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Alternative Assets in Hedge Funds

An alternative investment is anything other than stocks, bonds, or cash. Hedge fund managers, sniffing out opportunities to meet their investment objectives, often turn to alternative assets.

Hedge funds rarely purchase raw land for investment purposes, but they may provide lending to real estate investors, help finance construction projects, or take shares in mineral projects.

A hedge fund probably won’t buy commodities outright, but it may take a stake in them in one of a few different manners:

  • By purchasing real estate that generates income from commodities produced

  • Through futures contracts, which change in price with the underlying commodities

  • By managing its stock investments based on the exposure of the company issuing the stock to different commodity trends

Many hedge funds are in the business of taking on high risk in exchange for potential high returns, so venture capital fits neatly. Some hedge funds become partners in venture capital firms, and others seek out promising new businesses to invest in directly.

To manage risk, hedge funds often use derivatives, financial contracts that draw their value from the value of an underlying asset, security, or index.

Hedge funds sometimes use options to manage risk or to profit from price changes. An option is a contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at an agreed-upon price at an agreed-upon date in the future.

Hedge funds sometimes use warrants and convertible bonds to manage risk or to profit from price changes. A warrant is similar to an option, but it’s issued by a company instead of being sold on an organized exchange.

Futures contracts are useful for hedge fund managers who want to lock in prices. They also give managers exposure to commodity prices without having to handle the actual assets.

In many cases, a hedge fund manager uses forward contracts to cover a futures contract; the manager locks in the current price in hopes that the future value is different, creating a profit on the difference. The difference is known as the spread.

A swap is an exchange of one cash flow for another. Say a company has issued bonds that pay interest in U.S. dollars, but decides to incur expenses in Japanese yen to offset profits that it makes in Japan. The company finds another company making payments in yen that would rather be making payments in dollars, and they swap payments. As a result, each company can better manage its internal currency risk.

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