Hello, I'm having a hard time understanding the sentence in bold. This is from the core reading highlighting some examples of how derivatives can be used and I don't follow the example put here. I understand the concept of long/short portfolios but not the example given and how that fits into the long/short scenario. Any assistance would be much appreciated. Thank you. Long / short portfolios – derivatives allow a portfolio comprising long and short exposures to be built up, including on a leveraged basis. Many absolute return managers isolate particular asset exposures and aim to access these in their portfolios whilst hedging out other risks. For example, a manager could go long the US investment grade credit spread vs the Euro investment grade credit spread by using credit default swaps. Such a strategy could additionally make significant use of derivatives to hedge currency and interest rate risks.
Hi, Yes this is intended to be an example of a long/short trade. Quite a complex one to be honest. My feeling is that this involves taking a credit (such as Microsoft) which has debt trading in both dollar and Euro markets, and where there are marketable CDSs in both markets. As the chance of default of Microsoft should be the same in either market, the cost of a Euro CDS should be the same as a dollar one, but they are probably different. If you go long of the cheaper one where you have to pay a low annual cost, and sell the expensive one where the counterparty pays you the higher CDS fee, then you make a "risk free" profit and have no market risk. As one stream is in dollars and the other in Euros you would have to swap one to make sure you didnt have a currency risk. And if the position exposed you to two different points on the yield curve (eg a CDS on a 5 year bond and a CDS on a 7 year bond) then an interest rate hedge would also have to be considered.
