Harvard Case Study “Pine Street Capital”Contents 4 Overviews 1 2. Current Strategy and Alternative Strategy Analysis 1 2.1 Current Hedging Strategy (Short ~ Selling) 1 2.2 Alterative Hedging Strategy (Put Options) 3 ‘3. Comparison between Current Strategy and Alternative Strategy 5 4. Potential Risks involved in this credit derivative 6 Conclusion 7 6. Referenee 8Pine Street Capital 1. Overview Pine Street Capital (PSC) is a small hedge find specialized in the technology sector, It manages approximately about thirty-two million dollars fund. Three partners established PSC in January 1999. They graduated their bachelor's degree in engineering / sciences, master's degree in MBA and PhDs in finance. Then, they have an extensive background in both technoloay sector and finance, PSC is the market neutral fund, the fund hedged out all market risk. The current hedging strategy is short-seling or shorting the shares of market index. Now, they are thinking of another hedging strategy, which hedged though put options. ‘Then, the ‘managing director, Harold Yoon, is facing with the decision whether applying the old strategy (short-selling) or the new strategy (put options). 2. Current Strategy and Alternative Strategy Analysis Current Hed, Short Current strategy of PSC is using shor-sale strategy to eliminate general market tsk, which they felt less comfortable making bets on the direction of the entire market, fom the fund. They realize tat Market risk (systematic risk) isthe risk that the value of ‘an investment will decrease due to moves in market factors, The four standard market risk factors are Equity risk (the risk that stock prices will change), Interest rate risk (the risk that interest rates will change), Currency risk (the risk that foreign exchange rates ‘will change), and Commodity risk the risk that commodity prices will change). Unversile Or Market Fisk ‘Number OF Stocks in Portfolio Copytant@ 2008 ivesonedi.comFrom PSC strong background, they believe that they have potential to pick up out- performing stocks in technology sector. Which mean that PSC currently taking unsystematic risk as seen in Figure 1. According to PSC’s Strategy, PSC hedges market risks away while firm-specific risk is kept in the portfolio. This strategy is called “Market-neutral” strategy. Normally, PSC expected return should be compute form the following regression: Expected PSC portfolio return = a+ (Market Return) Generally, Market-neutral strategy is focusing on eliminate “B*(Market Return)” from the above regression. Therefore, the company has to short-selling the ‘amount equal to value of the portfolio multiplied by “B", so the market risk is hedged away and PSC expected return on the portfolio is equal 10 “a Payot Short-Sell Index ‘The upward-stright line represents the gain or loss on the long stock position, ‘The long stock position is gain when the market is up, and less when the market is down, ‘While, the short-selling index is gain when the market is dewn, loss when the market is up. AS a result, the combination of those positions will offset each other to be a constant ‘etum either the market is up or down, a illustrating inthe fellowing figure.Figure 3: Hedging by ShortSale Strategy Poyott a Constant Return PSC should short-selling amount equal fo the value of portfolio, $34.55 million, ‘multiplied by current “B”, 1.65 which is approximately to $57.01 million. As result, the company will get the retum equal to “a”, 3.35% of the value of the portfolio, approximately $1.16 million, 2.2 Alternative Hedging Strategy (Put Options) Referred to the marketsneutral strategy, the delta of the portfolio should be equal to (1 - B)*(otal value of the long position). We cannot use the delta-neutral theory because the aim of PSC is not to hedge overall portfolio, bt hedge only the market risk, ‘There isa litle bit complicated in computation the number of put option contract used to hedge and the premium to be paid, ‘he first step is to find the delta of each put option by plugging all known variables in the Black-Scholes Formula in order to find the implied volatility. After we {ct the implied volatility, we will use it to calculate deta of each put option, Remember that te different put options provide the different deltas, Black Sholes Formals; paXe"N(d,)-SN-d) where‘The Delta Formula; 4, 2e"1N@)=1) ‘The second step isto find the delta of portfolio when the market-neutral strategy is hold by the following formula; ‘Delta of portfolio = (1 - B)*(total value of the long position) ‘The third step isto find the deta adjusted to market neutral Delta adjusted to market neutral = Delta of portfolio-Delta of long position ‘The frth step is to find the number of put contract needed to hedge. nber of contract needed» Dela jus fo mart neutral “Number of contract neede~ — Delis of put option * Maltiplier ‘The fith step isto find the premium paid for the put option hedging strategy. ‘Premium paid = Put Option Price * Number of contract needed * Multiplier The expected return js the combination of the long stock position with the long. put option. The upward-straight line represents the gain or loss on the long stock positon, ‘The long stock positon is gain wien the market is up, and loss when the market is down. ‘While, the long put position will be gain when the market is down and has the constant loss (the premium paid) when the market is up. These positions are illustrated in the following figure. Figure 4: Long Stock and Long Put Option Payot Long Stock Combination a. Indox Long Put Option +‘The combined effect from the figure 4 will make PSC to have a constant gain/loss ‘when the market is down and the potential gain when the market is up. AS a result, this strategy is called a “protective put” as shown inthe following figure. Figure 5: Hedging by Long Put Option Strategy Protective Put 3. Comparison between Current Strategy and Alternative Strategy Market Current Strategy “Alternative Strategy Condition | (Short-Selling Hedging Strategy) | (Put Option Hedging Strategy) Bull Market | The return is eonstant which equal | There is a potential gain more thaw to alpha, the curent strategy. The gain is equal to the gain from the long stock postion minus the premium paid. ‘Bear Market |The return is constant which equal | There is & constant galn/io3s tht toalpha, a. equal to alpha, a, minus the premium paid; premium paid > @.=> loss = premium paid < a-=> gain4. Potential Risks involved in this credit derivative deal ‘Current Strategy : Alternative Strategy Risks (hort Selling Hedging oe (et Option Hedging Strategy) Market Risk | Hedged by shor-seling | Hedged by pat option (Gystematie Risk) | srateay. Tasystematic | PSC selects out-perfonning | PSC elec ot-perfonning soaks Risk stocks and ensures that it il | and ensures that stil isthe has the unsystemate risk in| unyserai risk inthe portfolio. the prdolio by ot by not diversified the porto. diversified the portol Downside risk | The constant retum protest | Ther i higher potential low tan from the potential loss when | the erent strtepy because of the the market tis bad ‘premium pid NASDAQ-I007s | No eet Changes in the prise of an Price changes risk undetying asets ead to. the chang in the portfolio vale. dr = 0065) +E)? where ‘br = Change in the porto valve 2 = Change in the underying asset prices. NASDAQTOO": — | No fet ‘Ghanses ia the sandard deviation Standard of the underiying assets lead to the Deviation changes Risk change inthe portfolio value. or = (60) where, ‘8: = Change in the portfolio value 60 = Change in the standard deviation ofthe underlying assets.‘Current Strategy. (Short-Seling Hedging Strategy) Alternative Strategy (Put Option Hedging Strategy) Maturity Risk (Time Decay) No effect Changes in Ge time to expiration date of put options lead to the change in the portfolio value r=0(8) where, ‘5x = Change in the portfolio value & = Change in the time to expiration date of put options. Taterest rate Risk No effect, ‘Changes in the interest rates Tead to the change in the portolio value. Ae) where, ‘5 = Change in the portfolio value & = Change in the interest rates, Credit Risk No effect, Tf the put option is inathe-money ‘and likely to exercised. There is a possibility that the short postion Would default Ifthe put coutofimoney and not likely to cexerise, there is no credit risk. ‘5. Conclusion ‘In making decision, which strategies applied depends onthe level of risk that PSC can tolerate; = RiskAdverse: If PSC cannot tolerate any risk at all, they should apply the ‘current strategy, short-selling index, because tis strategy provides the constant return whether the market goes up or down. = Risk Taker: If PSC can tolerate more risk than before, the also have to predict the funure market return. If they expect the market retumn will 0 up, zhey should apply the alternative strategy, long put options. But if they expect the market return will go down, they should apply the curent strategy, short-selling index. In other words, the alternative strategy will help PSC to capture the extra return from the bull market, while the curent strategy will guarantee PSC return, which equal to alpha, fom the bear market,(Our recommendation is to take the strategy asthe risk taker because purchasing the put option also guarantees PSC the minimum value ofthe portfolio when the market is down, 6, References ‘ohn C. Hull. Options, Futures, and Other Derivatives, Pearson Intemational Edition, 2006. Douglas Van Eaton, Ph.D., CFA. Schweser Study Notes: Book 1 Ethics and ‘Quantitative Methods. KAPLAN SCHWESER, 2007. R. Douglas Van Eaton, Ph.D., CFA. Schweser Study Notes: Book 4 Corporate Finance, Analysis of Equity Investments, and Portfolio Management. KAPLAN SCHWESER, 2007. (Chris Martison, PH.D. The Fundamentals of Risk Measurement, McGraw-Hill, 2002. hitpy/Avorw-pinecap.com bnpien. wikipedia.org