The following discusses one hour at Shilton Capital:
Charlene Hatchett manages a hedge fund focusing on foreign currencies. She buys currencies she considers undervalued, mostly those in countries whose economic growth potential is not reflected in the global market, and sells overvalued currencies in forward contracts in an effort to cash in on the fluctuations. During her first hour at work, Hatchett has been buying up the drang, a currency used in Extralatia, a small African country with a booming economy and an increasingly talented and educated workforce she believes is not acknowledged by the global business community. At 5 p.m. Extralatian time, or 10 a.m. Eastern time, a military coup in Extralatia’s neighboring country, Warmongaria, sends a flood of refugees running toward the Extralatian border. The new military governor of Warmongaria immediately threatens to invade Extralatia’s capital if the country allows in the refugees, many of whom are of Extralatian descent. With a few quick phone calls, Hatchett learns that two multinationals near to announcing large development projects in Extralatia are rethinking their plans because of the unrest. The political situation in Extralatia is dodgy at the best of times, and Hatchett is concerned that recent developments will wreak havoc with the currency.
Mitchell Stone runs a market-neutral sector hedge fund that takes long positions in securities Stone considers undervalued and short offsetting positions in expensive stocks in a couple of key industry groups within the industrial sector. Stone expects the stock market to decline, so he wants to seek alpha through stock selection and wash out market returns. Most of the long positions represent companies with increasing market share and strong finances, while the short positions generally represent companies with weak balance sheets, which have been punished by a choppy, volatile market in recent weeks. Today, the market opens up strong on higher-than-expected growth of the gross domestic product and optimistic news about industrial activity from the Federal Reserve. The entire industrial sector rallies, with the weakest companies – those most heavily punished in recent weeks – leading the way. Stone’s long positions are doing well, but his short positions are getting killed, more than offsetting gains in the long positions.
Carter Wainwright’s real-estate partnership owns a mix of industrial and retail properties across the Eastern Seaboard. Vacancy is low, and rental rates are rising. But at 10 a.m., Wainwright learns that the state legislature just passed a new inventory tax that will make it more expensive to store goods in Massachusetts. Several large industrial concerns immediately start trying to back out of contracts to use a half-dozen huge, newly constructed warehouses in Boston, properties expected to provide the bulk of the partnership’s revenue growth over the next year.
Lisa Cline’s partnership owns bonds issued by a number of troubled industrial and consumer companies, all of which pay yields well above the market average. At 10 a.m., Canton Metals files for bankruptcy, and Cline’s preliminary analysis suggests the company will default on its bonds, which represent about 10 percent of the partnership’s holdings.
Max Campbell is having a fine day. He attempts to beat market returns by using leverage during periods when he expects the market to rise, and using futures contracts to hedge market risk during periods when he expects the market to fall. He targets a return of 150 percent of the index in up markets. Campbell is bullish at the moment and highly leveraged, and the solid economic news has sent the market soaring.
Hatchett, Stone, Wainwright, and Cline arrive at Miller’s door at roughly the same time, panicking because they do not know how to address the risks. He meets with each one and recommends the following, in turn:
- To Hatchett: Since trading in Extralatian currency has been temporarily suspended, she should buy the currencies of neighboring countries in the region in an effort to hedge her risk.
- To Stone: He should sell some of his long positions and use the proceeds to cover the worst of the short positions.
- To Wainwright: He should do nothing.
- To Cline: She should liquidate her Canton bond position immediately for whatever price she can get before demand dries up altogether.
Which of Miller’s proposed solutions makes the least sense? Miller’s instructions for: