Alternative Investments: CAIA Level I, 3rd Edition

CHAPTER 19 Relative Value Hedge Funds

Relative value strategies attempt to capture alpha through predicting changes in relationships between prices or between rates. For example, rather than trying to predict the price of oil, a relative value strategy might predict that there will be a narrowing of the margin between the price of oil and the price of gasoline.

19.1 Overview of Relative Value Strategies

Relative value fund managers take long and short positions that are relatively equal in size, volatility, and other risk exposures. Ideally, the combined positions have little net market risk but can profit from short positions in relatively overvalued securities and long positions in relatively undervalued securities. Relative value funds tend to profit during normal market conditions when valuations converge to their equilibrium values. Convergence is the return of prices or rates to relative values that are deemed normal. Since returns to these convergence strategies are normally very small, managers have to employ substantial leverage to generate acceptable returns for these strategies. Therefore, relative value funds can experience substantial losses during times of market crisis, as leveraged funds may be forced to liquidate positions and wind down leverage at times when relative values appear dramatically abnormal.

Within the relative value class of hedge funds, four styles will be discussed: convertible bond arbitrage, volatility arbitrage, fixed-income arbitrage, ...