CHAPTER 10Portfolio Management

One of the keys to both consistency and longevity in the risk arbitrage business is the trait of discipline. Over time, the concept of risk management has grown in importance in both financial institutions as well as hedge funds. Given the nature of risk arbitrage, risk management is a critical element to successfully managing risk arbitrage portfolios.

The failure of many hedge funds and large losses incurred by many investment and commercial banks has elevated the need for the risk management profession. At this stage, for hedge funds to be able to raise additional capital, risk management procedures and staffing must be in place and the proper risk management disciplines must pass inspection in potential investor due diligence examinations.

In applying risk management techniques to risk arbitrage portfolios, I have found that there was no standard packaged software available to adequately perform the risk management function. One of the primary reasons is the nature of risk arbitrage returns. Once a deal is announced, the target company's securities have different characteristics than they possessed prior to the deal announcement. Post–deal announcement, the security returns are basically binary in nature for tender offers and mergers. If the transaction is completed successfully, the portfolio manager earns the deal spread. On the other hand, if the deal is canceled, there generally is a large drop in the security's price, which results in ...

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