A hedge fund is a type of investment vehicle that typically pools money from investors and invests in some form of security, such as stocks, bonds, real estate, or derivatives. Investors can also invest directly in the hedge fund. Hedge funds are often associated with high levels of risk because they may magnify returns when certain conditions are met but also carry a higher chance of losing money than an investment portfolio might. A hedge fund aims to generate profits through generally accepted market strategies, including:
In the event of a market crash, it is vital to have a hedge fund that can use debt instruments like credit default swaps and collateralized mortgage obligations. These strategies can help hedge funds mitigate risk and reduce the potential for significant losses. Credit strategies are also used to increase returns when markets are strong.
A hedge fund may invest in stocks, bonds, or other securities. Equity strategies are generally used to magnify returns during volatile market conditions.
Equity strategies may include:
- Buying shares of a company before it goes public
- Buying and selling options on the same underlying asset
- Buying and selling derivatives such as call options and put options
- Trading futures contracts on various commodities like oil or gold
- Trading currency futures contracts
- Trading interest rate swaps
In the event-driven strategies, the hedge fund manager is betting on a particular event happening in the future. The typical example of this type of strategy would be betting that a company will announce a significant acquisition at some point in the future.
Global macro strategies
The global macro strategy is a type of hedge fund that invests in the financial markets on a global scale. It aims to buy options to profit from market fluctuations. This strategy has a wide range of potential risks and rewards, but its main aim is to capitalize on volatility in the stock market.
Arbitrage or Relative value strategies
An arbitrage strategy is a hedge fund’s strategy of investing in two or more related markets in order to exploit the difference in prices. For example, a company may issue shares on one market but borrow money on another. The hedge fund would purchase shares on the first market and sell them on the secondary market, generating capital gains.
A relative value strategy is a hedge fund’s attempt to profit from price differences between related investments using leverage.