Basic Investment Banking/Hedge Fund Definitions

Investment banking: work with corporations that want to raise capital through public or private capital markets, risk-manage existing capital, complete M&A related transaction. Provide financing through direct investments in corporate equity and debt securities, provide loans. 

A bond is debt in the form of a security, issued as a long-term obligation of a borrower with a specific maturity and coupon. An investment bank underwrites a bond offering by purchasing the security from the issuer and reselling it to institutional investors/individuals. Coupon is the interest rate stated on a bond when it’s issued.

Convertible Security— a bond or preferred share offering converted into a predetermined # of common shares. A type of equity offering, even though most convertibles are issued in the form of a bond or preferred shares. Most are convertible anytime, at the option of the investor, into a predetermined number of shares (common shares) of the issuer. 2 types– optionally or mandatorily (converts at maturity).

If a company wants to issue debt, they might consider a convertible bond rather than a straight bond in order to reduce the coupon associated with debt issuance. A convertible option has an embedded call option on the issuer’s common stock, and the investor ‘pays’ for this option by accepting a lower coupon. 

Outright buyers – purchase convertibles with the expectation that the company’s share price will exceed the conversion price.

Arbitrage buyers – focus on hedging share price risk and creating profits in excess of the coupon.

Hedge— making an investment to reduce the risk of adverse price movements in an asset. Normally consists of taking an offsetting position in a related security.

Hedge fund investment strategies involve short selling, arbitrage techniques, derivatives, significant corporate events. They incorporate sophisticated trading and financial vehicles which are principally supplied by the prime brokerage, trading, and credit providing desks of investment banks. 

Derivative – a security whose price is dependent upon or derived from one or more underlying assets. These derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indexes. Characterized by a high leverage.

Arbitrage is possible when

  1. the same asset does not trade at the same price in all markets
  2. two assets with identical cash flows do not trade at the same price
  3. an asset with a known price in the future does not trade today at its future price

Delta hedging – principal investors are hedge funds engaging in convertible arbitrage strategies. Investors purchase the convertible and simultaneously sell short a certain number of common shares that underlie the convertible. The process of buy-low-sell-high continues until the convertible converts or matures. Buy stocks to reduce the short position when share price goes down, borrow and sell shares short when share price is up.

Hedge funds have–

  1. almost complete flexibility in relation to investments, incl. both long and short positions.
  2. Ability to borrow money (and further increase leverage through derivatives) in an effort to enhance returns.
  3. Minimal regulation
  4. some illiquidity since an investor’s ability to get an investment back is restricted through lock-up agreements and quarterly disbursement limitations.
  5. Investors include only wealthy individuals and institutions such as university endowments, pension funds, and other qualified institutional buyers.
  6. Fees that reward managers for performance

Absolute returns do not (in theory) depend on the performance of broad markets and the economy – unlike the returns associated with mutual funds.

 Hedge funds will borrow (create leverage) in order to increase the size of their investment portfolio/increase returns.

Hedge funds vs. private equity funds

  • both are private pools of capital that pay high management fees and high performance fees based on the fund’s profits.
  • both are lightly regulated.
  • HF invest in relatively liquid assets and purchase minority positions in company stocks and bonds and in many other assets (taking both long & short positions for many investments)
  • PE typically purchase entire companies, creating a less liquid investment that is often held for 3 to 7 years.
  • There is often intent to create liquidity after this period since exit events often include an IPO or M&A transaction but liquidity is not ensured even then.

Angel investors are high net-worth individuals who often fund investments in the so-called “equity gap” – transactions requiring equity investments of less than $1 million, which most equity firms don’t bother with.

from Stowell, David P. An Introduction to Investment Banks, Hedge Funds, and Private Equity: The New Paradigm. (Amsterdam: Academic Press, 2010).

and Yates, Geoff and Mike Hinchliffe. A Practical Guide to Private Equity Transactions. (Cambridge: Campbride University Press, 2010).


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