Government bond arbitrage hedge funds exploit temporary pricing anomalies in cash and derivative securities within the global government bond markets. The strategies used may include yield curve arbitrage, basis, volatility trading, cross-currency, and asset swaps trades.

The most important assessment a professional hedge fund investor makes when considering a government bond arbitrage portfolio is whether the portfolio manager has macro bets on interest rates or relative value trades with little directional interest rate exposure. The portfolio which is comprised of macro bets on interest rates will be highly correlated to directional changes in rates of the underlying countries in the portfolio. Abrupt changes in profit and loss (P&L) will be associated in changes in interest rate policy or anticipated changes in interest rate policy. They can be easy or difficult to identify in advance. The macro portfolio may not be overtly long or short government bonds, but it may have certain positions whose success is dependent upon changes in interest rate levels. Macro trades include ones which have large curve exposures. Some examples include a 2-year versus 10-year trade; a 2-year, 5-year, 10-year butterfly trade; or an unevenly weighted Eurodollar future trade. By contrast, relative value trades are expected to be largely uncorre-lated to interest rate movements. They also present with tamer P&L swings for the portfolio. The most common relative value trades are swap spread trades, basis trades, on the run versus off the run trades, and Eurodollar trades which do not take significant curve exposure.

Government bond arbitrage generally contains the highest leverage among all hedge fund strategies. The true relative value portfolio will contain spreads trades that seek to profit from movements of just a few basis points. The collateral posted is often considered on a par with cash. An example is U.S. government bonds arbitrage. Commensurate with such small anticipated moves, high leverage must be utilized. But for each substrategy of government bond arbitrage there is an appropriate amount of leverage. Basis trades (cash against futures) or an on-the-run versus off-the-run trade with less than three months of curve exposure, command larger amounts of leverage than does a curve trade. The appropriate leverage factor in basis trades or on-the-run versus off-the-run trades can easily exceed in excess of 30 times levered before 99% value at risk (VaR) approaches 5% of net asset value. VaR describes the potential for portfolio impairment. For example, a 99% value at risk means that on any given day, the portfolio has a 99% probability of not losing more than its stated VaR amount for stated standard deviation. Swap spreads should be less levered. Curve exposure greater than six months and positions involving swaptions (which have volatility exposure) should be significantly less levered.

If the portfolio contains interest rate options, the professional hedge fund investor must monitor the frequency and amount by which the portfolio manager is a net receiver of option premium. A key question when assessing the risk profile of a portfolio manager is the dollar vega for a 1% increase in index interest rate volatility. If it is a negative number, the manager is short volatility. The larger the negative dollar vega, the larger is the potential loss for an increase in volatility. Even if the portfolio is not a net receiver of premium, it is important to know if and where on the volatility surface the manager is receiving premium. Volatility spikes can strike different tenors differently, resulting in uncovered tail risk exposure. Tail risk increases if the portfolio is a net receiver of option premium and the amount of tail risk increases as the dollar amount of the premium received increases.

Options have asymmetric risks. The asymmetry changes for each new price level of the underlying asset. The asymmetry is adverse containing potential tail risk to the manager that sells options. The asymmetry is positive and contains a built in positive convex hedge to the manager that purchases options. This positive asymmetry costs money in the form of premium paid. Volatility cannot go below zero and can increase to spectacular levels under the right circumstances. In short, significant market movements in the interest rate markets can be expected to generate losses for the portfolio that receives option premium.

Leverage in option books is important to assess. One way to view this embedded leverage is to notionalize the option reference amount of the underlying government bonds. (This delta amount will change for any movement in the markets.) There are other useful measures such as the metric lambda which is a metric that measures how the option price varies as reference security's price varies. This result is the leverage embedded in an option position. This measurement is particularly useful in uncovering the embedded leverage in out of the money options where the embedded leverage can be quite high. That is to say, small changes in rates can create large percentage changes in option premium. The potential for portfolio impairment depends on the leverage in the option book.

Another type of potential tail risk exposure is in positions which consistently have the potential to generate losses in times of market dislocation. In times of global political or economic turmoil, AAA rated sovereign debt can be expected to out perform lower rated sovereign debt and bank credit instruments. The later exposure is most frequently represented by interest rate swaps in the government bond markets. Interest rate swaps involve parties exchanging London Interbank Offered Rate (LIBOR) rates for fixed rate sovereign debt rates at specified semiannual payment dates. Because default is always a possibility, the asymmetric bet favors the buyer of the AAA sovereign debt over the buyer of the less than AAA sovereign debt and over the receiver of LIBOR. Professional hedge fund investor should segregate the government bond arbitrage book between AAA credits and other credit. Then they should total up the exposures to ascertain whether or not the portfolio manager is net long the more highly rated debt in the portfolio.

Because government bond arbitrage is a highly levered strategy, it is susceptible to short squeeze situations on a widely shorted government bonds. Widely shorted bonds or ones with large open short interest can be so scarce, they are not deliverable. Even issues with in excess of 20 billion can be susceptible to squeezes. It may take regulatory intervention to alleviate these situations, but, sometimes, not before such shorts are costly to the portfolio manager. A measure of the portfolio manager's risk discipline is whether or not or after how long they pay up to cover or buy back the short position that is being squeezed.

Most government bond arbitrage portfolio managers will supply investors with VaR reports. However, it is useful to be aware of how the portfolio net asset value (NAV) alters during significant moves in interest rates such as 50 or 100 basis points. These large P&L moves help reveal adverse asymmetric risks in the manager's portfolio. This is particularly useful to those managers trading rate volatility.

Mortgage-backed security arbitrage hedge funds predominately invest in the residential mortgage and interest rate markets. The portfolio manager will typically employ hedging techniques to hedge out the adverse investment risks inherent in the prepayment feature embedded in mortgage securities. Mortgage debt includes mortgages pooled by financial institutions and government-sponsored enterprises. Portfolio managers can invest in a variety of styles including coupon arbitrage, basis, synthetic coupons and credit trading.

There are many sub-strategies in mortgage-backed security arbitrage. The most significant initial assessment to make is whether or not the portfolio has credit exposure. This exposure is broadly defined as securities which have a credit rating of below AA. Securities below AA have an increased probability of default over AA or AAA mortgage securities.

Mortgage securities are among the most complex financial securities. The embedded market exposures are difficult to detect unless one has access to the calculations of sophisticated risk systems which model the prospective cash flows. These securities have embedded optional-ity through their prepayment features and, hence potentially, widely divergent income streams. It is essential to look at mortgage portfolios through the lens of good risk software. The most important stress tests for a noncredit portfolio include changes in the yield curve, interest rate, prepayments, basis (mortgage versus Treasury positions) and volatility. A long mortgage portfolio contains an implied short embedded option exposure. The long mortgage security holder is short the prepayment option. Risk software will measure just how much exposure in dollar terms the portfolio can be expected to loose for changes in interest rate volatility. Yield curve, interest rate, basis and prepayments stress tests are paramount exposures to understand in a mortgage portfolio. In a given portfolio, the professional hedge fund investor may simply decide there is too much exposure for the current anticipated return.

The most relevant stress tests for mortgage credit portfolios are default sensitivity tests. For pools of mortgages which represent the lowest rated lenders one must evaluate a number of other metrics such as delinquency rates and days delinquent. All portfolio stress results should be relied upon for assessing tail risk as the mortgage markets can go through long periods of time without major disruptions. Volatility of returns in any given year may well disguise tail risk potential.

It is important to have quantitative risk software which is reliable and capable of evaluating all positions in the portfolio. It is also important to ensure that the prepayment model applied to the software is widely acceptable. Proprietary prepayment models must be vetted by knowledgeable professionals. The wrong prepay assumptions can be misleading about the tail risk in a portfolio. Reliable stress results give the professional hedge fund investor parameters with which to judge the potential for tail risk. Specifically, the professional hedge fund investor can assess the likelihood of a given move in the underlying markets and use the software results to understand the exposures they are assuming if they invest.

The underlying risk in a mortgage-backed security arbitrage portfolio is dependent upon the degree to which the portfolio is hedged. Beyond the aggregated position results as calculated by sophisticated risk software, the professional hedge fund investor should consider viewing the portfolio by its arbitrage substrategy security groupings. For example, how much exposure there is to basis, synthetic mortgages (e.g., interest-only and principal-only mortgage strips), coupon rolls, and so on? This qualitative or empirical approach allows the professional hedge fund investor to assess potential portfolio impairment during adverse moves in the underlying interest rate markets. For example, a prospective flight to quality in the interest rate markets can be assessed separately in the context of each substrategy exposure.

In most strategies, a view into positions is more revealing than top line stress results. However, because mortgage securities contain embedded options with many possible price paths on a forward-looking basis, a positions-level view is less helpful than with other strategies. Risk software must be relied on to reprice cash flows as underlying markets move and to reveal portfolio exposures.

While the primary stresses that should be evaluated are the portfolio's sensitivity to interest rate shifts, curve shifts, prepayment speed increases, volatility increases and mortgage versus U.S. Treasury spreads widening, equally important risk factors include the portfolio's duration, convexity and leverage. All these metrics are best understood when stated as a percentage of NAV impairment.

The professional hedge fund investor should be prepared to make assumptions on near term market volatility and on the prospects for a significant or an extreme rate or curve move in order to assess the risk versus reward contained in the mortgage-backed security arbitrage portfolio. Of course, the portfolio manager can alter the hedges or dynamically alter the included trades. The professional hedge fund investor when assessing portfolio risk must also consider these possibilities. In general, the professional hedge fund investor should be concerned if a reasonable set of stress events or stress events that are likely to occur in tandem could impair the portfolio beyond their loss tolerance.

Corporate bond arbitrage hedge funds trade investment grade and noninvestment-grade credit on a relative value basis. The strategies employed include basis (cash bonds against credit default swaps), long/short, pairs and structured credit trading.

When evaluating a corporate bond arbitrage portfolio manager's trading style, it is important to ascertain whether they trade in a relative value or in a macro style. The hedged portfolio manager will not have a significant difference between the notional long and short books regarding average spread, rating and industry descriptions. Let's consider two extreme examples: a basis trading portfolio and a portfolio that is long high-yield names and short AAA investment-grade names. In the former example, the basis trader could be long a corporate bonds and a holder of credit default swap protection. The differences in average spread will be limited and the rating and industry descriptions of the trading book will be identical between the long and short positions. The portfolio consisting of high-yield longs and AAA investment grade bond shorts will have large discrepancies in ratings, spread, and, perhaps, industries between the long and short positions. At times the long and short positions could perform in an uncorrelated fashion. Over long periods of time, the basis book can be expected to be the more conservative one, demonstrating fewer drawdowns in performance numbers and lower volatility. Either portfolio is not necessarily a good or bad investment. However, the styles are very different and the portfolio manager should be relied upon to demonstrate an understanding of the differences.

Corporate cash bond/derivative trades can present similar risks as government cash bond/futures trades. Assumptions on deliverability can prove to be incorrect at or well before settlement. If enough leverage is applied, small miscalculations can generate significant P&L swings. These changes occur due to prolonged supply and demand technicals which usually affect the cash markets more often. One such dislocation in the investment grade corporate bond markets could be caused by a corporate restructuring action which alters the value of an affected firm's debt. The bonds could become targets for short sellers and the bonds may become difficult to borrow. This would cause volatility in the basis trades. Two similar investment grade securities can present with large P&L changes. The professional hedge fund investor has to be sensitive to the possible risks a long and short book of unrelated credits could be subject to.

Corporate cash bond/derivative trades also in the lower rated credits are more susceptible than higher rated debt to jump to default risk. This risk is the uneven trajectory in prices which the cash and derivatives can take when a credit's rating migration is headed dramatically lower. This can present with prolonged dislocations and expensive borrows on short cash positions. This type of risk is difficult to forecast or protect against other than by limiting the potential harm it can do to the portfolio's value.

As can be expected, leverage plays a role in the corporate bond arbitrage portfolio. Even the more conservative basis trading style portfolio can become unstable from a volatility point of view if enough leverage is applied. A basis book at 20 times leveraged could become more risky than a long/short book at two times leveraged with large spread and rating discrepancies between the long and short positions. Each substrategy has an appropriate range of leverage for a given level of underlying volatility in the markets. They can be arguably rank ordered lowest to highest: unrelated long/short credit, net long credit exposure on a beta-adjusted basis, structured credit, pairs trades, and basis trades. The lowest levels of leverage should be applied to the seemingly unrelated long and short book or those with embedded leverage, as is often the case with structure credit securities. The highest leverage should be applied to trading books of securities which are highly similar.

Leverage should be assessed in context of the volatility of the underlying markets and to the extent the underlying markets' volatility can be understood. The more leveraged a position, the greater the P&L volatility. The professional hedge fund investor must not only evaluate current P&L swings within the portfolio but also anticipate prospective P&L swings. The professional hedge fund investor should consider the history of the markets as well as the current credit cycle when anticipating prospective volatility.

While net credit exposure in a portfolio usually presents with greater P&L volatility than pairs or basis trades, net credit exposure should be further evaluated. On a beta-adjusted basis, the long and short book differences in spread, curve location, credit rating, and industry should be considered. Most portfolios will not be fully hedged and will have net long credit exposure which correlates highly with a corporate bond index. Net credit exposure should be determined in context of a beta matching of the long and short books which should also factor in duration, particularly, in investment grade portfolios. A notional matched book of long and shorts should be considered to have net credit exposure if spread, curve, rating and/or industry differentials exist. The professional hedge fund investor considers these differences as containing larger amounts of investment risk the larger the net duration and spread exposures.

Single-name issuer concentration or trade-size concentration is an important feature to examine in a portfolio. One usually cannot predict consistently single-name credit problems, but through diversification one can limit the potential portfolio impairment a single credit problem can cause. At times, unexpected industry problems may emerge or expected problems may not emerge. Therefore, industry concentration limits are also prudent. For example, one country can lose its competitive advantage in a given industry. Suppliers to that industry can be negatively impacted in sympathy. The same is true for sectors. Diversification should be assessed in context of the percentage of NAV, not percentage to total portfolio value. Leverage plays a key role in the cost of an uncontrollable position. The larger the leverage in the portfolio strategy, the more likely one position can impair the entire portfolio in adverse market circumstances. If an industry problem occurs, the portfolio will be impaired faster if industry diversification limits are not placed and monitored as part of the risk process.

Another type of concentration risk is single-issue concentration risk. Prudent ownership percentages of a single issue are larger for longs than shorts. Liquidity is vitally important to the portfolio manager. It allows the portfolio manager to enter and exit positions at optimally chosen times. Large single issue concentration levels may afford the portfolio manager pricing power but not the ability to exit a position, which for a number of reasons, should be more important to the professional hedge fund investor. The other danger of large position concentration is that it can distract the portfolio manager from other profitable trades. Ten to 15% ownership of an issue for a long position is probably about the maximum one should assume allows for optimal trading flexibility. Shorts, which can be subject to squeezes, should probably be limited to 5% to 10% of a given issue. If a squeeze ensues, a small short position can be covered more easily than a large one. At times, a large single-issue concentrated short cannot be covered for a very long and costly period of time.

Corporate bond arbitrage can include structured security trades. Structured securities are constructed of multiple asset classes which include corporate bonds both cash and derivatives, asset-backed securities including mortgages and bank loans, among other securities. The portfolio risks are dependent on which tranche is owned in a given structured security. Ratings are a secondary consideration to tranche location. Lower tranches include the equity, preference shares or mezzanine. The principal risk in these tranches is default risk. (At the issue date, each structured credit security is overcollateralized which means that the market value of the pooled assets in the security exceeds the face value of the structured security.) Defaults beyond the over collateralized amount will impair the equity tranches first. The equity, preference shares, and mezzanine tranches are comparatively small in size versus the highest-rated tranche. In a sense these lower tranches contain high degrees of embedded leverage. That is to say, small amounts of capital assume the risks for a relatively large amount of securities. The leverage is implied but can be inferred through modeling of default scenarios and cash flow payout terms. If a portfolio contains deeply subordinated tranches of structured notes, the professional hedge fund investor needs to view leverage in a more circumspect way that by notional market value. It should be grossed up to reflect the leverage relative to a higher tranche to put the leverage in a risk equivalent terms.

Lower tranches are commensurately rewarded with higher coupons and the equity tranche is priced for the highest internal rate of return. These yields are dependent on supply and demand for the underlying collateral. The yields may be cheap on a relative basis but expensive on a historical basis. Ratings must be viewed in context of other structured transactions, not in context of corporate bonds. Professional hedge fund investors should be aware of subordinated tranches in a portfolio and be current on the possible impairment per new defaults in the pools of assets. In general, aging deals increasingly suffer collateral impairment, that is, the prospect of default increases as the deal ages. Structured product securities often have a trustee whose duty is to measure the statistical qualities of the collateral to determine compliance with the offering documents regarding securities diversity among other guidelines to preserve the rating. The professional hedge investor should occasionally request a sample of the trustees' reports to validate the performance of the individual investments. The structured credit markets include many derivative products. These products reference single-asset-backed security deals, aggregated loan pools, or tranches of these loan pools. These derivatives are often more liquid than the cash markets, however, issues about volatility, liquidity, and leverage have to be monitored and prudently traded.

While documents and rating evaluations can remain standardized for long periods of time, changes occur which affect the investor. It is important for the professional hedge fund investor to remain current with document and ratings changes.

Emerging markets credit hedge funds invest in the debt of economically developing countries. These countries tend to have lower per capita income and smaller stock and bond markets than developed countries' markets. Emerging market countries tend to use hard and local currency issued securities to access the publicly traded markets. Some of the underlying risks in this strategy are sourced from the sovereign investment environment which, at times, can include local policy shifts, currency devaluations, ineffective central bank policy to control economic growth and inflation, volatile credit spreads and unreliable liquidity.

Emerging market debt over long periods of time can have significant ratings migrations, and be susceptible to principal impairment and currency devaluations. Consequently, it is very difficult, over long periods of time, to not incur losses due to these reasons. The same risk rules apply to this strategy as highlighted in the section on government and corporate bond arbitrage. The prudently managed emerging market debt portfolio should employ lower levels of leverage than one constructed of investment grade sovereign debt, even in periods of prosperity and tight spreads. Within emerging markets portfolios, those with local currency debt should employ even less leverage than those portfolios constructed in hard currency, if all other factors are constant. As with government bond arbitrage, the professional hedge fund investor should expect lower levels of leverage when large amounts of yield curve or outright country exposures are present over portfolios with long versus short exposures which cover shorter maturity differentials on the same yield curve.

The carefully monitored and actively managed emerging markets hedge fund can present tremendous opportunity due to the potential volatility and significant yield curve movements. From a risk perspective the monitoring and hedging must be well timed and reactive.

Capital structure arbitrage hedge funds take offsetting long and short positions within the capital structure of a given company. The long and short positions may be debt or equity securities of a company that is experiencing financial difficulty. The arbitrageur buys and sells securities within the capital structure in accordance with their interpretation of recovery values. Capital structure arbitrage trades are constructed to profit from relative mispricings within the capital structure of a given company.

The capital structure arbitrageur in addition to assessing the recovery values of the securities of a given company must also assess the relative amounts to position long and short. The market movements of the different parts of the capital structure of credit-impaired companies are unpredictable and often path dependent with large relative price fluctuations. Because the price paths of the securities are highly sensitive to changing default probabilities, prospective valuations and, hence, price expectations can be widely divergent. Not only miscalculating the likely outcome of a company can be costly but also miscalculating the hedge can exacerbate potential losses. The price trajectories of companies heading into default can occur more rapidly than recovering ones. Consequently, for a given weighting, a professional hedge fund investor should evaluate capital structure trades which are long senior debt and short junior debt or equity as less risky than ones which are short senior debt and long junior debt or equity. Of course, the truth of this statement is dependent upon the sizing of the trade. The proper sizing is difficult to assess other than at the extreme where one can usually presume that securities more junior in payment priority are more volatile and should be sized smaller relative to securities more senior in payment priority. A portfolio which is sized counter to this expectation should be viewed as having outright long or short exposure to the financial outcome of the company.

The portfolio manager will typically have a catalyst event in mind when positioning each trade. They size their trades in accordance with their perception of the eventual outcome. The capital structure arbitrageur will position defensively through long and short positions to profit from the expected outcome of a catalyst event. For example, if they presume a company will recover, they may buy the securities that will improve the most and hedge with a security that will improve less. The risk-averse capital structure arbitrageur will position in a way that is counter to this assertion but will just weight the trade in a bullish or long bias manner.

This strategy lends itself to containing net credit exposure, either long or short for even the most risk-averse arbitrageur. The professional hedge fund investor should view the net exposure in light of whether that exposure seems balanced on a volatility basis. The appropriate weighting and net exposure are assessments, not necessarily a measurement. Relative volatility changes and presents a challenge to the professional hedge fund investor to assess the weightings of these trades. At the extreme, where the capital structure arbitrageur is quite long, the risk assessment is easier. But often, this is not the case. But the professional hedge fund investor should find sufficient evidence and logic offered by the capital structure arbitrageur that volatilities are monitored, hedges, dynamically adjusted, all with fundamental rationale.

Capital structure arbitrage's success is dependent on the ability of the portfolio manager to borrow securities. Often, the securities that the manager wishes to borrow are scarce. The prudent manager will carefully manage their borrowing relationships in a way which ensures maximum access to the securities they wish to borrow. Dialogues with various lending institutions are important. The professional hedge fund investor should monitor the frequency with which a portfolio manager has its short positions called by a lending institution, forcing the capital structure arbitrageur to close out a position.

As with most strategies, the professional hedge fund investor should be concerned about the diversification of a capital structure arbitrageur's portfolio. Because the portfolio is subject to unsystematic risk, it does not necessarily follow that systematic factors may not trigger the unsystematic risk. For example, if corporate default rates are on the rise, many troubled companies may be affected. Or if interest rates are rising, the cost of borrowing may prove too onerous for troubled companies. A high level of diversification will help protect the portfolio's value.

Distressed securities portfolio managers invest in the debt and equity of companies which are highly leveraged and liquidity impaired. These companies require legal action or restructuring to improve asset value and financial stability. This strategy generally employs low leverage and has a longer investment time horizon than most other hedge fund strategies. Usually, the investment opportunities occur due to potentially favorable restructuring, recapitalizations or fundamental improvements in the companies' circumstances.

Risk evaluations of distressed portfolios do not lend themselves to a heavy reliance on quantitative risk analytical tools. Distressed securities have unsystematic risk. The valuations of these securities are dependent upon structural changes in a given company's outlook. Changes by management and in the business environment may be particular or unique to individual companies. Changes in the underlying markets as represented by the broad market indices are least likely to impact companies that are experiencing financial distress. Therefore, the securities within a distressed portfolio must be evaluated individually for the risks that the portfolio might assume.

One key factor the professional hedge fund investor will consider is default characteristics. First, is the company in default already? If so, the professional hedge fund investor will assess the presumed recovery rates or what percentage of par the debt holder is likely to recover. In the case of defaulted debt, the recovery value is presumed to be the current price. If the defaulted debt does not trade frequently, a very high valuation should be a signal that the manager may be marking the book unrealistically. For each company that is stressed but not in default, the portfolio manager should be not only aware of the probability of default through a Merton-style model but also be able to provide an estimate of a possible recovery value as well. Recovery values as assigned by each portfolio manager should be justifiable in terms of each credit's applicable assets.

In general, distressed securities are the most vulnerable to market illiquidity. (At times, however, large companies with fairly deep capital structures can defy this rule.) This strategy has little room for leverage. Under times of great market stress, a leveraged distressed portfolio's survival could be compromised. The portfolio without leverage would be able to wait through some period of difficulty, surviving the daily position markdowns as long as it did not suffer withdrawals. Workout times for these companies can exceed the hedge fund's liquidity. It is important for the professional hedge fund investor to assess whether the hedge fund's liquidity is consistent with the workout times of the distressed companies in the portfolio.

Distressed portfolios are often subject to binary risk. That is to say, the companies' survival depends upon certain outcomes regarding board votes, financings or regulatory intervention to name a few. These outcomes create risk in the portfolio and sharp price swings. Therefore, as with most strategies, sizing becomes very important. The portfolio with fewer positions will be riskiest and can be expected to experience sharp price swings.

Another feature of distressed investing is that the portfolio manager may become involved in creditor committees. This work requires a great deal of time and focus. This time needs to be well managed, as it is time spent away from managing the portfolio. The professional hedge fund investor must focus on how the portfolio manages this aspect of their time. There are real and implied costs to this process including legal liability.

Merger arbitrage is the investment discipline of buying target companies and often, selling their acquirers. The practice may involve announced deals or proposals. The types of transactions may include exchange offers, cash tenders, stock for stock, leveraged buyouts, among others. The principal risk is that deal terms change adversely or the deal breaks.

Merger arbitrage deals have varying degrees of risk depending on the certainty with which a particular deal will close. Deals in which the target and acquirer have agreed on terms are the lowest risk deals. Unforeseen circumstances are generally the only risk factor to the arbitrager. Deal types with greater risk and whose outcome is dependent upon regulatory approval such as anti-trust, activist hedge fund financing, speculation that a higher bid will materialize, hostile takeovers, among other situations present higher risk to the arbitrageur. Some merger arbitrage portfolio managers will become actively involved in merger terms to facilitate a desired outcome for their investments. Their success is dependent upon their persuasiveness with the board of directors of the target company. Consequently, deal spreads or projected returns on deals can range from barely over LIBOR to thousands of basis points over LIBOR. The professional hedge fund investor should be aware of the spreads of the deals in which their invested merger arbitrage funds invest.

Risk arbitrage portfolios can have very different risk profiles depending on the types of deals that are included in the portfolio. However, one risk remains the same threat level to any risk arbitrage portfolio regardless of the type of deals that are included in the portfolio. Even the most assured low-risk deal can be the victim of an external shock in the broader equity markets which can threaten the portfolio NAV. If a portfolio is not adequately diversified, the portfolio is at greater risk for potential impairment. Beyond proper diversification which may mean no position is greater than 7% of NAV, the portfolio manager should demonstrate awareness of the portfolio's downside value during multiple deal breaks. This is defined as predeal prices for both the target and acquiring companies.

VaR or equity stresses are not as useful as a measurement of merger arbitrage portfolio risks as a semi-qualitative assessment of the portfolio's vulnerability during deal breaks. The merger arbitrage portfolio is likely hedged and risk software might not calculate the risk in some deal types accurately. It is useful to the professional hedge fund investor to view the portfolio as if all deals broke or fell through. This repriced value is a return to preproposal status of both the target and acquiring companies and a very useful measure.

Long/short equity hedge funds hold long and short positions in equities. The portfolio may contain longer time horizon investments as well as shorter time horizon investments. The portfolios tend to be net long, decreasing net exposure and leverage in times of market downturns. Long/short equity portfolios reflect investment and risk decisions on sector, market cap, and net exposures.

Traditionally, at investment banks and banks, proprietary capital was allocated more typically to fixed income and currency markets traders and less so to equity traders. The equity divisions of investment banks focused on distribution. Equity proprietary capital was more commonly allocated to risk arbitrage or special situation investments over the style of trading which is encompassed in the long/short equity hedge fund strategy. It is common for long/short portfolio managers to have had prior careers as highly regarded analysts or total return managers. Long/short portfolio managers have widely divergent approaches to risk management than do other hedge fund disciplines.

The professional hedge fund investor should evaluate how the long/short equity hedge fund measures and monitors their exposures. The recovery rates in equities can be presumed to be zero. Therefore, the portfolio manager must manage their risk carefully in order to maintain the portfolio's viability and success. Important topics to monitor include cap skew between longs and shorts, sector and industry exposures. The larger the imbalance between the long and short books for these classifications, the greater the potential for volatility in returns. In order for the portfolio manager to prudently manage these risks, they must monitor these exposures.

Diversification is similarly important. Positions which are larger than 7% of the NAV can generally be considered to be concentrated positions. Position limits for longs should be greater than those for shorts. Shorts have negatively asymmetric risk and can be more difficult to finance than long positions. A size limit protects somewhat the total portfolio value at risk during a short squeeze. Inattention to the possibility of short squeezes can be harmful to the portfolio.

The professional hedge fund investor should be familiar with the stop loss rules practiced by the portfolio manager. The advantage of stop loss limits is the imposition of nonemotional, nonanalytical protection of the portfolio's value. Stop losses may mean the end or partial end of a particular open position but they also do not prevent the portfolio manager from recommitting to the same trade. Large losses have a tendency to cloud the judgment of the portfolio manager.

Portfolio managers will often say that at a certain loss level the losing trade will come under greater scrutiny. However, if the original thesis is intact, they remain with the trade. This practice presents greater loss potential to the portfolio than a liquidation or partial liquidation stop loss rule. The riskiest practice is the so-called double-down practice which calls for the trader to take advantage of the lower price of a current long or higher price in the case of a current short by increasing the position in share amount terms. The double-down practice is the riskiest practice of all, as the portfolio manager has increased exposure to a trade which is going the wrong way for the portfolio.

Another consideration that the professional hedge fund investor should be attuned to is that the long/short portfolio manager applies less leverage when trading the equities of smaller cap, distressed and lower-rated sovereign countries. For example, the professional hedge fund investor should expect that the leverage limits applied to German equities be greater than emerging market equities. As well, shorting low price dollar stocks presents adverse asymmetrical risks for the portfolio.

Many long/short equity portfolio managers are required to file position reports with the Securities and Exchange Commission (SEC). These reports are readily available and should be reviewed by the professional hedge fund investor on a continuous basis. When reviewing the SEC reports, the professional hedge fund investor should affirm that the reported positions are consistent with printed material provided by the portfolio manager.

Emerging market equity funds should be monitored for the same practices but with lower leverage thresholds than are tolerated in G-7 government arbitrage and long/short equity portfolios. The professional hedge fund manager should also be aware of small-cap equities in the emerging market portfolio. These stocks can be more easily manipulated in terms of their valuations which not only could misrepresent the portfolio's true value but also become the subject of regulatory scrutiny.

Multistrategy hedge funds encompass multiple strategies weighted among any of the strategies covered in this chapter.

A risk evaluation of this strategy should begin with the separation of the portfolio into each of the substrate-gies and applying the risk monitoring techniques covered throughout this chapter. Only then should the professional hedge fund investor evaluate the portfolio in an aggregated perspective. Specifically, the professional hedge fund investor should evaluate whether the portfolio contains considerable overlap in themes or exposures which present concentration risk.

In addition to the strategies covered in this chapter, the multistrategy fund may include special situation investments or private investment in public entities (PIPEs). These substrategies, while rarely involving leverage, present unique risks to the portfolio. Often assets held in the portfolio which are classified as special situation or PIPEs are less liquid or illiquid. Often these investments are side-pocketed with different liquidity terms for the investor than the rest of the portfolio. In times of financial difficulty, these investments may have severely restricted liquidity and, hence, are difficult to price or value. Perhaps the portfolio manager is drawn to these investment opportunities because they present long-term gain possibilities not readily available in the liquid markets. If these investments are included in the portfolio, the professional hedge fund investor must pay careful attention to the basis for the portfolio manager's valuation. These investments can be the catalyst for a manager to enforce gate restrictions on fund withdrawals.

The professional hedge fund investor should evaluate the effectiveness of centralized risk controls within the multistrategy hedge fund for the sake of the unique risks multistrategy funds present. The professional hedge fund investor needs to evaluate the allocation method used to deploy risk capital and leverage among the investment strategies.

The equity market neutral portfolio can encompass qualitative and/or quantitative investment styles. Market neutral may be market value neutral or beta neutral. Usually, the market neutral portfolio will be more protected from market volatility than a long long/short hedge fund with a net long. Many equity market neutral hedge funds utilize sophisticated computer models and electronic trading systems working in tandem to remove net market beta or market directional exposure.

Quantitative and qualitative market-neutral portfolios may have non-market-neutral elements. It is important to figure out what the manager's tendency is toward exposure in the book. Important topics to monitor include cap skew, sector and industry exposure, and concentration between longs and shorts. The larger these imbalances between the long and short books for these classifications, the greater the potential return volatility. In order for the portfolio manager to prudently manage these risks, they must monitor these exposures. The professional hedge fund investor should be aware of these skews. This awareness will allow one to anticipate portfolio valuations changes in response to broad market movements. If the strategy is an option-based one, the professional hedge fund investor should follow the same guidelines regarding net premium exposure as detailed in the section on government bond arbitrage. The risk principal of being short vega or a net receiver of premium applies to both debt and equity options.

Academically a truly market neutral portfolio is one which is beta neutral at all times. Because market values and betas change constantly, market neutrality in a portfolio is almost impossible to achieve. Even if were to be achievable, it may not be the best strategy for creating alpha which is often the goal of hedge fund investing.

A convertible bond arbitrage position generally involves the purchase of a bond which is convertible into equity of the same company at a specified conversion rate and the short sale of the same equity. Convertible arbitrage presents the trader with the opportunity to take advantage of pricing inefficiencies between a bond and its reference equity. The timing of the trade may be catalyst driven or due to the trader's belief in the relative mispricing of the convertible bond and its equity. The trade can be asset swapped which eliminates much of the credit spread risk in the convertible bond arbitrage position. In this case the purpose of the trade is to profit on volatility changes in the embedded option to convert into equity. Convertible bond arbitrage positions which do not involve asset swaps are generally plays on credit as well as volatility and equity performance.

Assets that are good candidates for arbitrage should be relied upon to covary in some predictable way. If they deviate, it can be assumed the deviation will be for a brief period of time. One of the assumptions that an arbitrager must have is that they not only can position an arbitrage but that they can exit or unwind the trade when they want to as well, within some price range. In order for that assumption to hold, there must be an active, non-homogenous group of buyers and sellers. Historically, convertible bondholders are more likely to be leveraged investors than the holders of other types of debt. The risk that this fact presents is that the arbitrageur will not have a counterparty to unwind the arbitrage with during time of financial stress. The more homogenous the holders, the more likely all holders will assess the value of a given convertible bond similarly. Or more directly stated, all the holders of a given bond could head for the exit door at the same time with little prospect of a buyer emerging. Nonetheless, the professional hedge fund investor should review the issue percentage ownership for each convertible bond in the portfolio. A high percentage per issue held is roughly and arguably in the range of 15% to 20%. The professional hedge fund investor should also try to assess the other holders of the issues of the portfolio. Concentration of ownership per issue by the arbitrageur of the portfolio being assessed is a significant liquidity risk factor. As stated above, if the other holders are hedge funds or leveraged investors, the portfolio risk increases.

Convertible bonds are less senior than other bonds issued by a given corporation. Because of the convert feature, convertible bonds trade with lower yields than other bonds in the capital structure. As the price at which the convertible bondholder can convert to equity becomes significantly out of the money, the convertible bond will decline in price or its yield will rise in line with the corporation's other debt obligations, reflecting the convertible bond's lower payment priority. Finally, one might assume that the market will place a recovery value on the convertible bond that is in line with the payment priority of other debt which is senior to the convertible bond. However, there must be active market participants willing to perceive the convertible bond's value and bid for it. The convertible bond holder may find that the out of the money convertible bond's yield will not only rise but it may rise above any level the arbitrageur envisioned before other, nonconvertible bond arbitrageur investors materialize with bids. In times of market stress such as 1998, convertible bonds lacked bidders. A convertible bond arbitrageur will face, in times of stress, the market's disregard for the implied relationship between convertible bonds and equity. The correlation between them can deteriorate and break down. The portfolio can be severely impaired. At this point the bond will trade increasingly with a credit predominant feature. Liquidity risk is a significant risk that convertible bond arbitrage portfolio managers assume.

If the principal activity of the convertible bond arbitrageur is to buy cheap volatility, the professional hedge fund investor should assess the price of convertible bond volatility not only in historical context of implied volatility in the embedded option in the convertible bond but in context of the historical volatility of the reference equity. The professional hedge fund investor should be aware of this deviation and the portfolio manager's sensitivity to it. If the deviation between these volatilities is great enough and the portfolio manager has not in fact bought the cheaper one, the portfolio may not perform well as equity options will attract the marginal buyer looking for the cheapest price for equity volatility. If the convertible bond arbitrageur's volatility portfolio consists of overpriced volatility, liquidity risk rises.

Historically, there have been several well-publicized failures in convertible bond arbitrage hedge funds due to the use of matrix pricing models to determine the funds' net asset value. Investors need to be aware of this history and pay special attention to how convertible bonds are priced.