Established in January 1999, Pine Street Capital (PSC) was a market-neutral hedge fund thatspecialized in the technology field,

facing market risk and trying to decide whether and whichway to use in order to hedge equity market risk. They choose technology sector because thepartners of PSC felt that they have enough ability to evaluate this sector and specially begood at picking out-performing stock. Short-selling of NASDAQ and options hedging strategyare the two major hedging choices for PSC. Either strategy has its own advantages indifferent economic periods and conditions. The fund has just through one of the most volatileperiods in NASDAQ's history, and it was trying to decide whether it should continue its riskmanagement program of short-selling the NASDAQ index or switch to a hedging programusing put options on the index.The more common hedging strategy they used was a short-sale strategy to eliminate marketrisk from the fund. Short-sale strategy can be explained in the following model:Expected PSC Portfolio Return=+*(Market return): The amount of return in excess of that due to market risk: The response of PSCs portfolio to changes in the marketPSC established relationship between the performance between PSCs portfolio and themarket. PSC adopted the market-neutral strategy because they wanted to eliminate marketrisk (beta risk) which was hedged from PSCs portfolio by shorting the market in proportion tothe beta of the assets in the portfolio while firm-specific risk (alpha risk) remains. And theybelieve that it was very specialized in the technology sector and hence be able to evaluatethe field and pick up outperforming stocks accurately. The alpha return that PSC was left within their portfolio after hedging market risk could be negative if they picketed the wrongstocks. But PSC was so confident because their comparative advantage is to select positivealpha stocks in technology field and do profitable investment.The number of hedge funds around the world increased greatly in the late 19th century.Hedge funds are private group investments that offer equity pooling advantages. They arenot publicly owned and less regulated and enjoy additional privileges. So, the attribute of hedge funds make it more flexible in investment strategies and risk management and itseems to result in a higher return. Moreover, Hedge funds can use leverage and shorting orusing options to hedge. The advantage of using debt to finance a portion of the assets in aportfolio is that a higher return on the portfolios equity could be got compared with an all-equity financed portfolio. Hedge funds also have another privileges but the main differencesis the ability for hedge fund to use leverage and to hedge by shorting or using options to limitthe overall risk of their investments. But using leverage increases the risk of an investmentbecause if leverage is employed and the assets lose value, leverage will go far away from theinvestor. Then the loss on equity will be larger compared with an all-equity portfolio. Anotheradvantage of hedge fund is that it can use options as a hedging tool to limit the overall risk ata given investment amount. But the question is that the hedge position limits the potentialgains while it also protects the portfolio from the downside of risk.Currently, the return of the fund is given by : PSC(%)=alpha(%)+beta*[market return(%)].But PSC is willing to bear alpha riskthe risk associated with their own investmentdecisions in the technology sector because they feel they have a comparative advantagethere. They were unwilling to bear market or beta risk because they feel their weakness liesin anticipating moves in the overall market. The Beta hedging thus came to their mind.According to the market value and beta of the portfolio, short selling a certain amount indexfund, here we use QQQ, a ETF which tracks NASDAQ , we can eliminate the beta risk, thusthe return will always be the positive alpha. The formula behind beta hedging at initial is: If the market changes by x%, the portfolio changes by x*beta% market value of the market

representation product used for short selling (QQQ ) = market value of the portfolio forprotection multiplied by portfolio beta initial QQQ price * number of QQQ shares shorted = portfolio beta * sum of the initial marketvalue of every stock in the portfolio (1-1)If today PSC want to hedge out its 100 value of stock portfolio, assuming beta=1.67, alpha is3.35%:next year's valuetoday initial value QQQ+10% QQQ-10%long portfolio 100 100*(1+3.35% +1.67*10%)=120.05 100*(1+3.35%1.67*10)=86.65short QQQ 167 167*(110%)=150.3 167*(1+10%)=183.7total 267 270.35 270.35return on hedged portfolio 3.35% 3.35%the theoretical long portfolio value increase(portfolio return)=percentage increase inQQQ(QQQ return)*1.67+3.35%Pine Street Capitals Portfolio on July 26th,2000Ticker shares share price total Allocation Beta Alpha RSquaredAMCC 24000 162.88 3909000 11.31% 2.15 6.42 0.58AHAA 45000 36.19 1628438 4.71% 1.63 2.14 0.39ANAD 70000 26.81 1876875 5.43% 1.65 1.22 0.45CNXT 42500 35.75 1519375 4.40% 1.42 -0.08 0.39CY 15000 43 645000 1.87% 1.07 1.44 0.39HLIT 20000 28.06 561250 1.62% 1.63 -0.81 0.36JDSU 22000 135.94 2990625 8.65% 1.56 1.08 0.57LSI 12500 32.63 407813 1.18% 1.32 2.44 0.48PWAV 40500 36.88 1493438 4.32% 1.39 6.23 0.3QLGC 30000 77.94 2338125 6.77% 1.87 1.05 0.48RFMD 21000 39.75 834750 2.42% 1.62 1.66 0.46TQNT 25000 48.63 1215625 3.52% 1.74 4.22 0.57TXCC 30000 41.66 1249686 3.62% 1.64 4.21 0.47VTSS 20000 65.63 1312500 3.80% 1.65 3.35 0.42EMLX 30000 55.81 1674300 4.85% 1.86 -0.12 0.4PMCS 16000 197 3152000 9.12% 1.79 9.99 0.54SDLI 20000 387.25 7745000 22.41% 1.52 13.53 0.45PSC Portfolio 34553800 100% 1.67 3.35 0.8While at the same time, the QQQ price is 95.62, according to formula (1-1), the number of shares need to short ismarket value of portfolio * portfolio beta / QQQ share price=34553800*1.67/95.62=603481Now assume that day is the initial date, we shorted 603481 shares of QQQ, then we verifythe results using real monthly data, till 2001-2-1(the SDLI was acquired in 2001):Date QQQ price QQQ short selling value 1share PV with hedging PV without hedging PV ratiowith hedging PV ration without hedging 2000-7-26 95.62 95.62 92258664.22 34553811 100.00% 100.00%2000-8-1 101.62 89.62 96141967.22 42058000 104.21% 121.72%2000-9-1 88.75 102.49 97993882.69 36143115 106.22% 104.60%2000-10-2 81.7 109.54 98835008.74 32729700 107.13% 94.72%2000-11-1 62.98 128.26 101869023.1 24466550 110.42% 70.81%2000-12-1 58.38 132.86 106431710.7 26253225 115.36% 75.98%2001-1-2 64.3 126.94 105301308.1 28695430 114.14% 83.05%2001-2-1 47.45 143.79 100624223 13849690 109.07% 40.08%the portfolio value with hedging = value of the short selling QQQ stock + portfolio valuewithout hedgingvalue of short selling QQQ stock=[initial QQQ price+(initial QQQ pricecurrent price)]*numberof QQQ shares shortedPortfolio value with hedging can not be directly compared with the PV without hedging ,since their components are different. But the standard deviation when using hedging (4.75%of initial value) is much lower than that without hedging (23.29% of initial value).We can see the monthly value versus initial value ratio is much higher if hedging is used inmarket downturns. In the last month of the graph the portfolio lost 60% if without hedgingwhile the there is even a gain if hedging is used (compared to initial value). But notice thathedging can also limited the upward potential when price rises, as the second month in the