Case Study of Pine Street Capital

Managing Risks in Times of Volatility

Reported by:
Graduate Students

Table of Contents
I.
II.
III.

Abstract
Introduction to Hedge Funds
Risk Assessment and Solutions: the Short Selling

IV.

Strategy
Risk Assessment and Solutions: the Put Options

V.

Strategy
Conclusion

I.

Abstract
Pine Street Capital (PSC), founded in 1999, is a hedge fund specializing in the

technology sector. Having strong backgrounds in engineering, sciences, and

finance, the partners of PSC sought to generate alpha by identifying stocks in the
technology sector that were mispriced. To remove systematic risk from their
portfolio, they had the choice of short-selling a benchmark index, or using put
options on the index. In this report, we evaluate which of the two strategies is more
viable, considering the nature of PSCs operation, and we propose a way by which
PSC can successfully hedge its equity market risk in a broad range of market
scenarios. While PSC initially hedged the risk with a short-selling strategy, we
consider the benefits associated with switching to an option-hedging program.
We begin by introducing the basic concepts of hedge funds, with a focus on the
the differences between hedge funds and mutual funds. Next, we describe the
short-selling strategy and discuss its drawbacks, particularly as related to PSC.
Finally, we introduce the method and importance of options-based hedging, and
conclude that in the case of eliminating PSCs systematic risk, an options-based
strategy is ultimately more viable.

II.

Introduction to Hedge Funds

Hedge funds are private group investments that offer equity pooling advantages
similar to mutual funds. Because they are not regulated to the degree that mutual
funds are regulated, hedge funds can be managed very aggressively, employing,
derivatives and leverage to generate high returns.
Some other important differences between hedge funds and mutual funds include:

(1) Hedge funds are formed as limited liability partnerships. As a result, they are
not required to disclose the composition of their portfolio or their portfolio strategy,
unlike mutual funds, which require public disclosure of strategy and portfolio
composition in the form of a prospectus;
(2) Hedge funds generally only have up to 100 individual investors, all of which
must be accredited and make an initial investment of generally no less than
$250,000; this is not the case for mutual funds;
(3) Hedge funds lack regulation compared with mutual funds, so their investment
strategies are very flexible. Hedge funds can also act opportunistically and make a
wide range of investments, unlike mutual funds, which generally remain constrained
to a certain strategy or benchmark as stated in the funds prospectus;
(4) Hedge funds have lock-up periods, and require advance redemption notices,
but mutual funds have much higher liquidity, and can move an investment in and
out much easier;
(5) Hedge funds charge management fees around 1-2% of assets and sometimes
charge an incentive fee of 20% of profits, while mutual funds only usually charge a
fixed fee as a percentage of assets, typically 0.5% to 1.5%;
(6) Hedge funds can use leverage, which provides a higher return on the
portfolios equity, compared with an all-equity-financed portfolio. Hedge fund can
also use options, while mutual funds are more restricted in their use of both of these
strategies.

III. Risk Assessment and Solutions: The Short Selling Strategy

Generally, all funds are faced with two types of risks: market risk and firm-specific
risk. PSC is no exception.
Skilled managers are usually knowledgeable and confident in specific industries
and fields, which shapes their investing preferences and therefore leads to
differentiation in the mutual fund market. Because PSC was formed by a group of
managers who specialized in technology sector, this hedge fund had a remarkable
understanding of firms and stocks in this sector. On the other hand, PSC did not
consider itself an expert in predicting movements of the entire market. As a result,
PSCs natural preference is to eliminate the market risk and retain only firm-specific
risk.

Tomorrows Value

Today

Initial Value

Bet
a

Alp
ha

NASDAQ
+10%

(in millions)

NASDAQ -10%
(in millions)

(in millions)

Long
Portfolio

$ 34.554

1.65

3.35

$ 41.413

$ 30.010

Short
NASDAQ

$ 57.014

1.65

3.35

$ 51.312

$ 62.715

TOTAL

$ 91.568

$ 92.725

$ 92.725

Figure 1: Hedging by Short-Selling on July 26th, 2000

PSCs past strategy of removing its market risk was to short sell a market index
(the NASDAQ 100 was used based on its coefficient of determination or r 2 with the
portfolio). By way of an example, we show how the strategy would have been
implemented on July 26, 2000, at which time PSCs portfolio was worth $34,553,799
and had a beta relative to the NASDAQ 100 index of 1.65. To find the total dollar
amount to sell short, we multiplied total portfolio value ($34,553,799) by beta
(1.65), which yields $57,013,768.35. Using the share price of QQQ as of July 27th,
2000 ($95.63), we calculated that PSC would need to short sell
($57,013,768/$95.63) or 596,191 shares of QQQ in order to hedge away the risk
from overall market volatility. We show the results of this strategy in the case of a
10% increase and 10% decrease in the NASDAQ 100 index in Figure 1.
A significant deficiency of this short selling hedging strategy came to light over
time. By the end of the 20th century, a technology boom generated drastic
fluctuations in related industries. Per investors and funds, that was a period when
things went completely off track. Nothing seemed to move in accordance with its
historical beta. Managers with PSC suddenly figured out that the strategy which
they have been using could fail when the market deviated from its usual patterns,
resulting a breakdown of their prediction model and short-sale-based programs.
Such strategy proved vulnerable to unforeseen market changes. Furthermore, the
short selling strategy also eliminated the potential benefits of upside market
movements in the process of hedging away the downside risk.
With all the tradeoffs in mind, PSC started to consider a new hedging strategy
that could enhance the advantages and avoid the disadvantages. PSC then moved
into using derivative instruments to hedge their positions in the stock market. This

was a great strategy for a firm with great knowledge of a certain sector, in this case
PSC and their expertise in the technology sector. A major advantage that the option
strategy had over short selling was its protection against volatility. Empirical studies
have shown during the peak of the tech bubble, over half the notional value
underlying aggregate hedge funds put holdings were in the technology sector, so
during periods of increased volatility, it was advantageous for PSC in terms of price
directions and volatility. Options are associated with low after-fee return volatility,
higher Sharpe ratios, and greater excess returns relative to the style benchmark
compared to non-option-based portfolios. As Aragon and Martin estimate an
increase in directional put positions from 0% to 10% is associated with a 35 basis
point increase in monthly excess returns (Aragon, 2012).

IV.

Risk Assessment and Solutions: the Put Options Strategy

Next, we discuss a strategy to replace PSCs short-sell hedging strategy with one
that employs put options. As discussed, while the short-short selling strategy can be
an effective hedge against equity risk during periods of relative stability in the
market, this strategy has serious drawbacks in times of volatility. The first step in
short-selling is determining how many shares of the index to sell short. This is
determined by multiplying the number of shares of the index ETF corresponding to
the portfolio value by beta. Thus, the approach relies on the ability to predict beta,
or the degree to which a stocks returns are correlated with those of the market.
Beta is calculated by taking the slope of the linear regression between an
individual security's returns and the returns of the market over a certain time
period. The time period over which observations are gathered should be sufficient to
produce a statistically significant result. Bodie, Kane, and Marcus use monthly
returns over 60 months or five years to determine individual stock betas. The

problem with this approach is that sudden events in the market make beta difficult
to calculate, and inaccurate at best, particularly over short time horizons. Over a
short time horizon where large fluctuations are observed, it may even be impossible
to determine beta with any degree of statistical significance, let alone predict stock
returns based on a historical beta.
Technology stocks are associated with higher levels of volatility (Ararwal, 2014).
Thus, even if beta is able to be determined with statistical significance, it may not
be meaningful or useful as a forecaster of stock performance, given the frequency
with which technology stocks go in and out of favor.
Thus, over a short time horizon or period of volatility, the short-selling approach
fails due to the difficulty with calculating beta. A better, though more costly option
in this scenario, is to hedge risk using puts. We propose using a long put strategy to
effectively insure against the risk of market decline, while retaining some upside
potential.
Figure 2: Calculating the Delta using the Black-Scholes Model

To calculate the number of puts to buy, we use data provided in Exhibit 10 in

combination with the Black-Scholes model to first derive the implied volatility of put
options. An at-the-money put with strike price of K=$95.00 was used to calculate
implied volatility (49.65%). Using the implied volatility, we then calculated the value
of delta (0.4421) which we in-turn used to determine the number of puts to
purchase based on an index share value of $95.63 on July 27th and a multiplier of
100. It was determined that to hedge the portfolio holdings as of July 27th, 8173
puts would need to be purchased at a total premium of $34,735 (the cost of this
strategy was calculated simply by multiplying the premium, which we took as the
ask-price, of the put option by the number of options purchased).

V.

Conclusion

In this report, we investigated the advantages and disadvantages of PSCs two

hedging strategies. We determined which strategy is more viable under certain
market conditions. At last, we illustrated why PSC decided to utilize an option hedge
strategy to manage the risk rather than continuing their strategy of short-selling an
amount of the index based on portfolio beta.
Our conclusion is that to hedge using short selling, on July 27 th, 2000, PSC would
need to short sell $57,013,768.35 worth shares NASDAQ index, or 596,191 shares.
This would effectively eliminate the market risk. However, we conclude that the
short selling strategy does not protect against high market volatility. This approach
fails when beta is compromised by high volatility. As a result, we used Black-Scholes
pricing model to determine a comparable strategy using options. In this strategy,
we determine that to hedge the market risk, PSC would need to buy approximately
8173 put contracts to fully insure their portfolios risk.

VI.

References

Agarwal, Nipun. "Buying High Return Low Volatility Technology Stocks." Economics,
Management and Financial Markets 9.3 (2014): 73-85. Web.
Aragon, George O., and J. Spencer Martin. "A Unique View of Hedge Fund Derivatives
Usage: Safeguard or Speculation?" Journal of Financial Economics 105.2 (2012):
436-56. Web.
Bodie, Zvi, Alex Kane, and Alan J. Marcus. "20,21,23,26." Investments. Boston, MA:
McGraw-Hill Irwin, 2014. N. pag. Print.
"Implied Volatility Calculator." Implied Volatility Calculator. Vindeep, 17 Nov. 2015.
Web. 17 Nov. 2015.
"Black-Scholes." Calculator Online. Fintools, 17 Nov. 2015. Web. 17 Nov. 2015.