Fixed Income Investment Strategy

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Career Paths for Financial Mathematics Graduates

Thanh-Long Huynh M.S. in Financial Mathematics (2000), The University of Chicago Lake Partners LLC, Partner K&K Capital Management, Chief Strategist Email : [email protected]

Examples of alumni career
Graduates of 2000 : Thanh-Long Huynh - Quantitative strategies for LK2 Partners Roberto Torresseti - Credit derivatives quant for IMI David Gustafsson - Software developer for a hedge fund, former VP at JP Morgan (pension fund forecasts) Graduates of 2006 : Khalil al Dairi – Algorithmic Trading Nghia Huynh – Risk Management Florent Chagnard – Global Asset Allocation

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Major participants in the Financial Industry
Banks (Investment banks & Retail banks) Hedge Funds Mutual Funds Pension Funds Life Insurance Companies Retirement Funds

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Investment Banks & Hedge Funds
Markets Equity Fixed Income & Foreign Exchange Emerging Markets & Commodity Markets Fundamental Research and Merger & Acquisitions Private Equity

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What drives profit of banks and hedge funds?
Direction of the markets (stock market, interest rates, volatility, commodities) Flows, Commissions (Prime Broker) Origination (new issues, new products) Fundamental Research, Merger & Acquisitions Asset Management Examples

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Equity Capital Market
Structure Sales & Trading Research (fundamental & quantitative) Instruments Cash (stocks) Derivatives (futures, listed options, structured products) Where to find quantitative jobs in this department The “quants” Pricers – use of quant models for clients Quantitative research – investment strategies for clients Risk Management Trading (exotic options, listed options) - Arbitrage
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Risk Management

Traders

Cash Plain Vanilla options Exotic Options

Pricers

“Quants”

Sales

Stock Structured Products

Fundamental Research

Clients

Quantitative Strategies

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Debt Capital Market
Structure Sales & Trading Research Basic Instruments Sovereign Debt (Treasury Bonds) Investment Grade Corporate Bonds High Yield Bonds Derivatives Instruments Swaps Listed derivatives Securitized products – CDO, ABS, MBS,.. Credit Derivatives
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Debt Capital Market
Quantitative Jobs in this department
The “quants” Ex: Modeling of the interest rate curve Quantitative research – investment strategies for clients Ex : Econometric analysis of Treasury-bond based on mean reversal strategy Derivatives Desk : Sales & Trading Ex : Convertible Issues (pricing) Ex : Credit Derivatives Trading (risk must be quantified) Risk Management Ex: Validation of the models – always challenging because of the constant creation of different products Ex : Control of derivatives risk exposure
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Asset Management
Financial advise to governments, corporations, endowments, foundations and individuals worldwide from traditional cash management, equity, fixed income and asset allocation to alternative asset classes such as private equity and real estate. Growing demand not just for performance but for sustainable performance with emphasis on the quality of investment styles and risk management. Quantitative Jobs Portfolio modeling Structured products Risk management

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Interviews
Do NOT go to interview without basic knowledge of finance -> value of Dow Jones, volatility of index (S&P or Eurostoxx50), LIBOR, … Examples of interview questions ->If I have a call on SPX and hundreds of calls on all the stocks in SPX weighted in the way as the SPX , what would you prefer? (Goldman Sachs, Fixed Income Strategies, 26 oct 2005) Book about interview questions : “Heard on The Street: Quantitative Questions from Wall Street Job Interviews”

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How to use the Mathematical Advantage?
Clear understanding of valuation models => Understanding of assumptions of the models and consequently the risks involved Consequences a MUST for Risk Management : interesting & challenging job without the pressure of the front office Basic rule in trading (risk / reward) : understanding involved risks in a position is necessary for a consistent trading A good asset for a sale : much more confident to explain the product

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The Importance of Computer Programming
Implementing a portfolio Ex : Global asset allocation, Statistical Arbitrage Independence and Efficiency Ex : Test of quantitative trading strategies (if 10% of strategies work : it is excellent!!!) Ex : Avoid to rely too much on ‘pricers’ Significant advantage compared to a pure mathematics person or to a new graduated MBA professional Importance of Program Trading :Program trading in the week ended Sept. 1 2006 was 31.3% of New York Stock Exchange average daily volume of 2.6 billion shares

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Tendency
Numerous opportunities in risk management with very competitive salary and bonus Fixed Income Market : Numerous opportunities in structured products, proprietary trading due to equity uncertainty Equity Market : Numerous opportunities in structured products Europe : Strong hiring in investment banks US : Many opportunities in alternative investment industry and investment banks Asia : Japan starts to recruit intensively Highest bonuses in 2005 in proprietary trading and equity markets for investment banks Highest bonuses in 2004 in proprietary trading and fixed income markets for investment banks

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Hedge Funds & Mutual Funds
Some Numbers Mutual Funds : $ 8 trillion under management Hedge Funds : $ 1.2 trillion under magagement Definition Mutual Fund : security that gives small investors access to a well-diversified portfolio of equities, bonds or other securities Hedge Fund : private pools for wealthy, financially sophisticated investors, organized as partnerships

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Differences between a mutual fund and a hedge fund
Positions Mutual funds : Long only Hedge funds : Long and Short Returns Mutual Funds : Relative to Benchmark Hedge Funds : Absolute Returns Portfolios Mutual Funds : Diversified Hedge Funds : Concentrated Leverage Mutual Funds : Little or no leverage ( a few exceptions now) Hedge Funds : Use of leverage available Derivative use Mutual Funds : not widespread Hedge Funds : significant use

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Major types of strategies for a hedge fund
Long/ Short Equity Funds : invests in relative misvaluations of companies or sectors by simulateously buying and selling securities Event-driven Arbitrage : Purchase securities expected to appreciate from a corporate event (spin-off, change of management,…) Merger Arbitrage : Purchase the Target and sells the Acquiring Company Ex: Trading the spread until consummation of the acquisition Convertible Arbitrage :Buy convertible bonds and dynamically trading the company’s equity to extract the value of the embedded option Macro currency : Invests in money markets (with derivatives) of countries with high expected real returns and finances in money markets with low expected real returns Statistical strategies : Purely quantitative strategies to take positions on all the possible markets

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Another category of fund : the fund of funds
Strategy : Invests in pool of funds Required Competences: Understanding of strategies Evaluate the risks for each fund and the risks within a basket of funds And … it constitutes almost 1/3 of all the assets in the hedge fund industry

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About Mutual Funds
Numerous categories of mutual funds: Stock Funds (54%), Taxable Bond Funds (12%), Municipal Bond Funds (7%), Taxable Money Market Funds (19%), TaxFree Money-Market Funds (3%), Hybrid Funds (5%) How to use the maths? Build up efficient portfolio relative to an index (by minimizing the tracking error)

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About Pension Funds
Definition : Forms of institutional investor, which collect, pool and invest funds contributed by sponsors and beneficiaries to provide for the future pension entitlements of beneficiaries How to use the maths? Build up long-term efficient portfolio under numerous constraints

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About my work
Manager of a multi-strategy statistical arbitrage on-shore fund (80% of my time) LK2 Partners Consultant for a fund of funds (20% of my time) Lionheart L.P. Help other people to set up their own fund to develop their own trading strategies

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One day as single-fund manager
In Chicago 8:30 : Market opens 8:30 – 10:00 : Review the positions in the portfolio (especially losses) + overview of financial newspapers 10:00 – 10:30: Discussion with the partners about the portfolio and the market 10:30 – 13:00 : Testing of new ideas 13:00 : Conference call (potential/actual manager, partners) 14:30 – 16:00 : Trading, Construction of the portfolio and update of the database 16 :00 –16:30 : Discussion and Review of the new positions (long/short/risks) with the partners

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One day as fund of funds consultant
8:30 : Meeting with Okumus Opportunity Fund Presentation of Okumus Opportunity Fund Standard Questions : risks involved with the strategy (risk exposure, liquidity, …), due diligence 10:30 : Meeting with our fund of funds advisor 12:30 : Lunch with a classmate friend 14:30 : Meeting with Laurus US fund (micro cap long only), potential new manager 16:30 : Meeting with Jolly Roger Fund (event driven), due diligence – double digit loss in 3 months

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Development of new products
Synthetic CDO 2005 : 1.6 trillion USD 2004 : 1.0 trillion USD 2003 : 600 billions USD Credit Derivatives Insurance products Used to create (synthetic) CDO Ex : Credit Default Swap (2004) : 8.4 Trillion of notional value Hybrid Funds (leverage hedge funds, option on hedge funds, hedge fund + private equity component,…) ⇒ More complex products ⇒ More work to do….and can be a good source of profit or loss…
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Appendix : Investment Process and Due Diligence
MANAGER DISCOVERY
6000+ Existing hedge fund managers

FOUR STEP PROCESS

DUE DILIGENCE
In-depth research on a selected subset of managers

PORTFOLIO CONSTRUCTION
1 to 5 new managers become eligible for funding per year

MONITORING AND RISK MANAGEMENT
Detailed monthly, quarterly and annual reviews

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Appendix : Investment Process and Due Diligence
MANAGER DISCOVERY
6000+ Existing hedge fund managers

Referrals Strong professional and personal relationships create access to a network of managers with proven track records and high potential for future success.

Screening Managers are selected based on matching risk and return profiles with expectations. Basic qualitative and quantitative screening is performed utilizing information from various sources including, but not limited to, Bloomberg, Firstcall, Compustat, Dow Jones/Reuters News, SEC filings, company interviews and discussions with competitors, suppliers and distributors.

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Appendix : Investment Process and Due Diligence
DUE DILIGENCE
In-depth research on a selected subset of managers

Qualitative and quantitative due diligence continues with a more comprehensive analysis of specific managers and an assessment of their individual investment process and business structure with a specific focus on sources of return, strategy risks and business risks.

QUALITATIVE

QUANTITATIVE

Reference check Benchmarking against appropriate indices Client base Risk/Reward study Management/Organization Volatility analysis – VaR analysis, correlation studies, etc. Professionalism of manager Peer group studies Track record Review of leverage Investment objectives Diversification Performance consistent with investment philosophy Drawdown and time to recover analysis Ability to produce appropriate returns in the future Trading style Risk management (liquidity, credit and market) Potential conflicts of interest 100% investment committee approval is required to add a new manager. Reporting capabilities Legal/Regulatory

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Appendix : Investment Process and Due Diligence
PORTFOLIO CONSTRUCTION
1 to 5 new managers become eligible for funding per year

Portfolio is constructed to achieve overall investment objectives by combining and balancing funds with appropriate characteristics and investment strategies.

Bottom-up manager selection from the best managers Top-down strategy allocation based on economic and market conditions Target returns and volatility Risk and exposure analysis: • Sector concentration/Diversification • Hedging techniques • Leverage • Stress testing • Scenario analysis

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Appendix : Investment Process and Due Diligence
MONITORING AND RISK MANAGEMENT Detailed monthly, quarterly and annual reviews

The portfolio and portfolio managers are monitored on a comprehensive and proactive basis to ensure adherence to investment guidelines and appropriate risk management. Attribution analysis of concentration by industry, position and geography Portfolio and manager level monitoring and analysis Quantitative models used to analyze risk exposures Assessment of leverage, credit and net exposures Stress tests and correlation analysis Review transparency and liquidity issues Informal review of monthly financial data Periodic audit of financial records and operational controls Adherence to investment guidelines Frequent communication with managers Ongoing review of market, manager and industry Review changes in managers’ style and investment strategy

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Appendix : Investment Strategy Breakdown

Environmental Credits Equity L/S 1% 17% Asset Backed CBO 1% Distr./Hi Yld 10% Relative Value 1% Mortgage Arbitrage 2% Conv. Arb 3%

Other 3% Eq. Mkt. Neutral 1%

Asset Backed Finance 24%

Fixed Inc. 14% CTA/ Macro 7% Stat Arb 4% Multi-Strategy 3% Event Driven 9%

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