Alternative Investment Capital Gains

ALTERNATIVE INVESTMENT

What is an Alternative Investment?

An investment that is not one of the three traditional asset types (stocks, bonds and cash). Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, limited regulations and relative lack of liquidity.

Alternative investments include hedge funds, managed futures, real estate, commodities and derivatives contracts. Alternative investments are favoured mainly because their returns have a low correlation with those of standard asset classes.

HEDGING & HEDGE FUNDS

What is Hedging?

Hedging is the practice of limiting/minimizing one’s risks. It can serve as an effective tool to stabilize the returns one earns on their investments and limits the losses occurring in an unexpected turn of events. It usually involves some cost or giving up some return in exchange for more safety.

Example: Airline A is uncertain about the future prices of fuel and wants to hedge its risk. It can get into a contract of buying fuel at some fixed price on a future date. Such a contract is called a forward contract. Airline A is thus indifferent to changes in the fuel prices since it has locked in its purchase price.

Hedge Fund B, who doesn’t need fuel, gets into the similar forwards contract where he agrees to buy fuel at a fixed price on a future date, expecting fuel prices to increase. If the fuel prices actually increase the hedge fund makes money by buying fuel on the fixed price and selling on the market price. However, if the fuel prices dip, the hedge fund makes a loss (In a practical situation though, the hedge fund will square off the contract rather than actually waiting till the maturity date to purchase the oil physically and then sell it.)

Applications:

Companies or individuals hedge in order to reduce their risk exposure as mentioned in the above example. One can hedge the input / output prices, returns on an investment, etc. Speculation provides liquidity in the market by many a times forming the counter-party of a hedger.

What is a Hedge Fund?

Hedge funds are alternative investments using pooled funds that may use a number of different strategies in order to earn active return, or alpha, for their investors. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).

DERIVATIVES:

When an investor buys a security or for that matter makes any kind of investment, he bears various kinds of risks. Take an example of the investor, John buying an orange farm in Florida. He is betting on things such as weather conditions in Florida, the prices of oranges etc. He is confident about his farming skills but he has no way to forecast the future prices of oranges and weather condition in Florida. He wants to do the farming, but without the risks involved in the business. Weather conditions and variability in oranges prices in future are the main cause of risk in this context. This is where derivatives come into picture.

Definition: Derivatives, as the name suggests are the financial contracts between two counter-parties that derive their value from some underlying asset. The underlying can be a stock, interest rate, bond, commodity, currency or anything under the sun that can be measured. (In strict sense interest rate is not an asset, but there are some derivative products such as interest rate swaps which derive their value from interest rate movement.) For example, trading of weather derivatives is quite common in United States. The value of the derivative is a function of the value of the underlying.

Derivatives basically fall into two categories - Forwards (includes forwards, futures, swaps, etc) and Contingency Claims (includes options).

Applications: Two main applications of derivatives are hedging and speculating. There is no clear demarcation between hedging and speculating. General understanding is that one who owns the underlying is hedging his risk whereas the one who enters into a position (long / short) without holding a position in the underlying is said to be speculating.

We will continue the above mentioned example of John and try to hedge his risks by using the various kinds of derivatives.

John is bothered about the prices of the Oranges 2 years down the line, when his crop will ripe. He wants to fix the price that he will get by selling his Oranges. He meets a merchant who is looking to buy Oranges two years down the line. He negotiates for the price and gets into a contract to sell him the oranges on a date two years later. This is a simple example of a forward contract.

VENTURE CAPITAL (VCs)

What is 'Venture Capital'?

Money provided by investors to start-up firms and small businesses with perceived long-term growth potential. This is a very important source of funding for start-ups that do not have access to capital markets. This form of raising capital is popular among new companies or ventures with limited operating history, which cannot raise funds by issuing debt. It typically entails high risk for the investor, but it has the potential for above-average returns. Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in addition to a portion of the equity.