that shows both initial underreaction and final overreaction.

A second explanation for the success of trend following commodity strategies is their link to business cycles. Given that commodities are closer to consumption goods than to assets, they are unlikely to be priced by a forward-looking discounting mechanism.

As such they should be much more sensitive to changes in business cycle conditions as they lack the ability to look through to the future. Finally, it is intuitive that momentum strategies work best where it is hard for fundamental models to find fair values and as such learning from past prices is more widespread.

Trend Following

Turnaround

Turnaround refers to the positive reversal in the performance of a business, company, or the overall market. Financially distressed companies achieve a turnaround if they return to a profitable position. The downturn leading to financial distress can have different causes, such as a bad strategy or a poor operational efficiency.

The strategic or entrepreneurial turnaround comprises the efforts of a firm with financial difficulty to follow a return-to-growth strategy. It usually consists of controlling strategy components, such as restructuring the company’s product or service offering, its primary markets, principal technologies, distinctive competencies, and strategic alliances.

Operating or efficiency turnaround represents the substantial effort of a distressed company to follow its current strategy in a more efficient fashion. In general, it consists of methods to control costs, use assets efficiently, and ameliorate production processes and their associated managerial and structural changes.

The characteristics of successful turnaround strategies are often contingent on the actions taken in high profile achievements: rapid and powerful decision-making, heavy cost cutting, divestitures, as well as stressing quality. Such perceptions are neither generally precise nor consistently advantageous.

Additionally, they do not of er authenticated remedies for executives of firms encountering decreasing financial or competitive performance. There is a requirement for systematic theory building based on carefully designed and expertly executed empirical research on turnaround situations and responses.

Turnaround

Uncovered Options

Contrary to "covered options", the issuer of "uncovered options" does not hold the respective opposite position in the underlying. We further differentiate between selling uncovered calls and uncovered puts. For a premium, the issuer of an uncovered or naked call agrees to provide the underlying at some point in time in the future for a price determined in the present.

As security and proof of his ability to deliver in the future, the issuer needs to deposit a margin of the option premium plus about 10–20% of the underlying with his broker. The risk of such a transaction is virtually unlimited.

The issuer of a call expects prices to fall or at least a sideways movement of prices for the underlying on the one hand and judges the option premium to be overvalued on the other hand.

For the issuer this means that the (overvalued) option premium overcompensates the price change risk, included in the underlying. The risk of rising prices and hence the execution of the option can however be eliminated or mitigated at any time by closing the position or buying the underlying, in which case the option is transformed into a covered call.

When dealing with an uncovered put, we can assume that the issuer of the put neither sold the corresponding underlying short nor has the money to buy the underlying. Compared with the uncovered call, again a limited possible return—the premium—faces a substantial risk.

If the price of the underlying falls by an amount surpassing the premium, the issuer of the put faces a loss, which may end up being a multiple of his initial capital invested, but however, is limited by the complete loss of the underlying. The primary goal for the issuer of a put is to make a profit by obtaining the option premium, and by buying the underlying for a price below the market price.

Uncovered Options

Underlying Commodity

The underlying commodity is the cash commodity underlying a futures contract, forward contract, commodity or futures contract, whereby a commodity option is established and should be accepted or delivered when the option is exercised. The cash commodity is furthermore specified by the minimum quality of the delivered goods and by the delivery location.

Due to this relationship there is a high correlation between the market price of the future/forward contract and the spot market price of the underlying commodity. Deviations from the perfect correlation lead to the so-called basis risk. Indexes can have several underlying commodities, using same commodity classes, for example, grain or different commodity classes like agriculture and energy.

Examples of underlying commodities:

• The IPE Brent crude oil future has the underlying Brent crude oil with delivery location Rotterdam.
• The LME copper futures have copper "Grade A" as underlying.
• CBOT wheat futures and KCBT wheat futures have wheat as underlying, but different deliverable grades: CBOT references to soft red winter wheat, KCBT to hard red winter wheat.
• The Goldman Sachs Commodity Index (GSCI) uses metals, agricultural products, and energy products as underlying commodities.
• The GSCI U.S. grain refers to the underlying commodities like corn, soybean, Chicago wheat, and Kansas wheat.

Underlying Commodity