Jorion.01.14.
Explain directional and nondirectional market risks.
Identify hedge fund strategies that primarily expose to (i) direction and (ii) nondirectional risks [bonus #1, not in text]
Which of these risks (direction or non directional) are associated with (technically) pure arbitrage? [bonus #2]
Is the typical convertible arbitrage strategy (as explained by FRM assigned Jaegar) exposed to directional or non-directional risk? [bonus #3]
Explain directional and nondirectional market risks.
Directional risks involve exposures to the direction of movements in financial variables, such as stock prices, interest rates, exchange rates, and commodity prices.
Nondirectional risks involve the remaining risks, which consist of nonlinear exposures and exposures to hedged positions or to volatilities. Non-directional risk includes basis risk (“unanticipated movements in the relative prices of assets in a hedged position”) and volatility risk.
Identify hedge fund strategies that primarily expose to (i) direction and (ii) nondirectional risks
Directional Hedge Fund Strategies include:
Short selling
Equity long/short
Distressed security
Global Macro
Non Directional Hedge Fund Strategies include:
Equity market-neutral
Convertible arbitrage
Fixed income arbitrage
Volatility arbitrage
Event driven * (often classified into its own major category)
Which of these risks (direction or non directional) are associated with (technically) pure arbitrage?
Neither, technically arbitrage is riskless profit by the exploitation of (instantaneous) price discrepancies; ‘arbitrage’ is technically a misnomer for many, not all, strategies labeled as such.
Is the typical convertible arbitrage strategy (as explained by FRM assigned Jaegar) exposed to directional or non-directional risk?
Both! According to Jaegar, most convertible arb strategies earn returns from three sources:
(i) static returns. These typically contain at least a directional component; e.g., exposure to interest rates
(ii) gamma trading on stock volatility. Nondirectional.
(iii) exploiting price inefficiencies. Nondirectional.
This relates to the alpha/beta separation debate: most hedge fund strategies in fact are exposed to systemic, directional (beta) risks even where the beta may be “disguised” by apparent alpha