Hedge Fund Portfolio Construction and Analysis

Abstract

Every industry experiences its ups and downs in terms of development. As for the financial sector, it has recently experienced progress mainly thanks to technology, like any other sector. This thesis is also carried out in the spirit of innovation.

The goal of this thesis is to introduce a new approach to convertible arbitrage, which is a strategy used in financial markets incorporating hedging to monetize specific opportunities. Convertible arbitrage requires two main instruments, namely convertible bonds and short positions in stocks. The thesis presents a series of assumptions crucial to the functioning and explanation of the strategy's principle. The strategy itself works on the principle of correlations between the S&P500 index and individual companies that make up the index. It helps the arbitrageur find stocks that are likely in the process of forming their price after a certain shock. Using this portfolio selection method, a portfolio for years 2019, 2020, and 2021 is constructed.

Convertible bonds can be difficult for an arbitrageur to value, mainly due to their characteristics, which are a combination of stock options and bonds. Two approaches are presented for the purpose of valuation, one of which, namely the binomial model, is later used for calculations. The methodology of the binomial model is then adapted for the case of convertible bonds. Subsequently, individual trade profiles are constructed for each trade, detailing how much a particular convertible arbitrage will cost and how much profit is expected.

This new approach to convertible arbitrage seems to have its potential, but, for example, there are certain barriers in realizing the assumptions, and the profiles of individual arbitrages themselves have revealed further shortcomings. These are discussed at the end of the chapter dedicated to the analysis of this strategy, and their possible solutions are also proposed along with a proposed approach for further study.