Monthly Archives: August 2008

Hedge fund early redemption fees

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It was very common a couple of years ago, after the hedge fund registration rule, for funds to institute lock-ups of two years or more. After the hedge fund registration rule was effectively vacated by the courts, the lock-ups came down. Many hedge funds now have shorter lock-ups and many choose to go with a 1 year lock-up.

Whatever the time horizon, the issue often arises as to what to do when an investor needs to get out of the hedge fund because of an extreme personal emergency. Almost all hedge fund documents will give the manager the flexibility to allow a redemption in such an instance.  However, by doing so, the manager may be disadvantaging the other investors in the hedge fund (including the manager himself).

To discourage early requests for withdrawal (and to compensate the manager or other investors for the potential disadvantage of having to reposition the fund), the manager can institute an early redemption fee. The early redemption fee is simply a fee which is deducted from the withdrawal proceeds. The early redemption fee can be paid to the hedge fund manager, the hedge fund investors, or a combination of the two. The early redemption fee can range anywhere from 1% to 10% with a majority in the range of 2% to 5% of the withdrawal proceeds. Obviously, the exact amount a manager charges will depend on his investment strategy and the extent to which an early withdrawal would disadvantage the other investors and manager.

Discussion: Options on futures

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What Are Options?

There are two basic types of options on futures contracts: “calls” and “puts.” A call option on futures contracts conveys the right (but not the obligation) to the buyer to purchase a specific futures contract (for example, a corn contract for a December 1997 delivery month) at a particular price during a specified period of time. A put option conveys the right (but not the obligation) to the buyer to sell a specific futures contract at a given price during a specified period of time. The price for which the futures contract can be bought (in the case of a call option) or sold (in the case of a put option) under the terms of the option contract is referred to as the option’s strike price or exercise price. The date on which an option expires–the date after which it can no longer be exercised–is the option’s expiration date. The price of a specific option, that is, the amount of money paid by the buyer of an option and received by the seller of any option, is the option premium.

Where Are Options Traded?

Options are traded on the same exchanges as those of the underlying futures contracts. There are 11 different commodity exchanges in the U.S. as well as abroad. The major domestic agricultural crops are traded on the Chicago Board of Trade, the Kansas City Board of Trade, the Minneapolis Grain Exchange, the New York Cotton Exchange, and the Coffee, Sugar and Cocoa Exchange.

How Are Options Traded?

Options contracts are traded in much the same manner as their underlying futures contracts. There are several important factors to remember when trading options. The most important one is that trading a call option is completely separate and distinct from trading a put option. If producers buy or sell a call option, it does not in any way involve a put option. Trading a put does not involve a call option. Calls and puts are separate contracts, not opposite sides of the same transaction.

At any given time, there is simultaneous trading in a number of different call and put options–different in terms of delivery months and strike prices. Option delivery months are typically the same as those of the underlying futures contract.

Strike prices are listed in predetermined multiples for each commodity. The listed strike prices will include an at- or near-the-money option, at least five strikes below, and at least nine strikes above the at-the-money option. At-the-money is defined as an option whose strike price is equal–or approximately equal–to the current market price of the underlying futures contract. The five lower strikes would follow normal intervals. The nine higher strikes would include five normal intervals above the at-the-money option(s), plus an additional four strikes listed in even strikes that are double the normal interval. As prices increase or decrease, additional strike prices are listed as needed so that there are always five strike prices listed in normal intervals and four strike prices in double intervals above the current futures price, and at lease five strike prices below the current futures prices.

An important difference between futures and options is that trading in futures contracts is based on prices, while trading in options is based on premiums. The premium depends on market conditions such as volatility, time until expiration, and other economic variables affecting the value of the underlying futures contract. How various factors influence premiums and how and to what extent market price declines are offset by option profits are among the topics to discuss in detail with a broker.

The premium is the only part of the option contract negotiated in the trading pit; all other contract terms are predetermined. For an option buyer, the premium represents the maximum amount that he or she can lose, since the buyer is limited only to his initial investment. For an option seller, however, the premium represents the maximum amount he or she can gain, since the option seller faces the possibility of the option being exercised against him or her. When an option is exercised, the futures position assigned to an option seller will almost always be a losing one, since only an in-the-money option will normally be exercised by the option buyer.

Why Should Producers Consider Options?

Amid the perceived complexity of options, there is one feature that is especially important to hedgers: options offer price protection without limiting profit potential. This follows from the fact that the buyer of an option has the opportunity, but not the obligation, to buy or sell a particular commodity at a certain price for a limited period of time. The buyer’s risks are known up front and are limited. For producers, that means obtaining protection against declining crop prices without giving up the opportunity to profit if crop prices increase.

What is a “gate” provision?

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A “gate” provision is a hedge fund manager’s right to limit the amount of withdrawals on any withdrawal date to not more than a stated percentage of a fund’s net assets — often 10% to 25%, depending on how frequently investors have a right to withdraw capital. Gates are a very common feature in hedge funds of almost all strategies. Imposing a gate slows a potential “run on the fund” by forcing investors to wait until the next regular withdrawal date to receive the unfulfilled balance of their withdrawal requests. Gates are especially important for hedge fund strategies which are more illiquid like MBS strategies.

Deciding on a strategy for your hedge fund

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One of the most critical questions that a soon-to-be hedge fund manager must ask themselves is this: what exactly is my strategy going to be and (most importantly) is this a strategy I can sell to potential investors. Of course the strategy must be sound and must be something that the manager knows – this is not the time to begin experimenting.

It is most common for a manager to continue on with a strategy which he has been running for a long time, either on the side or with a previous employer. For many different reasons (fear, greed, uncertainty) the manager may decide to implement a dual strategy hedge fund . Often the dual strategy hedge fund will have a more conservative strategy and a more aggressive strategy. The dual strategy approach is different from a principal protection hedge fund and is more than simply hedge fund risk management procedures.

Whether a manager decides to utilize a dual strategy approach is business consideration. If you are running two strategies – a major and minor strategy – then you are going to be, at least somewhat, internally conflicted when it comes to time management, especially if the minor strategy is a time intensive strategy. It might be that the higher returns from the minor strategy (instead of, say, a money market) may not be high enough to justify the time necessary to achieve those higher returns. If that time cuts into the time for the major strategy, then you are probably going to be better off focusing in on your major strategy.

Like anything, when you focus on one trading program, especially for smaller, non-institutionalized fund managers, you are generally going to be better able to perform.