The CDO Strategy
The US housing boom seemed to have slowed down. Mortgage companies’ shares were also going down, and the Federal Reserve had begun raising interest rates. However, Hedge fund Magnetar Capital was making profits and had even returned a 27% with a gain of almost over $1 billion. Magnetar had a strategy that other investor did have. The approach revolved around some securities that are backed by fixed-income assets such as bank loans, bonds, mortgages among others all being referred to as CDOs. Magnetar’s strategy was on equity tranches of CDO’s and its derivative instruments. Magnetar discovered that certain tranches of CDOs are always in one way or another systematically mispriced (Stonewell, 2009) . This being the case, with the belief that at one point, the securities will be unstable; the company took advantage of this opportunity and leaped in on securities that were probable of being stable but still were attractive or had huge returns. Magnetar spawned CDOs and bought the most risk ones fetching a yield of over 20% when stable. The company further hedged by betting against fewer risk securities and other CDOs. Magnetar conducted own analysis and made calculations on risks involved on each tranche of security by comparing the returns it fetches. Through this method, it was discovered that a set of two similar securities had related perils but fundamentally, would yield different outcomes (Stonewell, 2009) . This was the inception of Magnetars strategy, to take advantage of the abnormality.
The Peloton, on the other hand, believed in a strategy that focused on going for highly related securities backed by mortgage and loan. Peloton assumed that the panicking investors were throwing baby tantrums. However, this was a misunderstanding of the subprime crisis. Peloton was unable to sell the securities as brokers were unwilling to bid thus the firm ran out of liquidity. Similarly, Magnetar strategy was different from Paulson's approach in several ways. While Magnetar was focusing on mispricing anomalies in the market, Paulson was concerned with the market view itself (Stonewell, 2009) . Paulson strategy was on betting that the company’s shares will rise towards the offer price and the bidders will fall. This was no different from Magnetar's strategy.
Delegate your assignment to our experts and they will do the rest.
Magnetar’s Strategy Correlation Trade
Interestingly, Magnetar’s approach was basically a capital structure arbitrage strategy. This strategy was and is still being widely used and adopted by companies especially in corporate markets. The plan’s focus is on the relative values between deferring components in an entity’s capital setup or structure. This is also a relation on a company’s supply and demand flows or imbalances and the current systematic value mispricing in equity tranches and securities. Considering this situation, one discovers that indeed this strategy is purely a Magnetar's strategy merely a correlation trade whereby comparison is drawn between two things. For instance, Magnetar was able to foresee and compare the two sets of a given CDOs and the different profit they would fetch. Considering how the strategy works, if Magnetar buys $100 of a CDO equity and takes a short position in the senior tranches and mezzanine, it is evident that Magnetar would make a return of $15 per year. However, when only the equity tranche is entirely exhausted, and there is no debt tranche, Magnetar loses approximately $105. This analysis indeed explains how Magnetar would lose money (Stonewell, 2009) .
The ABX.HE and DX.NX.IG Indices
Recently, there have been innovations of several indexes to cover growing segments of the credit market especially basing on the problems that emerged with the US sub-prime mortgage market. These indices include; the ABX.HE which tracks CDS especially covering the American sub-prime residential mortgage-backed securities otherwise referred to as RMBS. This epitomizes how Magnetar can replicate their trading strategy the ABX.HE indices. On the other hand DX.NX.IG is a secondary index; this index workability posits that security in which price depends on or is derived from one or more underlying assets. Different trading corporations and other fixed income entities always employ the usage indexes to achieve different results. Significantly, they are applied in situations where hedging is required. A good example is where a company owns a bond and has foreseen or believes that the bond will or may be affected or suffer price turn down for a reason related to financial deterioration of the economy or the issuer. In this scenario, the company will immediately buy protection on the bonds name with a single name CDS (Stonewell, 2009) . The rationale here is to increase or raise the bond’s value and avoid losses especially the situation where the same price is on a free fall downwards .
Peloton’s Liquidity Crisis and the Role of UBS
In 2008 Peloton became bankrupt. The company had borrowed heavily majorly to finance and boosts the company’s returns. The borrowing was also used to purchase bonds. The company had shorted the US housing market profitably prior to going down during the subprime crisis. Interestingly the Peloton opted to employ a strategy of going long on AAA-rated securities that are backed by forms of mortgages loans and levered 9x. In this regard, therefore, the company had aimed at surviving and redeeming itself, however same year, the American UBS marked down the value of the most rated mortgage securities. These were securities that Peloton was relying on. In this regard, Peloton was under pressure especially in disposing and selling these securities as fast as possible basing on UBS speculation. This situation made Peloton's security drop; this was in an attempt to find additional funding to raise cash. However, banks were not willing to neither help nor provided any bids on the securities or delay margin calls (Stonewell, 2009) . This was the core reason why Peloton indeed went into a liquidity crisis and massive losses thereby closing down .
J.P. Morgan’s “London Whale” Trade
In 2012, JPMorgan's Chief Investment Office incurred a tremendous financial loss, the losses were related to some transactions in their London branch by employing some forms of secondary operations as a bank's hedging plan, and this loss was nicknamed the ‘London Whale.' This loss was related to the 2007/2008 financial crisis. In the whale trade, the trader Iksil had several trading strategies referred to as packages. Here JPMorgan opted to purchase CDS on high yield bonds with the belief that the bank will make more profits if the high yield bonds would go down. In the same breath, J PMorgan had written a substantial amount of CDX.NA which significantly formed the basket of all the CDS especially on investment bonds from different stakeholders. There was a belief and probable chances that JPMorgan would earn some money when the economy tilted downwards, however, this did not happen as the economy substantially improved. This being the case, the trader opted to write CDS on investment-grade bonds is intended majorly with an intention to swoop on the advantage of significantly developing a financial system (Stonewell, 2009) . However, when this failed to materialize, Iksil the trader opted to recover by making JPMorgan buy CDS on investment-grade bonds thereby resulting in the losses.
Magnetar’s strategy focused on purchasing hedges out-of-the-money credit protection via CDS and also bought additional CDS protection on the mezzanine tranches in which Magnetar had no equity ownership interest. Magnetar being the initial purchaser of the equity had the belief that they would earn significantly more profit money where or if the said CDOs performed well in the market as compared when they played poorly. Examining the two cases, it is clear that JPMorgan had the same logic (Stonewell, 2009). However, in London whale case this strategy did not succeed making it slightly compatible with the Magnetar strategy.
References
Stonewell, D. (2009). A tale of two hedge funds: Magnetar and Peloton . Kellogg School of Management.
