L/S credit case study
What is the best way to think about and approach a L/S credit fund case study involving arbitrage trades around different tranches in the capital structure? I’m aware of the most notable books, I’m more looking towards practical advice from practitioners and people who have gone through the process.
When tackling a L/S credit fund case study, especially one involving arbitrage trades around different tranches in the capital structure, it's crucial to blend theoretical knowledge with practical insights. Here's a structured approach based on insights from the WSO Dataset:
Understand the Capital Structure: Start by thoroughly understanding the company's capital structure. Identify all the tranches of debt and equity, including seniority levels, interest rates, maturity dates, and any covenants or special features. This foundational step is critical for identifying arbitrage opportunities.
Analyze Market Conditions: Assess the current market conditions and how they affect different tranches. For example, in distressed scenarios, senior debt might be trading at a significant discount, presenting an opportunity for arbitrage between tranches.
Identify Mispricings: Look for mispricings between tranches that don't accurately reflect their relative risk. This could be due to market inefficiencies, changes in the company's outlook, or broader economic factors. The key is to find discrepancies that you can exploit.
Evaluate Arbitrage Opportunities: Once you've identified potential mispricings, evaluate the arbitrage opportunities. This involves calculating the potential return and risk of each trade. Consider both the long position (e.g., buying undervalued senior bonds) and the short position (e.g., shorting overvalued junior bonds or equity).
Construct Your Trades: Based on your analysis, construct trades that exploit the identified arbitrage opportunities. Ensure that your trades are hedged to minimize risk. For example, you might go long on senior bonds while shorting junior bonds or equity to capitalize on mispricings within the capital structure.
Risk Management: Critically assess the risks associated with your trades. This includes company-specific risks (e.g., bankruptcy risk, covenant breaches) and market risks (e.g., interest rate changes, economic downturns). Develop strategies to mitigate these risks, such as setting stop-loss orders or diversifying your positions.
Prepare Your Presentation: When presenting your case study, clearly articulate your analysis, the rationale behind your trades, and how you've managed risk. Use data and charts to support your arguments. Be prepared to defend your strategy and discuss potential outcomes under different scenarios.
Remember, practical experience and insights from practitioners are invaluable. Engage with forums like WSO, where you can find discussions and advice from people who have navigated similar case studies. This real-world perspective complements the theoretical knowledge from books and can significantly enhance your approach to L/S credit fund case studies.
Sources: Distressed debt / special sits investing - On the job, Starting a small hedge fund, Starting a small hedge fund, L/S Credit HF Analyst - Q&A, Q&A: Currently at a Credit Hedge Fund
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