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Case Study: Pine Street Capital By George Chacko, Eli Peter Strick Harvard Business Publishing product number: 201071-PDF-ENG, Length: 17P To purchase the case, please visit: http://hbr. org/product/pine-street-capital/an/ 201071-PDF-ENG Due date: December 05, 2013 Questions: 1- What risks does PSC face? How has it hedged these risks historically? Should it continue to hedge these risks? Market neutral fund – fund hedged out all market risk In the past, they hedged this out by short-selling shares ofa market index – Due to the unprecedented volatility seen in the markets over the past several months, onsidering hedging by purchasing put options on the market index- Specialized in the technology sector and felt they could pick outperforming stocks in this sector o Felt less comfortable making bets on the direction of the entire market – Initially been using a short-sale strategy to eliminate general market risk from the fund which was accomplished by: oExpected PSC Portfolio Return = alpha + beta * Market Return combined with data on PSC’s portfolio holdings and market returns, PSC established a relationship between the performance of the market and PSC’s portfolio o Beta – easured how the portfolio responded to changes in the market o Alpha – amount of return in excess of that due to market risk o Therefore, beta was a measure of the market risk of PSC’s portfolio while alpha measured its expected return if market risk were eliminated – Goal was to eliminate market risk and was achieved by shorting the market (used the Nasdaq as a proxy) in proportion to the beta of the assets in the portfolio – Finding positive alpha stocks in the technology sector was exactly what PSC felt to be its comparative advantage -Long run goal of maintaining a debt ratio of

Over the past year, technology sector had been extremely volatile due to tech bubble – huge returns during 1999 and QI 2000 but declined significantly thereafter o Enormous volatility was unexpected While fund was protected due to short sale hedge, this was only partially effective o Consecutive large dips in Nasdaq had resulted in enormous losses for fund on several days, particularly in March and April of current year o Volatility had not been foreseen and firm’s models estimating beta broke down leaving portfolio under hedged o To protect fund from future periods of high volatility in the market, one of artners suggested altering hedging program and use put options – appeared to e more sensitive to market movements and would better immunize portfolio 2- How would one hedge market risk from PSC’s portfolio on July 26 using a short-sale strategy? Use Exhibit 2 o Calculate average Beta of portfolio based on weightings o Determine portfolio value o These values can be gathered from exhibit 3 o Look at exhibit 10 to determine the current QQQ share price o Short the value where the beta times that value equals the portfolio value and then back out how many shares you need to short – What problems arise from the short-sale hedging strategy? – Beta may not be a perfect indicator at this point due to significant volatility- May result in the portfolio being under/over hedged so therefore, it will be exposed to broader fluctuations in the market 4- Can Options-based hedging of market risk help with these problems? How? Options based hedging allows you to have the option to choose whether or not you want to exercise at that specific price – Given the tremendous amount of volatility, this situation would be ideal 5- How would one hedge PSC’s portfolio on July 26 using options? Felt less com o t rtable making bets on the direction ot the entire market – a relationship between the performance of the market and PSC’s portfolioo Beta – partners suggested altering hedging program and use put options – appeared to be o Look at exhibit 10 to determine the current QQQ share price oshort the value 2- How would one hedge market risk trom C’s porttolio on July 26 using a snort-sa e been using a snort-sale strategy to eliminate general market risk trom the tund which was accomplished by: oExpected PSC Porttolio Return = alpha + eta b * Market Return Pine Street Capita

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