Dow Jones-AIG Commodity Index

According to Raab (2007), the Dow JonesAIG Commodity Index (DJ-AIGCI) uses two-thirds of a dollar-weighted liquidity measure combined with one-third of a dollar-weighted world-production measure to determine which commodities to include in the index. Any commodity that falls below a 0.5% threshold is eliminated from consideration.

Also, the DJ-AIGCI limits weightings for each commodity sector to 33% and rebalances annually. The sector weighting limits are in contrast to the S&P GSCI, which was weighted 70% in energies, as of the spring of 2007.

Like the GSCI, the DJ-AIGCI consists of the same five commodity sectors: energy, industrial metals, agriculture, livestock, and precious metals. The DJ-AIGCI consists of 19 individual commodities while the GSCI includes 24 commodities.

The DJ-AIGCI was launched in 1998. Akey (2007) notes that the unique benefits of the DJ-AIGCI are its emphasis on liquidity for weighting and its diversification rules. As of the end of 2006, there was an estimated US$30 billion tracking the DJ-AIGCI.

Dow Jones-AIG Commodity Index
Dow Jones-AIG Commodity Index

Down Capture Ratio

The down capture ratio is a measure of a manager’s sensitivity to an index when the index has negative returns. It is calculated by dividing the manager’s annualized performance return for the intervals of time during the measurement period when the index was negative by the index’s negative returns over the same intervals.

For example, if the S&P 500 was down 100 basis points and a manager was down 35 basis points over the exact same period of time, the down capture ratio would equal 35%. A down capture ratio that is greater than 100% indicates a manager lost more than the index when the index had negative returns.

Likewise, a down capture ratio that is less than 100% indicates a manager lost less than the index when the index had negative returns. Lastly, a down capture ratio that is negative indicates a manager had positive returns when the index had negative returns.

Since the down capture ratio measures how much of the negative index returns a manager captured, the less it is the better. However, the down capture ratio (and all risk measures) should be evaluated in conjunction with other investment metrics to best assess the manager’s performance and risk profile.

Down Capture Ratio
Down Capture Ratio

Down Round

A down round is private equity or venture capital financing for a company where the valuation is lower than that in the prior round of fundraising. This is especially common in venture capital, a subset of the private equity industry that focuses on high risk, high growth opportunities.

Venture capital firms use staged capital where they provide a limited amount of capital to an entrepreneurial company, typically investing enough to help it advance to an important milestone thereby demonstrating that the overall investment risk has been reduced. If the entrepreneurial company performs as expected, as per the business plan, then the next stage (or round) of funding is typically done at a higher evaluation.

However, should the company perform below expectations or have a material adverse event—for example, if the key drug of a pharmaceutical firm performed poorly in an FDA trial—then the valuation of the company would fall, resulting in a down round.

While down rounds are usually the result of performance issues in the portfolio company, they can also be the result of a poor external fundraising environment. An example of this situation was when the Internet bubble collapsed in 2001; this created a major shortage of risk capital, thereby putting companies needing to raise money in a weak bargaining position.

Down Round
Down Round

Drag-Along Right

This contractual right, most commonly contained in the company’s shareholders’ agreement, enables the majority shareholder (usually holding more than 75% in nominal value) to “drag” the minority shareholders into a specific action, such as selling their shares to the same purchaser.

The majority shareholder must give the minority shareholders who are being dragged into the deal the same price, terms, and conditions as any other seller. The right is intended to be a protection of the majority shareholding venture capitalists.

Some purchasers may be exclusively seeking to gain complete ownership of a company, in which case the drag-along right helps the venture capitalist to realize the deal by eliminating the minority shareholders and sell 100% of the shares to the purchaser.

As a result, founding partners or entrepreneurs could lose their companies. At the same time, the right ensures that the minority shareholders get the offer under the same conditions.

The drag-along right, along with other stringent investor rights, has gained more importance after the era of poor deal structuring in 1999 to 2000 and is now a common prerequisite to concluding any new investment. Not many venture capitalists today will be willing to forgo the drag along right in their contracts.

Drag-Along Right
Drag-Along Right

Due Diligence

Due diligence is quantitative and qualitative investigation and verification into the business practice, operations, financial statements, and legal details of a prospective business client or associate.

This process is generally done prior to a business relationship being established; however, routine investigations of existing relationships can also be beneficial in uncovering pertinent information.

A due diligence investigation reduces risk associated with conducting business with other individuals or companies by ensuring their credibility and accurate portrayal.

These examinations may expose disparaging details that could ultimately hinder a business affiliation. Failure to conduct proper due diligence can lead to false representation of a party involved in a relationship, potential monetary loss, as well as litigation.

Due diligence is of great importance in the hedge fund space with the lack of transparency and regulation. A major characteristic of these private investment vehicles is that they have an aversion to divulging information on investment processes and market positions. Proper due diligence may mitigate some of these information asymmetries as well as protect an investment.

This process has numerous components and can include (but not limited to):
  • Credibility assessment of the particular company and executives
  • On-site visitation and verification of internal control systems
  • Independent research for any publicly printed information about the company and officers
  • Research and overview of third-party service providers
  • Check of past, pending, or current litigations
  • Overview of financial statements

Due Diligence
Due Diligence

Dutch Auction

In a Dutch auction, the auctioneer begins with a high asking price and gradually lowers the price until a buyer accepts the current price. Thus, in contrast with the English or ascending price auction, where multiple bids can be observed, for a Dutch auction the first bid is the only bid.

A common example of this kind of auction is the Dutch wholesale flower auctions and treasury auctions by the United States Department of Treasury for all T-bills, notes, and bonds.

Bidding behavior in a Dutch auction depends on the reserve utility of the first bidder and his/her information about the probability of other bids. Reserve utility is his/her subjective valuation of the good being auctioned.

If he/she bids as soon as the price falls to his/her reserve utility, he/she maximizes the probability of winning the item, but minimizes his/her surplus, that is, the difference between the winning bid and his/ her reserve utility.

If he/she waits longer for prices to fall further, he/she increases his/ her surplus but reduces his/her probability of winning the item. Accordingly, other bidders will behave based on their expectation about the first bidder’s behavior.

Noble Laureate economist William Vickrey has shown that under a set of assumptions both the progressive price English auction and the regressive price Dutch auction results in the same average expected price and gains for the buyers and the sellers.

The variance of the price, however, is smaller for the Dutch auction by a factor of (N − 1)/2N than the English auction where N is the number of bidders. The variance of the gain by the winning bidder is smaller by a factor of 1/N2 in case of a Dutch auction. Hence, for risk-averse buyers and sellers, Dutch auction is slightly better than the English auction because of the smaller variance of gains.

Vickrey further argues that where bidders are fairly sophisticated and homogeneous, that is, they have similar information and bidding strategies, the Dutch auction may produce results that are close to Paretooptimal case of English auction.

The term “Pareto-optimal” suggests that an alternative allocation (than the existing one) where one bidder is better off without making at least one bidder worse off is not possible for the good being auctioned.

Where the bidders have different set of information or are less sophisticated, Dutch auction may produce higher price and lower average surplus for the buyers relative to the Paretooptimal English auction and can be relatively inefficient from the bidders’ point of view. Similarly, there are other extremes where Dutch auction produces lower price and may be inefficient from seller’s perspective.

Despite the complexity of the Dutch auction process and the optimization problem faced by the bidders due to the tradeoff between maximizing the surplus or gain from winning and the probability of winning the auction item, Vickrey argued and Milgrom further elaborated that the task of a bidder in a Dutch auction is similar to that of abidder in a sealed bid auction. In a sealed bid auction, the seller sells the goods to the highest bidder at his/her own bid.

Milgrom argues that in both cases the bidder’s choice is to determine the price at which he/she is willing to obtain the good. In case of a Dutch auction, the bidder starts with the highest price he/she is willing to bid. When price drops to that level, the bidder has the option to bid or to wait.

If he/she chooses to wait, he/she updates the highest price he/ she is willing to bid at that point based on the latest information. This process is repeated and can be summarized into a single price that the bidder is willing to pay. Hence, the Dutch auction and sealed bid auction should result in the same selling price.

In laboratory experiments where stakes are low, the above prediction does not hold. In these experiments, winning bidders in a Dutch auction on average pay a lower price than the sealed bid auction.

He postulates that the design of a Dutch auction discourages the bidders from advance planning and hence results in lower price. Other alternatives suggested by him are
  1. the bidders in these experiments are not maximizing utility, and 
  2. the lower stakes in the experiments encourage bidders to wait longer before bidding.

The term “Dutch auction” used in connection with share repurchase or Initial Public Offering (IPO) share allocation has a different mechanism. Bagwell describes the Dutch auction method for share repurchase.

The buying firm in such auction specifies a range of prices at which shareholders can offer to sell their shares. Selling shareholders indicate the reserve price or the minimum selling price he/she is willing to accept and the quantity available at that price.

The buyer aggregates the supply quantity and constructs the supply curve. The lowest price at which the demand of the repurchasing firm is fulfilled is paid to all sellers who are willing to sell at this price or below.

Share repurchase with a Dutch auction pays lower premium (relative to the open market price) than a fixed price repurchase but the number of shares demanded is also lower in the former case. They also find that Dutch auctions are preferred by large firms that are transparent in terms of information.

Dutch Auction
Dutch Auction

Early Redemption Policy

The early redemption policy refers to a charge levied to an investor that redeems units of a fund before a specified date. Early redemption penalties aim to discourage short-term trading in a fund. There is generally a lockup period that may last several years until the first redemption.

The units issued by a fund that follows an early redemption policy are thus illiquid for some laps of time after being issued. After the lockup period, there is a predefined schedule of redemptions dates with their corresponding penalties.

Some hedge funds also retain the right to suspend redemptions under exceptional circumstances. By lengthening the lockup period, hedge funds obviously seek more stable financing facilities and want to protect themselves from sudden withdrawals by investors.

To illustrate this point, we examine the prospectus of managed futures notes issued by the Business Development Bank of Canada (BDC) on March 27, 2003 and which mature on February 28, 2011. There is a lock-up period lasting until June 30, 2005.

Thereafter, the redemption fees follow a step function. Redemption is allowed every year on June 30 and on December 30 and the fees decrease from 4 to 2% until December 31, 2007. Thereafter, they are nil until the expiration of the notes.

Obviously, BDC wants to discourage withdrawals from 2005 to 2007 and the imposed penalty is higher, the nearer the redemption is from the date of issuance of the notes.

Early Redemption Policy
Early Redemption Policy

Early Stage Finance

Early stage finance encompasses any financing transaction or support operation (not exclusively financial) undertaken to benefit companies in the seed and start-up phases.

At a global level, early stage financing is considered a key to innovation. However, it must also be stressed that several problems arise in implementing solutions.

Specifically, financial players are unanimous in asserting that early stage projects are usually too expensive to investigate and too risky. At the same time, entrepreneurs in general are badly trained to appreciate the teamwork and leadership as well as sales competence required.

Corporate development can be summarized in four phases:
  • Preparation—excogitating a business idea, running feasibility studies, presenting the idea to the team of “colleagues”
  • Start-up—creating the company, team building, setting up production activities, marketing, selling
  • Growth—defining the organizational structure of the company, creating various supply/sales channels, growing the team, internationalizing, penetrating new markets
  • Exit—liquidating partially or totally the work of the original promoters

Again, ideally speaking, various financial needs may be associated with these phases;
specifically, early stage financing addresses two of them:
  • Preparation—pre-seed or seed. Normally the financial needs that arise here are negligible. In fact, the promoters of the initiative are the ones who take on these expenses personally, or in some instances together with their families or friends. In recent years, an increase in specialized public funds for this kind of venture has been seen, along with the appearance of specialized financial intermediaries, often “spin-offs” of venture capitalists attracted by the chance to finance these companies/ projects during later phases.
  • Start-up—development financing. Here more substantial capital is required which is invested directly in the company’s operations. In this phase, in addition to financial requirements, the need for competencies and skills must also be satisfied which help the entrepreneurial initiative along its development path.

Early Stage Finance
Early Stage Finance

    Economically Deliverable Supply

    The economically deliverable supply is that fraction of the deliverable supply of a commodity that is in position for delivery against a future contract, and is not otherwise unavailable for delivery.

    For example, oil that is held by a country for resources for crises is not considered part of the economically deliverable supply of oil futures contract. Another example is grain of a farmer.

    Assume that a portion of the grain is held by the farmer for his own cattle. This portion is not economically deliverable because it is captive and so unavailable for delivery as a part of a futures contract.

    The deliverable supply consists of the captive portion and of the portion that is part of the futures contract. Therefore, the economically deliverable supply is always equal or less than the deliverable supply.

    The economically deliverable supply can explain in comparison with the deliverable supply futures price reactions. When it is significantly less than the amount needed to fulfill the short position of a contract, the futures price may increase.

    That is the reason why futures contracts are closed nearby the delivery month. For example, the holder of a long position can close his position with a countertrade and realize profits because of the risen price.

    Economically Deliverable Supply
    Economically Deliverable Supply

    EDHEC Alternative Indexes

    Alternative investment strategies are often referred to as “absolute return” strategies. One could consequently argue that developing hedge fund indexes does not make sense.

    However, recent research has highlighted that the exposure of hedge funds to multiple risk sources (volatility, default, etc.) and the dynamic character of their management make monoand multilinear factor models inadequate for evaluating their performance.

    A pragmatic alternative to developing factor models involves comparing the return of a given fund to that of a portfolio of funds following the same strategy (peer benchmarking), or to that of a representative index (index benchmarking).

    The difficulties related to the development of indexes, which are already evident in the traditional universe, are exacerbated in the alternative investment world. Finding a benchmark that is representative of a particular management universe is not a trivial problem.

    In response to the needs of investors, the EDHEC Risk and Asset Management Research Center has proposed an original solution by constructing an “index of indexes,” the EDHEC Alternative Indexes.

    The aim of the methodology used to construct this index of indexes (see Amenc and Martellini, 2002) was to construct a benchmark which is more representative and stable than the indexes provided by Altvest, CSFB/Tremont, EACM, Hennessee, HF Net, HFR, MAR, Van Hedge, Zurich, etc. (the competing indexes). As a noncommercial initiative and in order to facilitate access. EDHEC has received support from Alteram for the promotion of its alternative indexes.

    EDHEC Alternative Indexes
    EDHEC Alternative Indexes

    EDHEC CTA Global Index

    EDHEC produces the EDHEC CTA Global Index by combining five of the most significant CTA indexes in the CTA universe:
    1. CISDM CTA, 
    2. CSFB-Tremont CTA, 
    3. S&P Managed Futures Index, 
    4. Barclay CTA, and 
    5. Hedgefund.Net’s Tuna CTA index.

    This universal index is considered by many as a comprehensive and complete collection of CTA indexes. The main idea and unique feature behind this index is its weighting method.

    By using principal component analysis, Amenc and Martellini (2002) obtain weights selected for each of the above CTA indexes and make sure that no other linear combination of other CTA indexes leads to a lower information loss, while minimizing the extent to which each index’s bias affects the EDHEC CTA Global Index.

    EDHEC CTA Global Index
    EDHEC CTA Global Index

    Eligible Contract Participant

    The Commodity Exchange Act takes almost two pages to define eligible contract participant (ECP). There are many entities that qualify to be called an ECP. The basic idea is that they are in some way more sophisticated than the rest of us, need less protection, and thus can trade on less-regulated markets such as Derivatives Transaction Execution Facilities and Exempt Boards of Trade.

    There are actually not many of these less-regulated markets. At the moment there are none of the first and six of the second. Entities typically qualify as ECPs based on the nature of their business and/or the amount of assets that they own or control, but ultimately a specific entity is an ECP only if that type of entity is on the list.

    ECPs currently include financial institutions, insurance companies, investment companies, commodity pools with assets exceeding $5 million and operated by a regulated person, other entities with total assets exceeding $10 million or with assets exceeding $1 million and trading only for risk management purposes, employee benefit plans, government entities, supranationals (such as the World Bank), SEC-regulated brokers and dealers, associated persons of such brokers and dealers, futures commission merchants, floor brokers and floor traders, individuals with assets in excess of $10 million, and anybody else the CFTC may throw into the definition.

    For example, floor brokers and traders who are guaranteed by a clearing member of their exchange were added to the list in about 2003 based on a petition from one of the markets.

    Note that there is also an eligible commercial entity (ECE), whose name is unfortunately close to and confused with ECPs. The difference is that the ECE category is a subset of ECPs having a commercial connection and the ability to make or take delivery of the underlying commodity.

    Eligible Contract Participant
    Eligible Contract Participant

    Enumerated Agricultural Commodities

    The commodities specifically listed in the Commodity Exchange Act are wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice.

    Designated contract markets (DCMs) must submit to the CFTC and receive CFTC approval prior to implementation of all new rules and rule amendments that materially change the terms and conditions of contracts on commodities enumerated in Section 1a(4) of the Commodity Exchange Act (CEA). This will also apply to contracts with open interest (CFTC).

    In 1936, the U.S. Congress prohibited options trading in all commodities regulated under the Commodity Exchange Act. The prohibition was a response to a history of manipulation and price disruption in the futures markets attributed to options trading. The prohibition applied to all the “enumerated” agricultural commodities named in the 1936 Act. In subsequent years the list of enumerated commodities grew.

    Enumerated Agricultural Commodities
    Enumerated Agricultural Commodities

    Equal Weighted Strategies Index (HFRX)

    An equal-weighted strategies index is composed of hedge funds characterized by different investment strategies. Each strategy group is given the same weight in the index portfolio. The covered investment strategies may be the same as in a global hedge fund index. This is for example the case with the HFRX Equal Weighted Strategies Index.

    An equal-weighted strategies index can be regarded as a special case of a global hedge fund index with static index weights. These static weights may eventually cause some shortcomings.

    In contrast to global hedge fund indices where the different strategies may be asset weighted according to the market capitalization of assets in the hedge fund industry, the weightings of the strategies in an equal-weighted strategies index are not in accordance with the true representation of the different strategies in the hedge fund universe.

    The static weightings of the individual strategies in the index may also lead to the problem that it becomes difficult to react to changing market conditions.

    A global hedge fund index offers more dynamic possibilities to react to changes in the hedge fund market/peer group and to changes in the importance of different strategies represented in the hedge fund universe. The static weightings of an equal-weighted strategies index prohibit this adaptability and flexibility.

    Besides its problems, an equal-weighted strategies index can also have positive side effects. In the case of an equal-weighted strategies index, there are no large strategy classes that dominate the index and that could cause a bias toward these strategies.

    For example, the HFRX Equal Weighted Strategies Index is meant to be characterized by a more balanced diversification and a historically lower volatility. This results in an enhanced attractiveness of such indices for investors.

    Another advantage concerns the heterogeneity of hedge funds. One important problem in the hedge fund industry is that, due to the large influence of the individual portfolio manager’s skills on hedge fund performance and due to manager specific investment strategies, even in the same strategy grouping, the hedge fund characteristics may be very different.

    In this case, an asset weighting of the different strategies may be disadvantageous and may lead to new distortions. In such a case an equally weighted strategies scheme could be preferable.

    Equal Weighted Strategies Index (HFRX)
    Equal Weighted Strategies Index (HFRX)

    Equally Weighted Index (HFRX)

    As the name implies, equally weighted indices are indices where all components receive the same weight during each measurement period. Equally weighted indices have been one of the first attempts to address some of the perceived flaws of asset-weighted indices.

    Equally weighted indices are widely used in the world of hedge funds because their calculation is remarkably straightforward and requires limited datasets. One just has to sum the performance of the N hedge fund managers that constitute the index and divide the result by N to obtain the index performance.

    There is no need to track the assets of each individual hedge fund month after month (as required in an asset-weighted index) and no need for using more complex averages. This explains why the majority of hedge fund indices are equally weighted.

    Equally weighted indices provide a clear indication of the average percentage performance of their constituent funds. However, their apparent simplicity also comes with several shortcomings:
    • Emphasis on smaller funds. Equally weighted indices consider the performance of small and large hedge funds the same way—each of them receives an identical weight in the index. By contrast, in an asset-weighted index, larger hedge funds would receive a larger weight. Supporters of equally weighted indices often argue that this is an advantage because the resulting index is less concentrated and avoids being driven by the largest funds. However, reality is often that investors feel more comfortable and are willing to invest in larger established funds.
    • Constant rebalancing. The returns of an equally weighted hedge fund index are not representative of the returns of a buy and hold strategy. Indeed, as soon as the value of one index component changes, the index is no longer equally weighted and requires some rebalancing. Theoretically, one would need to constantly rebalance the index to maintain an equal-weighted approach. While this is easy to do in theory, it is often harder to implement in practice as the underlying hedge funds may not authorize in and out movements on a monthly basis. Thus, the challenge facing any index provider is determining the adequate rebalance frequency.
    • Contrarian strategy. Rebalancing an equally weighted index is often counterintuitive in terms of investment strategy because one needs to sell winners (funds that performed well) to buy back losers (funds that underperformed). In practice, investors tend to allocate more to funds with a better performance.
    Equally Weighted Index (HFRX)
    Equally Weighted Index (HFRX)

    Equity Hedge

    The equity hedge strategy is considered as the most important one followed by hedge fund managers. According to statistics published in 2003 by the Hedge Fund Research (HFR), the market share of equity hedge funds is approximately 29% of the total universe.

    Following the HFR definition, equity hedge investing consists of holding long equities hedged at all times with stocks and/ or stocks index options. The equity hedge strategy is commonly called a “long–short” strategy, being the oldest strategy of the hedge fund industry. Despite this definition, these funds may have a market exposure.

    For instance, over the period 1997–2005, hedge funds from the HFR database following an equity hedge strategy had a CAPM beta, computed using the S&P500 as benchmark, equal to 0.52. This demonstrates that equity hedge funds have only a portion of their assets that is hedged.

    Some equity hedge funds also use leverage to magnify market exposure. According to Lhabitant (2006), the sources of profit of long–short funds deviate from the traditional investing that is based on capital gains.

    There are four sources of gains for an equity hedge fund: the spread between the long and the short position; the interest rebate on the proceeds of the short sale that are used as collateral; the interest paid on the margin deposit to the broker; the spread in dividends between the long and the short position.

    The spread between the long and the short position is often obtained by buying undervalued securities and selling overvalued securities. These are stock-picking activities and are related to a selectivity strategy that may be based on the securities’ relative Jensen alphas. Furthermore, equity hedge funds can invest in securities other than equities.

    Equity Hedge
    Equity Hedge

    Event Driven

    "Make money on events." Event-driven strategies invest during special events in the life cycle of a corporation. Such special events can be bankruptcies, reorganizations, mergers and acquisitions, spin-offs, and share buybacks.

    During these events, stock prices are mainly driven by the event and not by the market. An event-driven manager evaluates the probability of the event and the outcome of the event. Thus, he needs knowledge of how the security will behave depending on the outcome of the event.

    In addition, fast and reliable access to information is required. Therefore, most eventdriven managers are specialized in certain industries. The most popular event-driven strategies are distressed securities investing and risk arbitrage. The latter usually includes merger arbitrage and special situations.

    The distressed securities strategy identifies firms in financial or operational distress, usually linked with extreme price losses. Specialized in pricing securities in such extreme events, managers buy adequate stocks or bonds. Some managers practice an active strategy and take a hand in reorganizations while others follow a passive buy and hold strategy.

    Merger arbitrage is usually based on the empirical observation that stocks of the target rise after an announcement because of a premium included in the bid price. While some invest on the basis of rumors before the bid, others bet after the bid on the outcome.

    Special situations include rearrangements of stock indices, spin-offs, and share buybacks, for example, when a stock enters a big index, empirically there is a high probability of a price increase. The same is true when a share buyback is announced. At spin-offs, situations of negative stub values are of special interest.

    Event Driven
    Event Driven

    Evergreen Fund

    An evergreen fund is a pool of capital that certain private equity and venture capital firms maintain and replenish with the proceeds from successful investments. Investors are paid through distributions when the pool becomes large enough; should they seek liquidity before that, their share of the capital pool can be sold to another investor through a private transaction.

    This approach to managing a firm contrasts with that used by most private equity and venture capital firms in the United States in which a series of funds, limited in both time and money, are raised.

    These firms typically raise a new fund every 3–5 years, and commit to liquidate the fund as well as return all capital and any profits within 10 years, which fits the needs of institutional investors who seek periodic liquidity. While evergreen funds are uncommon in large American firms, there are notable exceptions such as Sutter Hill Ventures.

    Proponents of evergreen funds point to a major advantage: having only one capital pool means less time is spent fundraising and managing investors, allowing more focus to be put on finding and mentoring successful ventures.

    Evergreen funds are also commonly used by corporate venture capital firms that work with a capital pool provided by their parent corporation, and by government agencies that set up or sponsor venture capital funds to encourage regional development.

    Evergreen Fund
    Evergreen Fund

    Excluded Commodities

    The Commodity Exchange Act (CEA) defines excluded commodities as instruments that are not manipulable or influenceable by any party and thus are excluded from CEA regulation. They include any financial instrument such as an interest or exchange rate, currency, security, credit risk or measure.

    Apart from that, excluded commodities also include any other rate that is only based on commodities without cash markets. Also part of the definition of excluded commodities is an occurrence or contingency with a relevant consequence, but without the control of any party involved in the contract.

    Usually, the CEA regulates the trading of commodities to protect investors against fraud and to deter market manipulation. In 1999, The U.S. President’s Working Group on Financial Markets (PWG) concluded that commodity trading should be subject to CEA regulation only if it is necessary to ensure the achievement of public policy objectives.

    Accordingly, amendments regarding a more flexible structure for the regulation of futures and option trading have been established in the course of the Commodity Futures Modernization Act 2000.

    Since excluded commodities are usually large in scale, they are not considered to be susceptible to manipulation or influence of any interested party. Apart from that, professional counterparties are able to protect themselves against fraud.

    Thus, excluded commodities were excluded from regulation under some further conditions: eligible contract participants have to enter into the contract, the transaction has to be accomplished on an electronic trading facility, and trading must be on a principal-to-principal basis. As a result of these amendments, a broad range of over-the-counter derivative transactions are excluded from CEA regulation.

    Excluded Commodities
    Excluded Commodities

    Exercise Option

    The holder of an option contract may decide to exercise the option at the exercise or strike price if the contract is in the money. Exercising indicates that transaction of the asset takes place at the predetermined exercise price and the contract is terminated.

    For a European type option, holder of the contract can decide to exercise the option only at the maturity. However, for an American type option, holder of the contract has the flexibility to exercise the option before the expiration date.

    For a call option, which gives the owner the right, but not the obligation, to buy an asset at the exercise price, the contract will be in the money when exercise price is below the spot price, and owner of the contract will decide to exercise the option to take delivery of the asset. For a put option, on the other hand, owner of the contract will decide to exercise his/her rights if exercise price is above the spot price.

    Exercise Option
    Exercise Option

    Exit Strategy

    Disinvesting and liquidating an equity position is the last phase in the process of investing in a company by a venture capitalist. In fact, typically venture capitalists make temporary investments that are linked to the performance of the companies in which they invest.

    The study of the exit phase is important because it represents the critical transition that enables the venture capitalist to realize a profit, or give monetary value to the commitment and activity undertaken to the benefit of the counterparty.

    Beyond the principles that regulate the divestment process, or relational problems that one may encounter in defining the objectives of each party who participates in the transaction in various ways, in practical terms the main exit strategies available to a private equity player are the following:
    • To sell shares on a regulated market, either in the context of a placement through an initial public offering (IPO) or a placement after the listing (Post-IPO Sale)
    • To sell shares to a partner in the industry (trade sale)
    • To sell shares to another private equity player (replacement and secondary buy out)
    • To repurchase shares, which can be done by the company and/or group of majority or minority shareholders (buy back)
    • To reduce, totally or partially, the value of the shares without selling to third parties (write-off)
    Exit Strategy
    Exit Strategy

    Expiration Date

    The expiration date is the date when an option contract expires or may be exercised. This is also the last date when the futures contract trades. Expiration dates for exchangetraded contracts are not uniform, but are set by each individual exchange. The expiration date for stock options in the United States is usually the third Saturday after the third Friday of the expiration month.

    Trading in the option stops on the third Friday, but the option owner has the ability to exercise the option on the third Saturday, the day after expiration. Many contracts have a quarterly expiration cycle; this convention is done in order to generate increased volume and associated liquidity in the contract.

    For options on futures contracts, the expiration date may be different because the expiration does not necessarily coincide with the delivery month identified in the option contract. In certain instances, the expiration date for a future option may occur previous to the delivery month of a futures contract by a few weeks.

    Several times per year equity options, equity index options, and equity index futures expire on the same date. These Fridays have become known as triple-witching days; the period before this expiration is typically marked by heavy trading in the contracts.

    Expiration Date
    Expiration Date

    Extrinsic Value

    Extrinsic value is an expression used regularly to refer to options. It can be defined as the difference between the price of an option and its intrinsic value. In this sense, the intrinsic value corresponds to the difference between the strike price of the option and the market price of the underlying asset, the meaning depending on whether it refers to a Call or a Put.

    The extrinsic value is also known as the time value, and can be defined as the amount of money that the purchaser of an option is prepared to pay in the hope that, over the lifetime of this financial asset, a change in the price of the underlying asset leads to an increase in the value of the option.

    In this way, the option premium can be considered as the sum of the time value or extrinsic value and its intrinsic value. To the extent to which it reflects the excess of the premium over the intrinsic value, the extrinsic value of the option decreases as the moment of expiry of the title approaches.

    This is because the extrinsic value of the option reflects the likelihood of the option moving into the money, due to which it will be greater the longer the time that remains before it expires.

    Extrinsic Value
    Extrinsic Value

    Factor Models

    In general, factor models are used to predict random variables Y, with the help of explanatory variables, X. The basic idea behind these models is the relation between the dependent and the independent variables. The independent variables constitute the factors that determine the dependent variables.

    The explanatory variables must be carefully selected, as they are to be the factors that influence the dependent variables. A linear factor model can be formulized as follows:
    Ri = βi + βi1F1 + βi2F2 + ... + βikFk
    where Ri is the return of fund i, and F1, F2, ..., Fk are the k factors that are claimed to influence the fund’s return. We assume that there are n funds, i = 1, 2, ..., n.

    The beta coefficients βi1, βi2, ..., βik reflect the sensitivities of the fund to specified factors. These coefficients designate the change in the return on the fund per unit of change in the specified factor. The error term εi capture all randomness in the relationship.

    A popular factor model known as the CAPM has only one factor, k = 1. Models with a unique factor are called single-factor models, whereas models with more than one factor are called multifactor models.

    For hedge funds and managed futures, certain multifactor models are available in explaining managed futures and hedge fund returns. The factors used are justified on the distinctiveness of hedge fund manager trading styles.

    The single-factor model assumes that the factors are linearly related to fund returns, but nonlinearity of factor models is also possible. The linear multifactor model given above does not have the time dimension and is therefore static, but dynamic factor analysis is possible when the time dimension with subscript t is introduced.

    The following technical assumptions must be satisfied to make use of estimation by the Ordinary Least Squares (OLS) method and statistical inference in factor models:
    • The expected value of the error term must be zero, E(εi) = 0, i = 1, 2, ..., n.
    • Factors and error terms should be uncorrelated, Cov(Fj, εi) = 0, j = 1, 2, ..., k.
    • Error terms should not be autocorrelated, Cov(εi, εj) = 0, i ≠ j.
    • All error terms must have the same variance, E(<ε2) = σ2.

    Some additional assumptions of time series analysis such as stationarity of each series must be imposed for dynamic factor analysis.

    Factor models are introduced in the literature to facilitate the interpretation of a voluminous data set to reveal factors determining fund returns. Multifactor models can be categorized into broad classes of macroeconomic (macroeconomic indicators like interest rate series are used as factors), fundamental (factors concerning securities or firms, like firm size or dividend yield are used), and statistical models. Factor models are helpful in making decisions on asset valuation and are extensively referred in portfolio theory.

    The researcher must determine the appropriate factors in the analysis to produce a meaningful relationship. The coefficient of determination, R2, can be used as a benchmark criteria to assess the goodness of fit. There are several serious attempts in literature to work out the main factors that explain the hedge fund returns.

    Agarwal and Naik use the factor model approach to figure out that hedge fund returns are attributable to risk factors consisting of indices representing equities (Russell 3000 Index, lagged Russell 3000 Index, MSCI World Excluding the USA Index, and MSCI Emerging Markets Index), bonds (Salomon Brothers Government and Corporate Bond Index, Salomon Brothers World Government Bond Index, and Lehman High Yield Index), Federal Reserve Bank competitiveness-weighted dollar index, and the Goldman Sachs commodity index as well as the three zero-investment strategies representing Fama-French’s “size” factor (small-minus-big or SMB), “book-to-market” factor (high-minus-low or HML), Carhart’s “momentum” factor (winners minus losers), and the change in the default-spread (the difference between the yield on the BAA-rated corporate bonds and the 10-year Treasury bonds) to capture credit risk.

    In a similar study, Fung and Hsieh explain the HFR fund of funds index with two equity risk factors (S&P 500, SC-LC), “... two interest rate risk factors (the change in the yield of the 10 year treasury, and the change in the credit spread), and three trend-following factors (the portfolio returns of options on currencies, commodities, and long-term bonds).”

    In a similar attempt, Schneeweis and Spurgin explain the hedge fund performance index with the independent variables of nominal and absolute values of the SP500, GSCI, SBBI, and USDX, the intramonth standard deviation of the SP500, GSCI, bond, and USDX, and the nominal value of the MLM index. Meredith and Figueiredo present a more detailed study of factor models to explain the returns for every strategy.

    The factors they use are small cap stock minus large cap stocks, value stocks minus growth stocks, winners minus losers, GSCI, Russell 3000 (with up to four lags), Citigroup high yield composite, MSCI emerging markets, Fed dollar weighted index, MLCBI, reserve moving average, and traded implied volatility (change in VIX).

    Factor Models
    Factor Models

    Fallen Angel

    Fallen angel stands as an expression defining a stock (or an investment grade bond), the price (the quality) of which has substantially fallen since its original issue (88 or lower for an investment grade bond).

    Thus, fallen angels are considered as a type of junk bonds. The main difference lies in the fact that junk bonds are generally issued with ratings of 88 or lower. Many studies are devoted to the analysis of the announcement of a downgrade from investment-grade to high yield, creating a so-called fallen angel. This event seems to have the strongest impact on market reaction when investment grade status exhibits risks (especially credit risk).

    To a certain extent, stocks defined as fallen angels behave like growth stocks, and, thus, should be considered by GARP (Growth At a Reasonable Price) investors. Empirical studies show that they tend indeed to generate positive average returns when they experience good news.

    Fallen Angel
    Fallen Angel

    Fast Market

    Fast market conditions are categorized by heavy trading, highly volatile prices, and a great uncertainty about the equilibrium price. These conditions are often the result of an imbalance of orders and bid-ask spreads may be wider than normal, potentially much wider.

    Whenever price fluctuations in the pit are rapid and the volume of business is large, the pit reporter, upon authorization of the pit committee chairman or his designated representative from the pit committee, activates the “fast market” indicator clearly visible to the entire trading floor.

    The fast market labeling indicates that brokerage customers cannot expect their orders will be executed at the best published prices when the market is trading fast.

    In the middle of a fast market, brokers may be unaware of the best execution price for their clients. However, a fast market designation does not nullify or reduce the floor broker’s obligation for executive care to execute orders according to the terms of the order.

    Open outcry markets handle fast markets surprisingly well because a trader can change his previous bid or offer, simply by a hand signal and a verbal announcement. However, the danger of fast markets in open outcry is the increased risk of an out-trade.

    In contrast to this, the response time (elapsed time between the submission of a trading request and the system confirming or rejecting the action) of electronic matching systems, which normally do not generate any out-trades, decreases in fast markets as message traffic increases because of the rapid and numerous alternations of the bids and offers.

    Fast Market
    Fast Market

    Feed Ratio

    Feed ratio is the relationship between feeding costs and the dollar value of livestock. It is used in futures market to measure the profitability of feeding and selling animals as commodities. Feed ratio is measured by dividing the price of the animals used as commodity by the price of the grain required to feed them.

    Various feed ratios have been used extensively as a proxy for profitability since the first half of twentieth century. Moreover, since producers respond to expected profitability, feed ratio has been used as a predictor for future production levels in the relevant market.

    First hog/corn ratio charts, one of the most frequently used feed ratio type and equal to the number of bushels of corn equal in value to 100 lb of live hogs, were devised by Henry A. Wallace in 1915.

    Lower values of hog/corn ratio, high corn prices relative to pork prices, would indicate lower profitability of feeding and selling hogs. Naturally, lower profitability cause a decline in pork supply in near future. Similarly, higher values of hog/corn ratio reveal higher profitability and a rise in pork supply in the future.

    Other frequently used feed ratios are as follows: steer/corn ratio, number of bushels of corn equal in value to 100 lb of live cattle; milk/feed ratio, the number of pounds of 16% protein mixed dairy feed equal in value to 1 lb of whole milk; broiler/feed ratio, the number of pounds of broiler feed equal in value to 1 lb of broiler; egg/feed ratio, the number of pounds of laying feed equal in value to one dozen eggs; and turkey/feed ratio, the number of pounds of turkey grower feed equal in value to 1 lb of turkey.

    Feed ratios have been used to measure profifitability of feeding and selling animals for a very long time. The reason they work is that feeding cost usually represents more than half of the total production cost.

    If nonfeeding costs are relatively stable, livestock producers respond to higher than average feed ratios by increasing supply and respond to lower than average feed ratios by decreasing supply. However, even if we assume nonfeeding costs are stable, which might not be true, there is another major limitation of the feed ratio as a proxy of profitability.

    Profitability does not depend only on the feed ratio but also on the price of corn (or other feedstuff). Generally a higher feed ratio is required to represent a profitable situation when corn prices are low than when they are high.

    For example, while the level of 20 for hog/corn ratio represents a profitable hog business when the price of corn is $3, the minimum of 25 for hog/corn ratio might be needed for profitability when the price of corn is $2. Thus, although various feed ratios are time-honored measures of livestock production profitability, greater variability in the prices of feedstuff decreases their accuracy.

    Feed Ratio
    Feed Ratio

    Filing Range

    Filing range is a range of prices in which a minimum and a maximum offer price are given. The pricing of an IPO begins at the time the IPO is filed. To go public, a company must register with the Securities and Exchange Commission (SEC) and file a preliminary prospectus containing basic information on the company and a summary of the offering.

    The issuer and its underwriter agree on a filing range and this price range is listed in the preliminary prospectus. Underwriters incorporate available information about the company at the time they set the filing range.

    The filing range reflects the information derived from due diligence and through the underwriter’s long-term relationship with the issuer. Underpricing depends upon the location of the offer price, relative to the filing range contained in the registration statement.

    When the underwriters are faced with high demand among investors, the offer price is adjusted to a point at or above the maximum price of the filing range. The IPOs priced above the filing range are expected to be more underpriced.

    When the underwriters are faced with low demand among investors, the offer price is adjusted to a point at or below the minimum price of the filing range. The IPOs priced below the filing range are expected to be less underpriced or even overpriced. The midpoint of the filing range is used to estimate the expected offer price.

    Filing Range
    Filing Range

    Final Prospectus

    The final prospectus is the revised version of the preliminary prospectus (also called a red herring in the United States or a pathfinder prospectus in the United Kingdom), which a company that wants to sell its securities for the first time to public investors files with the appropriate regulatory authority such as the Securities and Exchange Commission (SEC) in the United States or the Financial Service Authority in the United Kingdom.

    The final prospectus is prepared after the regulatory authorities have verified that the information contained in the preliminary prospectus is adequate and complies with the relevant securities laws and stock exchange regulations.

    Generally, the regulatory authority may ask for additional information or further explanation to be provided in the final prospectus than what appeared in the preliminary prospectus. The regulatory authorities do not, however, guarantee either the accuracy or completeness of the final prospectus.

    The contents of the final prospectus may also reflect any clarifications deemed necessary as a result of the presentations, known as road shows, to investors. The final prospectus is the legal basis on which the securities in an initial public offering are sold.

    Aggrieved persons in a new issue of securities can take legal action against the issuing company and its advisers for misrepresentations and false statements that appear in the final prospectus. The final prospectus, unlike the preliminary prospectus, must contain the final pricing information.

    Final Prospectus
    Final Prospectus

    Financing Round

    Sometimes, new business ventures can be created with minimal cash contributions from savings, bank loans, and personal credit lines. More frequently, new ventures require substantial cash investment. Companies may require several rounds of financing at different stages of development to provide cash to get to the next stage of growth.

    The first stage of financing (outside investments made by the entrepreneur) is called angel financing. Angel financing may occur very early in the life of a company. In fact, such financing (or at least commitments to provide financing) may occur before a business plan is formally developed and perhaps before a company is legally created.

    These investors are called angels because they invest despite the high risk of failure at this nascent stage and often demand less favorable terms than would be expected by the investment risks present with the new company.

    Frequently, an angel is a relative or a friend of the entrepreneur. In any case, the investor relies heavily on the confidence in the entrepreneur in some cases more than the business prospects of the company.

    The second frequently identified stage of venture capital finance is called seed capital. This is the earliest stage that venture capital funds will invest. By now, part of the management team should be in place.

    The business plan is not complete but key decisions have been made. A prototype product may be complete or may require seed capital to finish the product development. Seed capital is used to test the prototype with customers and perhaps begin to market the product.

    The next venture capital state is the early stage investing. This investment is still early in the course of creating the new business and may provide funds to refine the prototype. The company prices and sells this beta prototype but revenues do not cover all costs.

    Production moves from the garage to the newly acquired manufacturing space. Most investors avoid making early stage investments because investments made this early frequently fail to develop and losses of some or all of invested funds occur frequently. As a result, early stage investors extract favorable terms.

    Entrepreneurs often have trouble ceding as much ownership as early stage investors demand, but experienced entrepreneurs realize that the early stage investors bear much of the risk of failure and must be motivated by a share of the upside potential to accept the risk.

    The fourth stage of venture capital investment is called late stage financing. This stage generally requires more funds than either angels or earlier stage investors, but the risks of failure are considerably lower.

    By the time of the late stage financing round, the company should have substantial revenues and may have reached breakeven point. Rapid growth creates a need for cash that cannot be generated fast enough internally. Many venture capital funds invest in late stage venture funding.

    The fifth stage of venture capital financing is called mezzanine financing. By now, the company may be producing and possibly distributing the second production version of the product. The company may be creating its own manufacturing facilities for the first time. The company may be seeking to expand internationally.

    Mezzanine financing is sometimes called bridge financing as the company grooms itself for sale. Mezzanine financing is frequently in the form of debt or preferred stock, although lenders often get options to buy stock or convert their interest into common stock.

    The next stage of venture capital financing is often an initial public offering of equity. U.S. securities laws require a formal registration process (including substantial financial and risk disclosures).

    Not every new company issues publicly traded common stock. Instead, the entrepreneur may sell the operation to a larger competitor or a company in a related industry without registering securities and making a public offering.

    A strategic acquisition by another company may be the best way to maximize the potential created with the new company. This exit strategy may leave the entrepreneur with a smaller role to play in the combined company, which may or may not appeal to the management team.

    These stages exist for the benefit of both the entrepreneur and the investor. Early stage investors extract more favorable terms from entrepreneurs, so are often seen as expensive sources of financing (at least by the entrepreneur,who is convinced that the business will defy the odds of success).

    The stages also force some control or accountability on the entrepreneur because the company may be prohibited from additional financing until certain business milestones are achieved.

    Likewise, investing in stages also benefits the investors who have observed the past success ratio at different stages and have decided to limit their risk somewhat by investing in late stage companies.

    Financing Round
    Financing Round

    Firm Commitment

    The underwriter agrees to purchase the entire securities issue from the issuer. He/ she will then resell them to institutional and individual investors. Hence, the underwriter will assume the market risk associated with the purchase of the entire issue.

    Any unsold securities will be held by the underwriter. This agreement is different from the best efforts deals, where the underwriter does not buy any of the IPO issue and does not guarantee that all the new securities will be sold.

    Welch notes, “In best-efforts offerings, minimum sales constraints permit issuers to precommit to withdraw the offering if a fixed minimum number of shares is not sold. In firm-commitment offerings, the over allotment option allows the underwriter to increase sales when demand is strong.”

    Bower (1989) shows that the choice between firm commitment and best efforts affects both a firm’s cost of obtaining capital and investors’ perceptions about firm value.

    Firm Commitment
    Firm Commitment

    First Notice Day

    The first day notice is an announcement on the first day of the applicable period that a seller intends to deliver a commodity under a futures contract. Some exchanges require the first day notice to be given one day prior to the expected delivery date.

    There are various reasons for investing in a futures contract. Depending on the investment goal, the first day notice can be either something that completes the transaction, or is a problematic event in an investment gone awry.

    Typically, the seller of a commodity uses a futures market to lock in a future price for delivery of their commodity. This helps in planning and reduces risk and uncertainty.

    Likewise, buyers of the commodity can use futures market to reduce the uncertainty of a future commodity price. However, investors can also invest in futures contracts for speculative reasons alone, with no intention, and indeed no capacity, to take delivery.

    In doing so, they provide for greater market liquidity and depth, and also use all available market, climate, supply, and demand information in determining the value of contracts to deliver commodities on a given date. Consideration of all available information contributes to market efficiency and hence assists commodity buyers and sellers alike in reducing uncertainty.

    As a contract future date nears, the spot price and the future price of the contract narrows. A speculating investor who still holds the right to purchase the commodity on a given date typically will attempt to sell this contract before the date arrives.

    First Notice Day
    First Notice Day

    First Time Fund

    A first time fund is the first fund that a private equity firm ever raises since its foundation. Usually, the firm is a spin-off, where managers of established funds—either of different firms or of the same firm—create their own new firm.

    Sometimes the firm is made up of managers who have never raised a fund before. In this case, the managers do not have a track record; therefore, raising the first time fund requires more efforts for them than for more established fund managers.

    Even for managers with a proven track record from their previous firms, raising the first time fund may be more difficult than follow-up funds, as in most cases they have never worked together as a team before.

    Thus, investments in first time funds are ranked as more risky. Furthermore, the importance of reputation in raising capital might induce young fund managers to take actions that are not in line with the limited partner’s interests.

    Young venture capital firms might, for example, have incentives to take companies public earlier and more underpriced than more established firms, to establish a track record and signal quality to potential investors. This behavior is known as “grandstanding”.

    First Time Fund
    First Time Fund

    First Stage Financing

    First stage financing or otherwise known as seed financing occurs when the venture has launched and attained initial momentum, thereby increasing company sales. At this stage the company is in its infancy stage and it commences its manufacturing and selling process by launching its product in the market. The venture capitalists appear at this stage by showing interest in the company.

    By this time, the management team and the officers are in place along with the line employees and other marketing/ sales staff. The funding from this stage is used to boost sales in an attempt to reach the company’s breakeven point, and create an elaborate system of distribution. During this stage, attempts are made by the firm to reduce its variable costs, increase production, and reduce its breakeven point.

    First Stage Financing
    First Stage Financing

    Five Against Note Spread (FAN Spread)

    A five against note spread (FAN spread) is a futures operation, specifically, on 5-year Treasury Notes (T-Notes) and 10-year Treasury Bonds (T-Bonds). It consists of a spread operation that involves taking offsetting positions, that is, the simultaneous buying of one future contract against the sale of another future contract, either in the same or in a related market, with the aim of profiting from the price difference (Schwager, 2001).

    This precise operation consists in buying/selling a future contract on a 5-year T-Note and at the same time selling/buying a futures contract on a 10-year T-Bond. In this way, the investors can take advantage of the fluctuations of the interest rate and at same time try to reduce the risk of the futures market, which is typically high.

    The futures market is risky because it is characterized by the use of leverage allowing investors to have large margins. However, this leverage can be very dangerous if the signals for the market movements are misunderstood.

    One of the most common ways to take advantage of this leverage and reduce the risk is to use spreads (take two offsetting positions in the market). It should, however, be remembered that this type of operation does not always eliminate risk, and can concurrently limit the gain in the same way that it reduces the risk.

    Five Against Note Spread (FAN Spread)
    Five Against Note Spread (FAN Spread)

    Fixed Income Arbitrage

    Fixed income arbitrage is a certain type of a hedge fund strategy. In general, three different kinds of hedge fund strategies are distinguished: market neutral strategies, event driven strategies, and opportunistic strategies.

    Fixed income arbitrage belongs to the group of market neutral strategies, as is the case with convertible arbitrage strategies and equity market neutral strategies.

    Market neutral strategies aim at exploiting pricing inefficiencies in capital markets without incurring systematic, that is, nondiversifiable, risk. Nevertheless, gains are not riskless as suggested by the term “arbitrage,” but investors hope to be more than adequately compensated for the risk taken.

    Fixed income arbitrage strategies are designed to exploit relative mispricing in fixed income financing instruments as implied by inconsistencies of the term structure of interest rates, observed credit spreads, and/or liquidity spreads.

    Five of the most widely used fixed income strategies are swap spread arbitrage, yield curve arbitrage, mortgage arbitrage, volatility arbitrage, and capital structure arbitrage.

    Swap spread arbitrage combines entering a par swap with a fixed coupon rate against paying the floating LIBOR rate while at the same time shorting a par Treasury bond with the same maturity as the swap and investing the proceeds at the repo rate. Yield curve arbitrage is characterized by taking long and short positions for different maturities along the term structure.

    A mortgage backed security arbitrage emerges by buying mortgage backed securities pass-throughs, that is, mortgage backed securities that pass all (remaining) cash flows of a pool of mortgages through to the investors, and hedging their interest exposure with swaps.

    Fixed income volatility arbitrage attempts to make use of the difference between the implied volatility of financial instruments and the subsequently realized volatility by selling options and delta hedging the exposure of the underlying asset.

    Capital structure arbitrage (also called credit arbitrage) tries to exploit mispricing between a company’s debt and its other financial instruments. In 2004, about 7% of the total value of hedge fund investments were managed according to fixed income arbitrage strategies (see Garbaravicius and Dierick, 2005).

    The most important hedge funds strategies are long/short equity strategies, an example of opportunistic investment strategies of hedge funds (32% market share in 2004), and event driven strategies (19% market share in 2004). Fixed income arbitrage strategies lead to mean–variance return combinations that may be interesting for investors with rather high risk aversion.

    Although in Figure 1 the mean–variance profile of fixed income arbitrage is dominated by that which is achievable by equity market neutral strategies, fixed income arbitrage strategies may be an important component of an overall portfolio of hedge funds for an investor because of diversification effects.


    Flipping is a term, mainly used in the United States, referring to the practice of purchasing an asset and immediately reselling (flipping) it for profit. Flipping applies when shares are sold in the immediate aftermarket by investors who receive an initial allocation at the offer price and does not include purchases in the aftermarket.

    Flipping is the simplest method to make money through an IPO (by purchase of the new shares directly from the underwriter and then selling them immediately on the open market).

    Particularly, flipping involves reselling of a hot IPO stock in the first few days (or day) of trading to make a quick profit. This task is not a simple one and difficult to perform, and investors are highly dissuaded by underwriters.

    The logic is that underwriters prefer that long-term investors keep their stocks. There does not exist any laws that preclude flipping, but underwriters may blacklist “bad” investors from future offerings.

    Fishe (2001) indicates that stock flippers are a massive problem for underwriters. They depress the market by immediately reselling their shares, creating a confusing environment for the remaining long-term oriented investors.

    Underwriters’ main characteristic is to aggressively attempt to discourage flippers by various penalty schemes, such as threatened exclusion from future hot offerings. Consequently they should favor a lower offer price and overselling of the issue, which may lead the underwriter to assume a short position of the issue.

    The short position should be covered ideally with aftermarket purchases. Through an estimation of the total demand and flipping, underwriters select an optimal offer price that produces a cold, weak, or hot IPO.

    Krigman et al. (1999) empirically measure flipping. The authors report that flipping is responsible for 45% of trading volume on the first day of trading for cold IPOs (this is due to the decreased trading volume in weak IPOs and is a result of frequent flipping) and 22% for hot IPOs.

    Recent indications favor the mainstream notion that institutions are intelligent investors and therefore flip a great deal more of the cold IPOs during the first few days, whereas the main investment bank provides price support.

    Welch and Ritter (2002) state that penalty bids are rarely formed and “flipping may even be encouraged in order to keep market demand from pushing to unsustainable levels.” The authors also argue that in instances of elevated levels of unnecessary flipping, the lead underwriter collects the commission paid to syndicate members for selling shares.

    Each syndicate obtains a selling concession based on the number of shares it issues. In the event that clients of a syndicate decide to flip their shares, the selling concession on those shares is credited back to the lead underwriter.



    Float refers to the outstanding shares held by outsiders, usually reported as a percent of the total shares outstanding. A corporation (usually the board of directors) will authorize a certain number of shares. This authorization permits the company to issue shares, but most companies issue fewer than the total number of authorized shares.

    From time to time, the company will sell some of the authorized shares. The company might sell shares by registering an offering, and then selling through an initial or secondary offering.

    The company may also issue authorized shares as private equity, sell shares through employee stock purchase plans and employee stock option plans, or issue shares on exercise of convertible bonds or preferred stock options. Some companies sell shares to existing shareholders through dividend reinvestment plans (DRIPs).

    Many companies buy their shares. A company may buy registered shares in the open market or from holders to support the value of their shares or to buy shares to distribute through employee stock option plans. A company may reacquire restricted shares if an employee leaves the company before the full vesting date.

    Shares issued by a company increase the number of shares outstanding. The company can retire the shares reacquired but, by convention, these shares are held by the company as treasury stock. In either case, the number of shares outstanding decreases by the number of shares acquired.

    Employees, family members, managers, and members of the board of directors often hold significant positions in a company’s stock. For a variety of reasons, these owners may be motivated differently than other shareholders.

    Employees, managers, and board members are more likely to vote as directed by the management. Sometimes, these stakeholders have an interest in preserving the status quo (including their jobs), rather than maximizing the shareholder’s welfare.

    Family members and other large holders may have controlling positions that are more valuable because of the control, and so may be less likely to sell their shares at a particular price. Also, this group may have large deferred capital gains that discourage them from selling.

    The percent of shares not held by insiders provides a rough measure of the amount of control held by insiders. It also provides a measure of the chance that a hostile company could force a takeover.


    Floor Broker

    Floor broker is an investment professional whose firm is a member of an exchange, typically a stock exchange, and who helps clients buy and sell securities on the floor of that exchange. Orders are transmitted to floor brokers via the firms they work for or through other registered representatives.

    These brokers could also be independent brokers, where they work for themselves and accept orders from any firm wishing to employ their services. In exchange for the services they provide, floor brokers receive commissions for executing transactions.

    With the growth in the over-the-counter (OTC) markets and electronic trading in general, floor brokers will become less necessary in future, and the services they once provided will be carried out electronically. Floor brokers have also been called two-dollar brokers, as the compensation at one time for executing trades was $2 per trade.

    Floor Broker
    Floor Broker