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An Overview of Mathematical Finance
Mathematical finance is the branch of applied mathematics concerned with the financial markets . The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory. Generally, mathematical finance will derive, and extend, the mathematical or numericalmodels suggested by financial economics. Thus, for example, while a financial economist might study the structural reasons why a company may have a certain share price, a financial mathematician may take the share price as a given, and attempt to use stochastic calculus to obtain the fair value of derivatives of the stock . In terms of practice, mathematical finance also overlaps heavily with the fields of financial engineering and computational finance . Arguably, all three are largely synonymous, although the latter two focus on application, while the former focuses on modelling and derivation; see Quantitative analyst . Contents 1 Mathematical finance articles 1.1 Mathematical tools 1.2 Derivatives pricing 2 See also 3 External links 3.1 Theory 3.2 Research Mathematical finance articles Mathematical tools Calculus Differential equation Numerical analysis Real analysis Probability Probability distribution Binomial distribution Log-normal distribution Expected value Value at risk Risk-neutral measure Stochastic calculus Brownian motion Lévy process Itô's lemma Fourier transform Girsanov's theorem Radon-Nikodym derivative Monte Carlo method Partial differential equations Heat equation Martingale representation theorem Feynman Kac Formula Dynkin formula Stochastic differential equations Volatility ARCH model GARCH model Stochastic volatility Mathematical model Numerical method Numerical partial differential equations Crank-Nicolson method Finite difference method Derivatives pricing Rational pricing assumptions Risk neutral valuation Arbitrage -free pricing Futures Futures contract pricing Options Put-call parity (Arbitrage relationships for options) Moneyness Option time value Pricing models Black-Scholes Black model Binomial options model Monte Carlo option model Implied volatility Volatility smile The Greeks Interest rate derivatives Short rate model Hull-White model LIBOR Market Model Heath-Jarrow-Morton framework See also Computational finance Financial Engineering Derivative (finance) , list of derivatives topics Modeling and analysis of financial markets Fundamental financial concepts - topics Model (economics) QuantLib Mathematical finance library List of finance topics , List of finance topics (alphabetical) List of economics topics , List of economists List of accounting topics List of marketing topics List of management topics
Finance Topics and Links
Topics in finance include: Contents 1 Fundamental financial concepts 2 Accounting (financial records) 3 Actuarial topics 4 Institutional setting 5 Financial services companies 6 Banking terms 7 Financial regulation 7.1 Designations and accreditation 7.2 Fraud 7.3 Industry bodies 7.4 Regulatory bodies 7.4.1 United Kingdom 7.4.2 European Union 7.4.3 United States 7.5 United States legislation 8 Financial markets 8.1 Market and instruments 8.2 Equity market 8.2.1 Equity valuation 8.2.2 Investment theory 8.3 Bond market 8.4 Money market 8.5 Commodity market 8.6 Derivatives market 8.6.1 Forward markets and contracts 8.6.2 Futures markets and contracts 8.6.3 Option markets and contracts 8.6.4 Swap markets and contracts 8.6.5 Derivative markets by underlyings 8.6.5.1 Equity derivatives 8.6.5.2 Interest rate derivatives 8.6.5.3 Credit derivatives 9 Valuation 9.1 Discounted cash flow valuation 9.2 Relative valuation 9.3 Contingent claim valuation 10 Corporate finance 11 Investment management 12 Personal finance 13 Public finance 14 Insurance 15 Economics and finance 16 Mathematics and finance 16.1 Time value of money 16.2 Financial mathematics 16.2.1 Mathematical tools 16.2.2 Derivatives pricing 17 Constraint finance 18 Virtual finance 19 The history of finance 20 Financial software tools 21 Finding related topics Fundamental financial concepts Finance an overview Arbitrage Capital (economics) Capital asset pricing model Cash flow Cash flow matching Debt Default Consumer debt Debt consolidation Debt settlement Credit counseling Bankruptcy Debt diet Debt-snowball method Discounted cash flow Financial capital Funding Financial modeling Entrepreneur Entrepreneurship Fixed income analysis Gap financing Hedge Basis risk Interest rate Risk-free interest rate Term structure of interest rates interest effective interest rate nominal interest rate interest rate basis Fisher equation Crowding out annual percentage rate interest coverage ratio Investment Foreign direct investment Gold as an investment Over-investing Leverage Locked-in value Long (finance) Liquidity Margin (finance) Mark to future Mark to market Market Impact Medium of exchange Microcredit Money Currency Coin Banknote Counterfeit Portfolio Modern portfolio theory Reference rate Reset Return Absolute return Investment performance Relative return Right-financing Risk Risk management Risk measure Coherent risk measure Spectral risk measure Value at Risk Scenario analysis Short (finance) Speculation Day trading Position trader Spread Standard of deferred payment Store of value Time horizon Time value of money Discounting Present value Future value Net present value Internal rate of return Modified internal rate of return Annuity Perpetuity Unit of account Volatility Yield Yield curve Accounting (financial records) Accounting List of accounting topics Financial accountancy Financial statements Balance sheet Cash flow statement Income statement Auditing Management accounting Accounting software Actuarial 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Fundamental analysis Futures contract Fungibility Gold as an investment Hedging Jesse Lauriston Livermore List of traded commodities MACD Ownership equity Position trader Risk (Futures) Seasonal traders Seasonal spread trading Slippage Speculation Spread Technical analysis Breakout Bear market Bottom (technical analysis) Bull market Moving average Open Interest Parabolic SAR Point and figure charts Resistance RSI Stochastic oscillator Stop loss Support Top (technical analysis) Trade Trend Derivatives market Derivative (finance) (see also Financial mathematics topics ; Derivatives pricing ) Underlying instrument Forward markets and contracts Forward contract Futures markets and contracts Backwardation Contango Futures contract Currency future Financial future Interest rate future Futures exchange Option markets and contracts Options Stock option Box spread Call option Put option Strike price Put-call parity The Greeks Black-Scholes formula Black model Binomial options model Implied volatility Option time value Moneyness At-the-money In-the-money Out-of-the-money Straddle Option style Vanilla option Exotic option Binary option European option Interest rate floor Interest rate cap Bermudan option American option Quanto option Asian option Employee stock option Warrants Foreign exchange option Interest rate options Bond options Real options Options on futures Swap markets and contracts Swap (finance) interest rate swap basis swap stock swap equity swaps currency swap variance swap see: w:Swap (finance) Derivative markets by underlyings Equity derivatives Interest rate derivatives Financial future LIBOR Forward rate agreement Interest rate swap Interest rate cap Exotic interest rate option Interest rate swap Swaption Credit derivatives Credit default swap Collateralized debt obligation Credit default option Total return swap Valuation Value (economics) Fair value Discounted cash flow valuation Cash flow Cash flow from operating activities Operating cash flow Time value of money Present value Future value Actualization Discounting Bond valuation Yield to maturity Duration Convexity Equity valuation Equivalent Annual Cost Net present value Discount rate Capital Asset Pricing Model Arbitrage pricing theory Cost of capital Weighted average cost of capital Fundamental analysis Stock valuation Business valuation The investment decision Relative valuation Dividend yield Financial ratio Market-based valuation PE ratio Relative valuation Stock image Stock profile Contingent claim valuation See also derivatives pricing Rational pricing assumptions Risk neutral valuation Arbitrage free pricing Derivatives pricing Futures Futures contract Pricing Options (and Real options ) Black-Scholes formula Black model Binomial options model Short-rate modelling Hull-White model Corporate finance Balance sheet analysis Financial ratio Business plan Capital budgeting Capital investment decisions The investment decision Business valuation Stock valuation Fundamental analysis Real options Valuation topics Fisher separation theorem The financing decision Capital structure Cost of capital Weighted average cost of capital Modigliani-Miller theorem The Dividend Decision Dividend Dividend tax Dividend yield Modigliani-Miller theorem Corporate action Managerial finance Management accounting Mergers and acquisitions leveraged buyout takeover corporate raid Real options Return on investment Return on assets Return on equity Return on capital Working capital management cash conversion cycle Return on capital Economic value added Just In Time Economic order quantity Discounts and allowances Factoring (trade) Investment management Fund management Active management Efficient market hypothesis Portfolio Modern portfolio theory Capital asset pricing model Arbitrage pricing theory Passive management Index fund Activist shareholder Mutual fund Open-end fund Closed-end fund List of mutual-fund families Financial engineering Long-Term Capital Management Hedge fund Hedge Visualization of Financial Implications Personal finance 529 plan (college savings) Budget Coverdell Education Savings Account (Coverdell ESAs, formerly known as Education IRAs) Credit & Debt Credit card Debt consolidation Mortgage loan Debit card Direct deposit Employment contract Commission Employee stock option Employee or fringe benefit Health insurance Paycheck Salary Wage Financial literacy Insurance Predatory lending Retirement plan 401(a) 401(k) 403(b) 457 plan Individual Retirement Account Roth IRA Traditional IRA SEP IRA SIMPLE IRA Conduit IRA Pension Social security Tax advantage Wealth Personal Finance software Comparison of Personal Finance software Investment club Collective investment scheme Car financing Public finance Central bank Federal Reserve Fractional-reserve banking Deposit creation multiplier Tax Income tax Payroll tax Sales tax Tax advantage Tax, tariff and trade crowding out industrial policy agricultural policy currency union monetary reform Insurance 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present value Internal rate of return Annuity Perpetuity Financial mathematics Mathematical tools Probability Probability distribution Binomial distribution Log-normal distribution Expected value Value at risk Risk-neutral measure Stochastic calculus Brownian motion Itô's lemma Girsanov's theorem Radon-Nikodym derivative Monte Carlo methods in finance Partial differential equations Heat equation Martingale representation theorem Feynman-Kac formula Dynkin formula Stochastic differential equations Volatility ARCH model GARCH model Mathematical model Numerical method Derivatives pricing Rational pricing assumptions Risk neutral valuation Arbitrage free pricing Futures Futures contract pricing Options Black-Scholes formula Black model Binomial options model Implied volatility Historical volatility The Greeks Interest rate derivatives Short rate model Hull-White model Brace-Gatarek-Musiela model Heath-Jarrow-Morton framework Constraint finance Creditary economics Environmental finance 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Topics and Concepts in Islamic Banking
Islamic banking refers to a system of banking or banking activity that is consistent with Islamic law ( Sharia ) principles and guided by Islamic economics . In particular, Islamic law prohibits usury , the collection and payment of interest , also commonly called riba in Islamic discourse. In addition, Islamic law prohibits investing in businesses that are considered unlawful, or haraam (such as businesses that sell alcohol or pork, or businesses that produce media such as gossip columns or pornography, which are contrary to Islamic values). In the late 20th century , a number of Islamic banks were created, to cater to this particular banking market. Contents 1 History of modern Islamic banking 2 Principles 3 Shariah Advisory Council/Consultant 4 Concepts In Islamic debt banking 4.1 Bai' al-Inah (Sale and Buy Back Agreement) 4.2 Bai' Bithaman Ajil (Deferred Payment Sale) 4.3 Bai muajjal 4.4 Baihaqi kasi salam 4.4.1 Basic Features And Conditions Of Salam 4.5 Hibah (Gift) 4.6 Ijarah 4.7 Advantages of Ijarah 4.8 Ijarah Thumma Al Bai' (Hire Purchase) 4.9 Ijarah-Wal-Iqtina 4.10 Istisna'a 4.11 Mudarabah (Profit Loss Sharing) 4.12 Murabahah (Cost Plus) 4.13 Musawamah 4.14 Musharakah (Joint Venture) 4.15 Qard Hassan (Good Loan) 4.16 Sukuk (Islamic Bonds) 4.17 Takaful (Islamic Insurance) 4.18 Wadiah (Safekeeping) 4.19 Wakalah (Agency) 5 Islamic Equity Funds 6 Islamic laws on trading 7 Criticism 8 See also 9 External links 10 Islamic Financial Institutions History of modern Islamic banking The first modern experiment with Islamic banking was undertaken in Egypt under cover without projecting an Islamic image—for fear of being seen as a manifestation of Islamic fundamentalism that was anathema to the political regime. The pioneering effort, led by Ahmad El Najjar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in 1963. This experiment lasted until 1967 (Ready 1981), by which time there were nine such banks in the country. [1] Principles Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shariah , known as Fiqh al-Muamalat (Islamic rules on transactions). The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of riba´ (interest). Amongst the common Islamic concepts used in Islamic banking are profit sharing ( Mudharabah ), safekeeping ( Wadiah ), joint venture ( Musharakah ), cost plus ( Murabahah ), and leasing ( Ijarah ). In an Islamic mortgage transaction, instead of loaning the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the fact that it is profit cannot be made explicit and therefore there are no additional penalties for late payment. In order to protect itself against default, the bank asks for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction. This arrangement is called Murabaha . Another approach is Ijara wa Iqtina , which is similar to real-estate leasing . Islamic banks handle loans for vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor and then retaining ownership of the vehicle until the loan is paid). There are several other approaches used in business deals. Islamic banks lend their money to companies by issuing floating rate interest loans. The floating rate of interest is pegged to the company's individual rate of return. Thus the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is concluded. This practice is called Musharaka . Further, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing lender to monopolize the economy. And finally, Islamic banking is restricted to Islamically acceptable deals, which exclude those involving alcohol, pork, gambling, etc. Thus ethical investing is the only acceptable form of investment, and moral purchasing is encouraged. Islamic banks have grown recently in the Muslim world but are a very small share of the global banking system. Micro-lending institutions founded by Muslims , such as Grameen Bank , use conventional lending practices, and are popular in some Muslim nations, but some do not consider it to be true Islamic banking. Islamic banking should be synonymous with full-reserve banking , with banks achieving a 100% reserve ratio [2] . However, in practice, this is rarely the case [3] . Shariah Advisory Council/Consultant Islamic banks and banking institutions that offer Islamic banking products and services (IBS banks) are required to establish Shariah advisory committees/consultants to advise them and to ensure that the operations and activities of the bank comply with Shariah principles. In Malaysia, the National Shariah Advisory Council, which additionally set up at Bank Negara Malaysia (BNM), advises BNM on the Shariah aspects of the operations of these institutions and on their products and services. (See: Islamic banking in Malaysia ) Concepts In Islamic debt banking Bai' al-Inah (Sale and Buy Back Agreement) The financier sells an asset to the customer on a deferred-payment basis, and then the asset is immediately repurchased by the financier for cash at a discount. The buying back agreement allows the bank to assume ownership over the asset in order to protect against default without explicitly charging interest in the event of late payments or insolvency. Bai' Bithaman Ajil (Deferred Payment Sale) This concept refers to the sale of goods on a deferred payment basis at a price, which includes a profit margin agreed to by both parties. This is similar to Murabahah, except that the debtor makes only a single installment on the maturity date of the loan. By the application of a discount rate , an Islamic bank can collect the market rate of interest. Bai muajjal Literally bai muajjal means a credit sale. Technically, it is a financing technique adopted by Islamic banks that takes the form of murabaha muajjal. It is a contract in which the bank earns a profit margin on the purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. It has to expressly mention cost of the commodity and the margin of profit is mutually agreed. The price fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price. Baihaqi kasi salam Bai salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver, or currencies. Barring this, Bai Salam covers almost everything that is capable of being definitely described as to quantity, quality, and workmanship. Basic Features And Conditions Of Salam First of all, it is necessary for the validity of Salam that the buyer pays the price in full to the seller at the time of effecting the sale. It is necessary because in the absence of full payment by the buyer, it will be tantamount to sale of a debt against a debt, which is prohibited, as the basic wisdom behind the permissibility of salam is to fulfill the instant needs of the seller. If the price is not paid to him in full, the basic purpose of the transaction will be defeated. Therefore, all the Muslim jurists are unanimous on the point that full payment of the price is necessary in Salam. However, Imam Malik is of the view that the seller may give a concession of two or three days to the buyers, but this concession should not form part of the agreement. Salam can be effected in those commodities only the quality and quantity of which can be specified exactly. The things whose quality or quantity is not determined by specification cannot be sold through the contract of salam. For example, precious stones cannot be sold on the basis of salam, because every piece of precious stones is normally different from the other either in its quality or in its size or weight and their exact specification is not generally possible. Salam cannot be effected on a particular commodity or on a product of a particular field or farm. For example, if the seller undertakes to supply the wheat of a particular field, or the fruit of a particular tree, the salam will not be valid, because there is a possibility that the crop of that particular field or the fruit of that tree is destroyed before delivery, and, given such possibility, the delivery remains uncertain. The same rule is applicable to every commodity the supply of which is not certain. It is necessary that the quality of the commodity (intended to be purchased through salam) is fully specified leaving no ambiguity which may lead to a dispute. All the possible details in this respect must be expressly mentioned. It is also necessary that the quantity of the commodity is agreed upon in unequivocal terms. If the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it is quantified through measures, its exact measure should be known. What is normally weighed cannot be quantified in measures and vice versa. The exact date and place of delivery must be specified in the contract. Salam cannot be effected in respect of things which must be delivered at spot. For example, if gold is purchased in exchange of silver, it is necessary, according to Shari‘ah, that the delivery of both be simultaneous. Here, salam cannot work. Similarly, if wheat is bartered for barley, the simultaneous delivery of both is necessary for the validity of sale. Therefore the contract of salam in this case is not allowed. Hibah (Gift) This is a token given voluntarily by a creditor to a debtor in return for a loan. Hibah usually arises in practice when Islamic banks do not voluntarily pay their customers interest on savings account balances. Ijarah Ijarah means lease, rent or wage. Generally, Ijarah concept means selling benefit or use or service for a fixed price or wage. Under this concept, the Bank makes available to the customer the use of service of assets / equipments such as plant, office automation, motor vehicle for a fixed period and price. Advantages of Ijarah The following are the advantage of Ijarah to lessee: Ijarah conserves capital as it may provide 100% financing. Ijarah enables the Lessee to have the use of the equipment on payment of the first rental. This is important since it is the use (and not ownership) of the equipment that generates income. Ijarah arrangements are flexible because the terms and rental provision may be tailored to suit the needs of the Lessee. Therefore, it aids corporate planning and budgeting Ijarah is not borrowing and is therefore not required to be disclosed as a liability in the Balance Sheet of the Lessee. Being an “off balance sheet” financing, it is not included in the computation of gearing ratios imposed by bankers. The borrowing capacity of the Lessee is therefore not impaired when leasing is resorted to as a mean of financing. All payments of rentals are treated as payment of operating expenses and are therefore, fully tax-deductible. Leasing therefore offers tax-advantages to profit making concerns. There are many types of equipment, which becomes obsolete before the end of its actual economic life. This is particularly true in high technology equipment like computers. Thus the risk is passed onto the Lessor who will undoubtedly charge a premium into the lease rate to compensate for the risk. A Lessee may be willing to pay the said premium as an insurance against obsolescence. If the equipment use is for a relatively short period of time, it may be more profitable to lease than to buy. If the equipment is for short duration and the equipment has a very poor second hand value (resale value), leasing would be the best method for acquisition. Ijarah Thumma Al Bai' (Hire Purchase) These are variations on a theme of purchase and lease back transactions. There are two contracts involved in this concept. The first contract, an Ijarah contract (leasing/renting), and the second contract, a Bai contract (purchase) are undertaken one after the other. For example, in a car financing facility, a customer enters into the first contract and leases the car from the owner (bank) at an agreed rental over a specific period. When the lease period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed price. In effect, the bank sells the product to the debtor, at an above market-price profit margin, in return for agreeing to receive the payment over a period of time; the profit margin on the lease is equivalent to interest earned at a fixed rate of return. This type of transaction is particularly reminiscent of contractum trinius , a complicated legal trick used by European bankers and merchants during the Middle Ages, which involved combining three individually legal contracts in order to produce a transaction of an interest bearing loan (something that the Church made illegal). Ijarah-Wal-Iqtina A contract under which an Islamic bank provides equipment, building, or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the promise does not become an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum along with profit over the period of lease. Istisna'a Istisna'a is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery or a future payment, and future delivery. Istisna'a can be used for providing the facility of financing the manufacture or construction of houses, plants, projects, and building of bridges, roads, and highways. Mudarabah (Profit Loss Sharing) Mudarabah is an arrangement or agreement between a capital provider and an entrepreneur, whereby the entrepreneur can mobilize funds for its business activity. The entrepreneur provides expertise and management and is referred to as the Mudarib . Any profits made will be shared between the capital provider and the entrepreneur according to an agreed ratio, where both parties share in profits and only capital provider bears all the losses if occurred. The profit-sharing continues until the loan is repaid. The bank is compensated for the time value of its money in the form of a floating interest rate that is pegged to the debtor's profits. Murabahah (Cost Plus) Main article: Murabaha This concept refers to the sale of goods at a price, which includes a profit margin agreed to by both parties. The purchase and selling price, other costs, and the profit margin must be clearly stated at the time of the sale agreement. The bank is compensated for the time value of its money in the form of the profit margin. This is a fixed-income loan for the purchase of a real asset (such as real estate or a vehicle), with a fixed rate of interest determined by the profit margin. The bank is not compensated for the time value of money outside of the contracted term (i.e., the bank cannot charge additional interest on late payments); however, the asset remains in the ownership of the bank until the loan is paid in full. This type of transaction is similar to rent-to-own arrangements for furniture or appliances that are very common in North American stores. Musawamah Musawamah is a general and regular kind of sale in which price of the commodity to be traded is bargained between seller and the buyer without any reference to the price paid or cost incurred by the former. Thus, it is different from Murabaha in respect of pricing formula. Unlike Murabaha, however, the seller in Musawamah is not obliged to reveal his cost. Both the parties negotiate on the price. All other conditions relevant to Murabaha are valid for Musawamah as well. Musawamah can be used where the seller is not in a position to ascertain precisely the costs of commodities that he is offering to sell. Musharakah (Joint Venture) Musharakah is a relationship established under a contract by the mutual consent of the parties for sharing of profits and losses in the joint business. It is an agreement under which the Islamic bank provides funds, which are mixed with the funds of the business enterprise, and others. All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions. This concept is distinct from fixed-income investing (i.e. issuance of loans). Qard Hassan (Good Loan) This is a loan extended on a goodwill basis, and the debtor is only required to repay the amount borrowed. However, the debtor may, at his or her discretion, pay an extra amount beyond the principal amount of the loan (without promising it) as a token of appreciation to the creditor. In the case that the debtor does not pay an extra amount to the creditor, this transaction is a true interest-free loan. Some Muslims consider this to be the only type of loan that does not violate the prohibition on riba, since it is the one type of loan that truly does not compensate the creditor for the time value of money [4] . Sukuk (Islamic Bonds) Main article: Sukuk Sukuk is the Arabic name for a financial certificate but can be seen as an Islamic equivalent of bond. However, fixed-income, interest-bearing bonds are not permissible in Islam. Hence, Sukuk are securities that comply with the Islamic law and its investment principles, which prohibit the charging or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets. Conservative estimates suggest that over US$ 500 billion of assets are managed according to Islamic investment principles. Such principles form part of Shariah, which is often understood to be Islamic law, but it is actually broader than this in that it also encompasses the general body of spiritual and moral obligations and duties in Islam. Takaful (Islamic Insurance) Main article: Takaful Takaful is an alternative form of cover that a Muslim can avail himself against the risk of loss due to misfortunes. The concept of takaful is not a new concept; in fact, it had been practiced by the Muhajrin of Mecca and the Ansar of Medina following the hijra of the Prophet over 1,400 years ago. Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large numbers . In modern business, one of the ways to reduce the risk of loss due to misfortunes is through insurance which spreads the risk among many people. The concept of insurance where resources are pooled to help the needy does not contradict Shariah. However, conventional insurance involves the elements of uncertainty ( Al-gharar ) in the contract of insurance, gambling ( Al-maisir ) as the consequences of the presence of uncertainty and interest ( Al-riba ) in the investment activities of the conventional insurance companies that contravene the rules of Shariah. It is generally accepted by Muslim jurists that the operation of conventional insurance does not conform to the rules and requirements of Shariah. Wadiah (Safekeeping) In Wadiah , a bank is deemed as a keeper and trustee of funds. A person deposits funds in the bank and the bank guarantees refund of the entire amount of the deposit, or any part of the outstanding amount, when the depositor demands it. The depositor, at the bank's discretion, may be rewarded with a hibah (gift) as a form of appreciation for the use of funds by the bank. In this case, the bank compensates depositors for the time-value of their money (i.e. pays interest) but refers to it as a gift because it does not officially guarantee payment of the gift. Wakalah (Agency) This occurs when a person appoints a representative to undertake transactions on his/her behalf, similar to a power of attorney . Islamic Equity Funds Islamic investment equity funds market is one of the fastest-growing sectors within the Islamic financial system. Currently, there are approximately 100 Islamic equity funds worldwide. The total assets managed through these funds currently exceed US$5 billion and is growing by 12–15% per annum. With the continuous interest in the Islamic financial system, there are positive signs that more funds will be launched. Some Western majors have just joined the fray or are thinking of launching similar Islamic equity products. Despite these successes, this market has seen a record of poor marketing as emphasis is on products and not on addressing the needs of investors. Over the last few years, quite a number of funds have closed down. Most of the funds tend to target high net worth individuals and corporate institutions, with minimum investments ranging from US$50,000 to as high as US$1 million. Target markets for Islamic funds vary, some cater for their local markets, e.g., Malaysia and Gulf-based investment funds. Others clearly target the Middle East and Gulf regions, neglecting local markets and have been accused of failing to serve Muslim communities. Since the launch of Islamic equity funds in the early 1990s, there has been the establishment of credible equity benchmarks by Dow Jones Islamic market index and the FTSE Global Islamic Index Series. The Web site failaka.com monitors the performance of Islamic equity funds and provide a comprehensive list of the Islamic funds worldwide. Islamic laws on trading The Qur'an prohibits gambling (games of chance involving money). The hadith , in addition to prohibiting gambling (games of chance), also prohibits bayu al-gharar (trading in risk, where the Arabic word gharar is taken to mean "risk"). The Hanafi madhab (legal school) in Islam defines gharar as "that whose consequences are hidden." The Shafi legal school defined gharar as "that whose nature and consequences are hidden" or "that which admits two possibilities, with the less desirable one being more likely." The Hanbali school defined it as "that whose consequences are unknown" or "that which is undeliverable, whether it exists or not." Ibn Hazm of the Zahiri school wrote " Gharar is where the buyer does not know what he bought, or the seller does not know what he sold.” The modern scholar of Islam, Professor Mustafa Al-Zarqa, wrote that "Gharar is the sale of probable items whose existence or characteristics are not certain, due to the risky nature that makes the trade similar to gambling." There are a number of hadith who forbid trading in gharar , often giving specific examples of gharhar transactions (e.g., selling the birds in the sky or the fish in the water, the catch of the diver, an unborn calf in its mother's womb etc.). Jurists have sought many complete definitions of the term. They also came up with the concept of yasir (minor risk); a financial transaction with a minor risk is deemed to be halal (permissible) while trading in non-minor risk ( bayu al-ghasar ) is deemed to be haram . [5] What gharar is, exactly, was never fully decided upon by the Muslim jurists. This was mainly due to the complication of having to decide what is and is not a minor risk. Derivatives instruments (such as stock options) have only become common relatively recently. Some Islamic banks do provide brokerage services for stock trading and perhaps even for derivatives trading.. Criticism Islamabad , Pakistan , June 16 , 2004 : Members of leading Islamist political party in Pakistan, the Muttahida Majlis-e-Amal (MMA) party, staged a protest walkout from the National Assembly of Pakistan against what they termed derogatory remarks by a minority member on interest banking: Taking part in the budget debate, M.P. Bhindara, a minority MNA [Member of the National Assembly]...referred to a decree by an Al-Azhar University 's scholar that bank interest was not un- Islamic . He said without interest the country could not get foreign loans and could not achieve the desired progress. A pandemonium broke out in the house over his remarks as a number of MMA members...rose from their seats in protest and tried to respond to Mr Bhandara's observations. However, they were not allowed to speak on a point of order that led to their walkout.... Later, the opposition members were persuaded by a team of ministers...to return to the house...the government team accepted the right of the MMA to respond to the minority member's remarks.... Sahibzada Fazal Karim said the Council of Islamic ideology had decreed that interest in all its forms was haram in an Islamic society. Hence, he said, no member had the right to negate this settled issue [6] . Many Muslims and non Muslims alike have opposed these Islamic banks, claiming that they do deal in interest but merely conceal it through legal tricks. Indeed, from an economic perspective, Islamic banks do compensate and charge for the time value of money , thus paying and receiving what is known in economics as interest. Such people compare Islamic banking to contractum trinius —a legal trick devised by European bankers and merchants during the Middle Ages , designed to facilitate the borrowing of money at a fixed rate of interest (something that the Church fiercely opposed) through combining three different contractual agreements that in and of themselves were not prohibited by the Church. While Islamic law prohibits the collection of interest, it does allow a seller to resell an item at a higher price than it was bought for, as long as there are clearly two transactions. These arguments and criticism are exactly the same as those used at the time of Prophet Muhammad. The Qur'an addresses this issue in simple terms, Interest is forbidden by Allah, while trade has been permitted by Him: "Those who devour usury will not stand except as stand one whom the Evil one by his touch Hath driven to madness. That is because they say: "Trade is like usury," but Allah hath permitted trade and forbidden usury. Those who after receiving direction from their Lord, desist, shall be pardoned for the past; their case is for Allah (to judge); but those who repeat (The offence) are companions of the Fire: They will abide therein (for ever)." (Surah Baqarah 2:275) - http://www.usc.edu/dept/MSA/quran/002.qmt.html See also Contractum trinius e-dinar e-Dirham Full-reserve banking Gold dinar Islamic economical jurisprudence Islamic banking in Malaysia Reserve requirement Green economics Creditary economics Micro venture capital Economy of the OIC Mont de Piété List of Islamic terms in Arabic
Topics in Options and Derivatives Markets
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How to set up a Hedge Fund
[Latestpages-all-1-none] More Tutorials Focus Home Page Services Providers Hedge Fund Books: US Hedge Fund Books: UK Introductions & Guides Papers & Research People & Profiles Research Centres Getting Started Money Legal Services Prime Broker Services Office Space Hedge Fund Mechanics Fiduciary Audits Time Line Accredited Investors Income Test What is Income? Net Worth Test Partnerships and Corporations as Accredited Investors Trusts as Accredited Investors List of Accredited Investor Tests Proposed Change to Accredited Investor Standard Investment Adviser Registration Side Letters Incubator Hedge Funds Offshore Good News By and large there seem to be two groups of people in circulation these days: those who want to run a hedge fund and those that want to invest in them. For many, the dream of running a hedge fund is realized once they move beyond the bounds of cocktail party chatter and investigate for themselves what is required to set up a hedge fund. Luckily for Main Street , the answers from Wall Street are amazingly simple. Today, pretty much anyone with $15k or thereabouts can start a hedge fund. What money cannot buy is talent, courage and entrepreneurial drive. Traders and money managers often dream about one day running their own hedge fund, managing large sums of money, and competing toe-to-toe with the world's top traders. For the uninitiated, the first step toward setting up a hedge fund is getting a better grasp on what exactly a hedge fund is and what it is not. Not a Mutual Fund. Unlike a mutual fund, a hedge fund is not open to any and all investors and it cannot advertise for investors. Unlike a mutual fund, a hedge fund can use any means necessary to make money. The SEC does not allow a mutual fund manager to use derivatives or employ shorting strategies to make money. As a mutual fund manger is limited to taking long positions in stocks and in bonds, there is more risk to investing in the typical mutual fund than investing in the typical hedge fund. Unlike a mutual fund manager, a hedge fund manager can use long and short positions and is better positioned to make money in good and bad markets. A mutual fund manager is paid on the basis of the amount of assets under management and makes money even when he or she loses money for investors. Unlike a mutual fund manager, a hedge fund manager is paid primarily for results. Unlike a mutual fund manager, a hedge fund manager often invests significant amounts of his or her own money into the funds that they manage. Unlike a mutual fund manager, a hedge fund manager must aggressively preserve capital and make money for investors. Hedge fund managers cannot afford to be “gunslingers” and take uncalculated risks since, as the old adage states, “it takes money to make money.” For these reasons, hedge funds are far more attractive to investors than mutual funds. It is widely agreed that the best minds in the money management business have moved from mutual funds and brokerages to the world of hedge funds. Hedge or Hedged Fund? The term “hedge fund” was reportedly coined by Alfred Winslow Jones in the 1940s. Hedge funds are private investment pools of money. Originally, a hedge fund invested in equities, used leverage, and actually had to “hedge” and protect itself against market swings by taking long and short positions. Only a hedging fund was actually called a “hedged fund.” A hedge fund is structured as a limited partnership structured to give the general partner ( e.g., the fund manager) a share of the profits earned on the limited partner's ( e.g., the investors) money. The profit sharing ( e.g. called a “performance fee” if referring to an offshore fund or an “incentive allocation” if referring to an onshore fund) is typically 20 percent of the fund's profits. It is believed that probably about the time when the powers that be on Wall Street changed the term from “hedged fund” to “hedge fund,” it added on management fees. Management fees – typically 1 to 2 percent of assets under management — are paid to support the cost of day-to-day fund operations. From an investor's standpoint, management fees are unfortunate in that they cause fund managers to focus on asset gathering rather than fund performance. The best hedge funds are those that actually engage in arbitrage and employ hedging strategies and duck or minimize management fees. As noted, a genuine hedge fund has a manager that engages in arbitrage and employs hedging strategies. So-called “hedge fund managers” that use traditional, long-only equity strategies and do not hedge in fact operate a type of mutual fund, and an expensive one at that. A hedge fund manager that uses large amounts of leverage to take long positions but fails to use short positions to protect against market bottoms will most likely fail. Though they represent a very small portion of the U.S. financial markets, hedge funds are (reportedly) rapidly increasing in number and pose a threat to world financial markets (allegedly). Whatever growth in the industry exists, it is fueled by increased interest from both the top and bottom levels of the investing public. At the top level, hedge funds attract a mix of institutional investors, pension plans, funds of hedge funds, endowments, and foundations seeking to diversify their portfolios. At the bottom level (under $200 million in assets), hedge funds attract the working wealthy and their IRAs, high net worth investors, family offices, and small businesses looking for superior returns. This growth has not escaped the notice of the SEC, which has expressed concerns about the retailization of hedge funds and its potential impact on the securities markets. Getting Started It is very easy for people to join the hedge fund industry. Setting up a hedge fund gets easier every year. By networking, some of the best legal and financial services talent in the business is either a click or a phone call away. Brokerages, lawyers and accountants team up in order to provide a one-stop shop approach to developing and launching a hedge fund. Much of the consultation work (if not all of it) is conducted over the phone or Internet. Key items needed to start a hedge fund are the following: money, a lawyer, a prime (or introducing) broker, office space (or a home office), and eventually, an accountant. Money. The first people hedge fund managers tap for seed capital money are friends and family members. It is hard to attract institutional investors to a new fund. The first investors in a new fund are usually the fund manager's close associates and family members who know and trust the fund manager. As noted, all hedge funds have some if not most of their manager's wealth invested in them. Legal Services. The legal development process normally begins with a planning consultation. This is when important issues ( e.g., investment adviser registration, location of the hedge fund and its management, reliance on safe harbors and exemptions, etc.) are addressed and resolved. A good legal consultation will expose areas (outside the legal process) that need further planning. Once the course is charted, the legal development process begins. The fund and management company entities are first formed in their appropriate jurisdictions. This enables the fund manager to begin the process of opening bank and brokerage accounts and preparing for the administrative needs of the hedge fund. After the entities are formed, the legal team gathers the necessary information to form the operating agreements for the entities and then the offering documents, first in draft stage and then finalized for distribution to prospective investors. Prime Broker Services. Once the lawyer is engaged, the hedge fund is organized, and the offering documents are drafted, the next thing needed is a relationship with a prime (or introducing) broker. An introducing broker is a registered broker/dealer that has an agreement with a prime broker to use that firm's custody and clearing services. A good prime broker or introducing broker will provide marketing and capital introduction services. Conventional advertising and marketing of hedge funds is not allowed but workarounds have been developed by brokers so that good fund managers get the right kind of investor attention. When setting up a hedge fund, it is best to stay away from the retail brokerage firms since they are not geared toward hedge funds and the needs of hedge fund managers. Office Space. Advances in technology and the proliferation of information have made investment research and trading convenient as well as efficient. One can work from any location where there is high-speed Internet service. As everyone knows someone starting a hedge fund these days, the industry cannot not keep track of all the hedge fund managers and their business operations, whether based at home or at a hedge fund hotel. There is no stigma to running a hedge fund from home. Hedge fund managers — the best in the business — can and do work from home. Enough said. Hedge Fund Mechanics. To start a hedge fund, the aspiring hedge fund manager needs to set up the hedge fund entity and the management company. In the United States , the hedge fund is typically established as a limited partnership and in some cases as a limited liability company. With hedge fund start ups, the management company will also function as the hedge fund's general partner and is set up as a limited liability company or, in some special cases, as a corporation. The lawyer is responsible for drafting the offering documents. Some fund organizers try to draft their own set of documents or use a family member who is a lawyer with experience in a specialty other than securities law. In most cases, it will be obvious to the potential investor that proper legal counsel was lacking. A poor set of offering documents is a mark against the hedge fund manager. One document that is of particular importance is the private placement memorandum (PPM), since potential investors generally rely heavily on the information that the PPM provides. The PPM is an extensive document individually created for each hedge fund. Although there are no specific disclosure requirements for the PPM (provided the offering is made solely to accredited investors) and a lot of boilerplate language is used, basic information about the hedge fund's manager and the hedge fund itself is disclosed. The information provided is general in nature, and it normally presents in broad terms the fund's investment strategies and practices. For example, disclosures generally include the fact that the hedge fund's manager may invest fund assets in illiquid, difficult-to-value securities, and that the hedge fund manager reserves the discretion to value such securities as he believes appropriate under the circumstances. Also often included is a disclosure about the hedge fund manager having discretion to invest fund assets outside the stated strategies. PPMs tend to be very protective of the hedge fund manager. As a fallback measure, the PPM will list every type of security, commodity, or futures contract in the financial market to provide the hedge fund manager with freedom and latitude to make money. The PPM usually provides information about the qualifications and procedures for a prospective investor to become a limited partner. It also provides information on fund operations, such as fund expenses, allocations of gains and losses, and tax aspects of investing in the fund. Disclosure of lock-up periods, redemption rights and procedures, fund service providers, potential conflicts of interests to investors, conflicts of interest due to fund valuation procedures, “side-by-side management” of multiple accounts, and allocation of certain investment opportunities among clients may be discussed briefly or in greater detail, depending on the fund. The PPM also may include disclosures concerning soft dollar arrangements, redirection of business to brokerages that introduce investors to the fund, and further disclosure of how soft dollars are used. Copies of financial statements may be provided with the PPM. Fiduciary Audits. In theory, the investment policy and strategy sections of the PPM exist to help investors evaluate the hedge fund as an investment opportunity. Therefore, PPMs should be written with accountability in mind. Consider the PPM that states that “the goal of the fund is capital preservation.” Unless capital preservation is clearly defined in terms of asset allocation, one might expect that all of the fund's assets consist of principal protected investments with specific maturity dates as such investment would most likely preserve capital. Given this, PPMs should not state capital preservation as a goal unless the fund invests in items that return the principal investment. When used in a PPM, the terms “capital preservation,” “liquidity and marketability,” “risk aversion” need to be defined (and adhered to by the hedge fund manager) with a future audit in mind. In the future, there may be a trend toward investment policy audits (at the top levels of the hedge fund industry). An investment policy audit evaluates whether the hedge fund manager is in compliance with the statements made in the investment policy and investment strategy section of the PPM. An asset allocation audit examines whether the fund's portfolio is within the range of a PPMs stated asset allocations percentages. Time Line. The legal process of setting up a hedge fund usually can be completed within 60-90 days, though registration as an investment adviser, specialized circumstances, or delays in providing information can lengthen the fund launch process. Accredited Investors Offerings made to “accredited investors” exclusively are exempt from disclosure requirements under Rule 506. Before you allow an investor into your hedge fund, you will need to determine if a prospective investor is accredited. There are two tests for accreditation: the Income Test and the Net Worth Test. Generally, accredited investors include individuals with a minimum annual income of $200,000 ($300,000 with spouse) or $1 million in net worth and most institutions with $5 million in assets. Income Test The Income Test states that any natural person who had an individual income in excess of $200,000 in each of the 2 most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year is an accredited investor. Though joint spousal income can be used to establish accredited investor status, proposed investors cannot use separate income for one year and joint income for the next year to meet the Income Test. What is Income? Salary and bonus income; Taxable income (gross receipts less cost of goods or services and expenses) in the case of sole proprietorships; Distributable income from trusts and partnerships; Interest and dividend income excluding unrealized gains; and Vested contributions to a profit-sharing or pension plan made on behalf of an individual. Future income is relevant. You are required to inquire into the proposed investor's income for the year in question to determine whether an individual can meet the income levels. You cannot simply accept a proposed investor's representation as to his future income. If the prospective investor has a consistent pattern of income that exceeds $ 200,000, or $300,000 joint income, the investor's representation is acceptable. If the proposed investor's past income includes unusual and non-reoccurring income, you should request that the proposed investors provide you with an audited (or CPA confirmed) income statement. Net Worth Test Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of purchase exceeds $1,000,000 is an accredited investor. Neither the Securities Act of 1933 nor the various rules and interpretations associated with the law in this area define exactly what makes up net worth. To determine net worth, a spouse's assets can be counted even if only one is the purchaser and does not exclude any of the purchaser's assets (e.g., home, furnishings, clothing, jewelry, etc.) from determination of net worth. When in doubt of a proposed investor's income or net worth, the best bet is to request a no-action letter from the SEC or to request that prospective investors provide you with an audited (or CPA confirmed) financial statement of net worth or income. Partnerships and Corporations as Accredited Investors The net worth of all the partners in a general partnership proposed investor may be combined to establish accredited investor status (which may be greater than the net worth of the general partnership itself). The net worth of a consolidated group of corporations may be combined as well. Trusts as Accredited Investors The net worth of the grantor and not the trust or its beneficiaries is to be considered where the trust is revocable. With respect to an irrevocable trust, the net worth of the trust itself must be evaluated to determine whether the net worth requirement is met. The grantor of an irrevocable trust will be deemed the purchaser where the grantor possesses significant rights with respect to the trust. Note, however, that if a bank is acting as fiduciary, any trust can qualify as an accredited investor under Rule 501(a)(1). You should obtain from proposed investors considered to be accredited investors the following: Representations and financial information confirming net worth in the case of investors whose accredited net worth status depends on net worth exceeding $1 million; and Representations and copies of relevant portions of individual tax returns, along with representations as to the expectation of the level of future income, in the case of the investor whose accredited status depends on income. List of Accredited Investor Tests In addition to the Income and Net Worth Tests, there are other accredited investor categories. They are listed below. In all cases, a proposed investor must have knowledge and experience in financial and business matters so as to be capable of evaluating the relative merits and risks of an investment in your fund. Individual with Net Worth In Excess of $1.0 Million. A natural person (not an entity) whose net worth, or joint net worth with his or her spouse, at the time of purchase exceeds $1,000,000. (Explanation: In calculating net worth, you may include your equity in personal property and real estate, including your principal residence, cash, short-term investments, stock and securities. Your inclusion of equity in personal property and real estate should be based on the fair market value of such property less debt secured by such property.) Individual with a $200,000 Individual Annual Income. A natural person (not an entity) who had an individual income of more than $200,000 in each of the preceding two calendar years, and has a reasonable expectation of reaching the same income level in the current year. Individual with a $300,000 Joint Annual Income. A natural person (not an entity) who had joint income with his or her spouse in excess of $300,000 in each of the preceding two calendar years, and has a reasonable expectation of reaching the same income level in the current year. Corporations or Partnerships. A corporation, partnership, or similar entity that has in excess of $5 million of assets and was not formed for the specific purpose of acquiring an Interest in the Partnership. Revocable Trust. A trust that is revocable by its grantors and each of whose grantors is an accredited investor. (If this category is checked, please also check the additional category or categories under which the grantor qualifies as an accredited investor.) Irrevocable Trust. A trust (other than an ERISA plan) that (i) is not revocable by its grantors, (ii) has in excess of $5 million of assets, (iii) was not formed for the specific purpose of acquiring an Interest, and (iv) is directed by a person who has such knowledge and experience in financial and business matters that such person is capable of evaluating the merits and risks of an investment in the Partnership. IRA or Similar Benefit Plan. An IRA, Keogh or similar benefit plan that covers a natural person who is an accredited investor. (If this category is checked, please also check the additional category or categories under which the natural person covered by the IRA or plan qualifies as an accredited investor.) Participant-Directed Employee Benefit Plan Account. A participant-directed employee benefit plan investing at the direction of, and for the account of, a participant who is an accredited investor. (If this category is checked, please also check the additional category or categories under which the participant qualifies as an accredited investor.) Other ERISA Plan. An employee benefit plan within the meaning of Title I of the ERISA Act other than a participant-directed plan with total assets in excess of $5 million or for which investment decisions (including the decision to purchase an Interest) are made by a bank, registered investment adviser, savings and loan association, or insurance company. Government Benefit Plan. A plan established and maintained by a state, municipality, or any agency of a state or municipality, for the benefit of its employees, with total assets in excess of $5 million. Non-Profit Entity. An organization described in Section 501(c)(3) of the Internal Revenue Code, as amended, with total assets in excess of $5 million (including endowment, annuity and life income funds), as shown by the organization's most recent audited financial statements. Other Institutional Investor A bank, as defined in Section 3(a)(2) of the Securities Act (whether acting for its own account or in a fiduciary capacity); A savings and loan association or similar institution, as defined in Section 3(a)(5)(A) of the Securities Act (whether acting for its own account or in a fiduciary capacity; A broker-dealer registered under the Exchange Act; An insurance company, as defined in section 2(13) of the Securities Act; A “business development company,” as defined in Section 2(a)(48) of the ICA ; A small business investment company licensed under Section 301(c) or (d) of the Small Business Investment Act of 1958, as amended; or A “private business development company” as defined in Section 202(a)(22) of the Investment Advisers Act of 1940, as amended. Executive Officer or Director. A natural person who is an executive officer, director or general partner of the Partnership or the General Partner. Entity Owned Entirely By Accredited Investors. A corporation, partnership, private investment company or similar entity each of whose equity owners is a natural person who is an accredited investor. (If this category is checked, please also check the additional category or categories under which each natural person qualifies as an accredited investor.) Of course, the hedge fund may wish to allow non-accredited investors into the fund, in which case it will not be exempt from disclosure requirements. Moreover, even if the fund will only open to “accredited investors,” those investors will want information about the fund before buying into it. Indeed, prospective investors will often subject the fund and its managers to an extensive process of due diligence. Investors often spend significant resources, frequently hiring a consultant or a private investigation firm, to discover or verify information about the background and reputation of a hedge fund adviser. Prospective investors may gain access to brokers, administrators, and other service providers during the initial due diligence process, verifying most information contained in the PPM (including the adviser's history). Since the PPM usually is the starting point for those conducting due diligence, it remains a crucial document, even for offerings made exclusively to “accredited investors.” Proposed Change to Accredited Investor Standard In mid-December of 2006, the SEC voted to propose several new rules that are intended to provide additional protections to investors in hedge funds. One of the proposals would define a new category of accredited investor that would be used for offers and sales of securities issued by hedge funds and other private investment pools to natural persons (e.g., individuals). The proposed definition would include any natural person who (a) meets either the net worth test or income test specified in rule 501(a) or rule 215, as applicable, and (b) owns at least $2.5 million in investments, as defined in the proposed rules. The SEC states that rule proposal to increase accredited client standards reflects its concerns over the retailization of the hedge fund industry and desire to protect unsophisticated investors. The foregoing SEC proposed rule change, if adopted, would not affect hedge fund managers with less than $30 million under management, unless the state in which the hedge fund manager is based in adopts some form of the proposed the SEC rule (not a likely event outside of California). Another rule proposal would create an anti-fraud rule that would have the effect of looking through a hedge fund to its investors. The proposal would make it a fraudulent, deceptive, or manipulative act, practice, or course of business for an investment adviser for a pooled investment vehicle to make false or misleading statements or to otherwise defraud investors or prospective investors in that pool. The rule as proposed would apply to all investment advisers for pooled investment vehicles, regardless of whether the investment adviser is registered with the SEC. Investment Adviser Registration In some cases (subject to a state-by-state determination), a hedge fund manager will have to register with his or her state as an investment adviser if he or she has less than $25 million under management. If the fund manager has more than $30 million under management, he would need to register with the SEC as an investment adviser once he has 15 clients. In August of 2006, the U.S. Court of Appeals vacated the SEC's rule that required more fund managers to register as investment advisers via an expanded definition of a “client” under the Investment Advisers Act of 1940. The expanded definition of a “client” imposed a look through rule counting every investor in a hedge fund as a client of the fund manager. The SEC did not appeal the decision of the court to nix this expanded definition of a client. As a result, for purposes of SEC (not state) investment adviser registration, any hedge fund manager with $30 million or more under management that has had fewer than 15 clients in the past 12 months and does not hold himself out as an investment adviser can avoid registration. For investment advisers based outside the United States , only U.S. clients are counted. As a practical matter, “holding out” would seem to be a moot question in the case of the hedge fund manager that acts to increase funds under management by seeking additional investors, and registration should be considered seriously on those grounds alone once the fund manager has more than 15 investors in the fund he or she manages. If the fund manager is actively adding investors to its hedge fund, it is hard to believe that the fund manager is not “holding out” his services as an investment adviser (despite the view of some that hedge fund investors are spontaneously generated without any effort at all). For those hedge fund managers with less than $30 million under management, state investment adviser registration issues are relevant. It is impossible to make a blanket statement pertaining to registration requirements and exemption options, except to say that they vary by state and fund structure. In general, the strictest states are located on the West Coast, with the state of Utah and Colorado being the most hostile toward hedge funds and hedge fund managers. Texas and Arizona are strict states, but very fair in their approach to regulating hedge fund managers. California is one of the slowest states to process investment adviser registration. On the East Coast the toughest states in which to base hedge fund management, due to strict approach to regulating of investment advisers, are New Hampshire , Connecticut and Massachusetts . In those states where the fund manager must register as an investment adviser, the Series 65 (or its equivalent) is required, unless the state is satisfied with some other credential, such as that of a Certified Financial Planner. No sponsor is needed to take the Series 65 exam. Side Letters Investments in a hedge fund are subject to the fund's offering documents (PPM, limited partnership agreement, etc.). A hedge fund manager may enter into a separate agreement ( e.g., side letter) with an investor in the hedge fund. Typically, seed capital investors and large institutional investors seek preferential terms from a hedge fund's manager in a side letter. A side letter provides preferential treatment to the investor that obtains the side letter. Other investors in the fund do not benefit from the terms of the side letter. Side letters cover a range of topics. They may provide the investor with reduced fees or impose limits on the expenses that can be charged to the hedge fund. Side letters may grant the investor special redemption rights ( e.g., no “claw back,” a percentage of the amount redeemed that is held back from the investor for a specified period of time) and modify the lock-up period ( e.g., a time period during which an investor cannot redeem money from the hedge fund) or notice period for withdrawals from the hedge fund. Some side letters provide the investor with daily or weekly net asset values for the fund and information on levels of leverage and risk. They may also grant to an investor “most favored nation” status. This status automatically provides an investor the most favorable terms or conditions granted to other investors through side letters. The problem with side letters is that they may create a new share class in the fund and/or cause a breach in the hedge fund manager's fiduciary duty to the hedge fund. Fiduciaries of a hedge fund owe an identical obligation to each investor in the fund. Should a side letter favor one investor at the expense of another, legal complications could arise. In some cases, the terms of a side letter may be so unique that the investor is arguably, in legal and economic senses, a separate client of the fund manager rather than just another investor in the fund. Incubator Hedge Funds There is an alternative approach for hedge fund managers who want to test the waters before spending $15k or more to set up a hedge fund. Setting up an incubator hedge fund allows a hedge fund manager to develop a track record which will assist in attracting investors later in time. An “incubator” can be created by breaking down the hedge fund development process into two stages and isolating the first. Stage One. The first stage sets up the hedge fund and management company, and creates the required operating documents and resolutions. Completion of the first stage allows the hedge fund to begin trading and developing an auditable performance record. The incubator fund, in nearly all cases, is seeded with the fund manager's money. By trading under this structure, the hedge fund manager develops a track record, which, once audited by an accountant, can be marketed legally to potential investors through the offering documents which are developed in the second stage. Stage Two. In the second stage, the offering documents are developed and an audit of the fund is completed by an accountant. The offering documents, with the financial statement of the hedge fund, is circulated to prospective investors. Starting out with an incubator method affords the opportunity for those with a skill for trading (often in their personal accounts) to break down the hedge fund development process into a cost manageable undertaking. One of the caveats of the incubator approach to launching a hedge fund is that the aspiring fund manager is not paid for trading his own money. The acceptance of third party money (and whether this is permitted depends on the state or country where hedge fund management is based), creates a fiduciary obligation and risk for which the hedge fund manager is not paid. Acceptance of third party money into an incubator fund, in the rare case when allowable, is not recommended, given the legal exposure it creates for the hedge fund manager. Offshore Hedge funds are set up as offshore or onshore funds to allow for different groups of investors. U.S. based hedge fund managers who have significant potential investors outside the United States and/or U.S. tax-exempt investors typically create offshore funds. Many hedge fund managers use offshore hedge funds to provide privacy to investors. In those cases where complete investor confidentiality and privacy are necessary, an offshore fund should not accept U.S. investors and the fund manager should not be based in the United States . Confusing to some is the use of onshore and offshore funds in a master/feeder structure. The master/feeder structure allows a hedge fund manager to manage money for a broad spectrum of investors. The master fund, structured as an offshore corporation (but treated as a partnership for U.S. tax purposes via a “check-the-box” election), engages in all trading activity. A hedge fund manager will pool money and “feed” it in to a master fund and allocate trading gains and losses back to the onshore and offshore feeder funds based on the percentage assets under management in each feeder fund. A master/feeder structure typically includes (in addition to the master fund company) a U.S. limited partnership or limited liability company as the feeder fund for U.S. taxable investors and a foreign corporation as the offshore feeder for foreign investors and U.S. tax-exempt investors. If U.S. taxable investors invest in or effectively control an offshore hedge fund, some complex U.S. tax rules applicable to controlled foreign corporations, foreign personal holding companies, or passive foreign investment companies (PFIC) need to be addressed. However, these rules are manageable when knowledgeable tax advisors are on board. An offshore fund is set up outside of the United States in offshore financial centers (“OFC”) and is usually managed from a low or zero tax jurisdiction. OFCs are countries that cater to the establishment and administration of mutual and hedge funds. Offshore funds generally attract the investment of U.S. tax-exempt entities, such as pension funds, charitable trusts, foundations, retirement plans and accounts, and endowments, as well as non-U.S. residents. U.S. tax-exempt investors favor investments in offshore hedge funds because they may have exposure to U.S. taxation if they invest in U.S. based hedge funds. Under U.S. tax laws, a tax-exempt investor (such as an IRA, an ERISA-type retirement plan, a foundation, or an endowment) is liable for income tax on “unrelated business taxable income” (“UBTI”), notwithstanding its tax-exempt status. UBTI exposure exists when a U.S. tax-exempt investor invests in a hedge fund that uses leverage (e.g., trades on margin). The UBTI tax is avoided by investing in an offshore hedge fund. A U.S. based hedge fund manager should consider setting up an offshore fund if he or she manages money for foreign and/or U.S. tax-exempt investors. For a new hedge fund manager who is a small operator and for whom the extra costs are a major burden, the best location to launch an offshore hedge fund or a master feeder fund is the Cayman Islands or the Bahamas . Both countries have tiered statutory regimes for hedge funds, allowing hedge funds to start out as unregistered funds and then later upgrading to registered fund status if necessary. Hedge fund attorneys in both countries are familiar with hedge fund start ups and will work with a new hedge fund manager. Related service providers (accountants, administrators, etc.) in both countries are good, with the Cayman Islands offering a greater number of service providers. Good News Despite some bad press, hedge funds are here to stay and remain an intriguing topic du jour. Hedge funds are no longer for the elite. Hedge funds will grow in good and bad times because they have complete market freedom. The hedge fund industry has years of success ahead of it. With respect to traditional mutual funds, it is safe to say that the market is self correcting and that investors will continue to gravitate away from them toward hedge funds. In a capitalist country, talented money managers will find profitable outlets for the skills, regardless of government regulation. Hedge funds are about making money and running a hedge fund is a great way to do so. Starting a hedge fund is probably one of the most efficient ways to make money today. Author Hannah M. Terhune, JD, LLM (hterhune@capitalmanagementservicesgroup.com), is Partner and Chief Attorney for Capital Management Services Group, PLLC . Ms. Terhune specializes in hedge funds, international and domestic tax, shareholder litigation, and business law. In addition to practicing law, she lectures about tax, accounting, and business law at two universities in Washington, D.C. She also contributes articles to prominent publications. © Copyright 2006 – Hannah Terhune
Due Diligence, Disclosure and Fund Managers
More Tutorials Focus Home Page Services Providers Hedge Fund Books: US Hedge Fund Books: UK Introductions & Guides Papers & Research People & Profiles Research Centres Fund managers should be prepared for the proverbial "check under the hood" when it comes to attracting new investors. While at times the due diligence check may amount to a mere formality, at other times it may seem more like a formal inquisition. Prospects not infrequently seek due diligence information beyond that provided in the fund's offering documents. When dealing with potential investors ("prospects"), it may be helpful for fund managers to understand the due diligence process in order to be better prepared for all contingencies. Prospects may seek meetings with the officers of the fund and other persons significantly involved in the issuer's business to gain a basic understanding of the terms of the offering and its purposes; the nature of the issuer's business, including its management, workforce, creditors, major suppliers, customers, assets, liabilities, revenues, competition, and other business risks; and the regulatory schemes applicable to the enterprise. The following are areas of inquiry likely to be investigated by a prospect (or his legal counsel) before committing to an investment in your fund. size, history and structure of the Fund and fund manager ownership of the fund manager, including employee ownership registrations and regulation of the fund and/or fund manager (including copies of Part II of Form ADV, if applicable) number of employees, including descriptions and biographies of portfolio managers compensation and incentive arrangements for key employees fund manager's total assets under management fund manager's level of investment in the fund performance history fees maximum size of the fund largest withdrawals from the fund since inception types of clients and investors in the fund (e.g., institutional, high net worth, etc.) lock-up and withdrawal periods investment process ( i.e., the fund manager's approach to selecting investments) portfolio characteristics (e.g., typical number of long and short positions, breakdown of industries held long and short, average holding period, turnover, volatility, etc.) concentration of exposures and any exposure limits (e.g., a possible limit might be no more than five percent (5%) in any particular holding and no more than ten percent (10%) in any particular industry) average holding period for investments use of derivatives leverage information for the fund and aggregate leverage limitations manager's risk management processes contingency and business continuity plans prime brokerage arrangements manager's front and back office operations trade entry and trade processing procedures, as well as personnel authorized to place orders description of trade allocation process method for valuing portfolio holdings, including illiquid holdings fund's accountants, lawyers and other professional advisors (including references) litigation and/or regulatory proceedings involving the fund or fund manager fund's most recent PPM (or similar offering document) fund's audited and unaudited financial statements (e.g., balance sheet, cash flow statements, statement of operations) monthly net asset values frequency and detail of information given to investors copies of the fund's recent correspondence to investors (e.g., quarterly letters) Prospects may submit a due diligence checklist to the issuer's management, requesting extensive information covering every major aspect of the issuer's organization, business, and management. They may review the documents submitted to ensure satisfactory compliance with the request and to determine what additional information is required for the initial draft of the disclosure document. In addition, prospects may prepare and distribute questionnaires to directors, officers, and principal shareholders asking for their background and experience, including any involvement in bankruptcy, criminal, civil, or administrative proceedings; ownership of the fund's securities; business transactions with the fund; and other information related to their knowledge and participation in the issuer's business.Although the SEC has expanded the scope and reliability of exemptions from registration, fund managers nevertheless can be liable for fraud if they fail to disclose material information. To minimize disclosure problems, fund managers should be aware of the kind of questions and concerns prospects are likely to raise. The well-prepared prospect may be working with something like the following checklist: "What the astute fund investor should ask, and why." Organizational Documents What is the fund's mailing address? physical address? If there are multiple addresses for the fund or if the fund shares an address or office space with another fund or another business or company, require an explanation and obtain document (written contract) that enables sharing or colocation. Look for soft dollar arrangements. Is the fund registered with the SEC? the State? Request a copy of Form D, as filed with SEC and relevant states. Verify the Form D or state regulatory equivalent filings in all states. What state is the fund organized in? Most domestic funds are organized in Delaware, although some are organized in Nevada, and, occasionally, in another state. What is the form of organization? Domestic funds are typically organized either as a limited partnership (in which the manager is the general partner and the investors are limited partners) or as a limited liability company in which the manager is the managing member and the investors are non-managing members). What is the fund's mailing address? physical address? If there are multiple addresses for the fund or if the fund shares an address or office space with another fund or another business or company, require an explanation and obtain document (written contract) that enables sharing or colocation. Look for soft dollar arrangements. Is the fund registered with the SEC? the State? Request a copy of Form D, as filed with SEC and relevant states. Verify the Form D or state regulatory equivalent filings in all states. What state is the fund organized in? Most domestic funds are organized in Delaware, although some are organized in Nevada, and, occasionally, in another state. What is the form of organization? Domestic funds are typically organized either as a limited partnership (in which the manager is the general partner and the investors are limited partners) or as a limited liability company in which the manager is the managing member and the investors are non-managing members). Obtain fund formation documents (e.g., Articles of Organization or Articles of Association) Request State Certificate of Good Standing from fund. This can be obtained from the state of formation. Contact state to verify certificate status or request that certificate be mailed directly to you. Is the fund domestic or offshore? If offshore, determine whether manager and/or fund are regulated by any regulator, and, if so, obtain regulatory filings. Ask about prime broker or other custodian, and administrator. Are they reputable? Where are the funds and securities custodied? If the answer is not New York, London, or some other major financial center, this is a warning sign. Inquire about the lawyers and the accountants: there is a limited universe of professionals in each offshore jurisdiction, and use of professionals who are not well known raises concerns. What is the management fee? What is the performance fee? Does the manager have the right to more than 20% of the profits? If so, think twice about investing. Does the manager's right to profits require that it first exceed a stated return to the investors (termed a hurdle rate)? If not, think twice about investing. Does the agreement have a "high water mark" (where an investor has had profits, and the manager taken a share of profits, manager can only take profits in a later year if the losses are made up first). If not, it is probably inadvisable to invest, since this indicates unfairness on the part of the manager. Is it a fund of funds? If the fund is a fund of funds, there are special considerations, the most important of which concerns fees and compensation to the two levels of managers. The costs should be kept to only slightly more than investment in a stand-alone fund entails. Obtain Investment Advisory Agreement between the fund and the investment advisor. Verify that it conforms to stated relationship in the fund's Offering Memorandum. What are the Withdrawal Terms? Does the agreement permit an investor to withdraw all or part of its capital? If so, on what conditions must the investor give written notice (such as 90 days or 180 days) and how often in each year can an investor withdraw? Industry standards vary. In some cases, withdrawal four times a year is permitted, in other cases, only on December 31, after giving notice 90 days in advance. If the agreement contains very restrictive withdrawal rights, think twice about investing. Does the fund have an Engagement Letter with an attorney on file? Obtain a copy and contact attorney to verify the client relationship. Does the fund have an Engagement Letter with an auditor on file? Obtain a copy and verify the client relationship Financial Statements Obtain copies of the last three years audited financial statements directly from the auditor. Do not accept copies provided by fund. Review them to see whether they agree with what the manager has represented to be the fund's results. Obtain copies of filed tax returns for last two years directly from the fund's accounting firm. Do not accept copies provided by the fund. Tax returns should include schedules and statements (except Schedule K-1, which discloses each investor's position in the fund). Compare results to audited financials, and reconcile tax results with financials (through unrealized gain/loss). Determine whether for tax purposes the fund is treated as a trader in securities (favorable treatment) or as an investor (unfavorable treatment). If the fund is a fund of funds, when does the manager issue its financials and tax returns are they timely, or are there extensions (it takes longer, and more work, for the fund and its accountants to issue the results in the case of a fund of funds)? What are the strategies employed by each of the sub-managers in the investee funds, and are they sufficiently diversified to spread risk? Obtain Performance Reports for the past 5 years. If PPM gives statistical history, review this and compare to audited financials. If manager supplies historical results, ask if these results are presented in compliance with AIMR (industry association) guidelines for presentation of results. Does the fund report far superior results to other funds in its investment strategy group? If so, ask for an explanation since there have been a number of frauds involving purportedly excellent results that ran counter to prevailing trends. Offering Memorandum Review the fund's Offering Memorandum. If there is a Form ADV (there will be if the manager is a Registered Investment Advisers), compare the Form ADV to the PPM (search for Form ADV Part I at www.adviserinfo.sec.gov/IAPD/Content/IapdMain/iapd_SiteMap.asp and ask manager for Form ADV Part II). What is the fund's brokerage firm(s)? Who are the prime brokers or other custodians for the fund? It is common for a hedge fund to have one or more prime brokers, who track the investments and custody the funds. Use of a prime broker is a positive indication. However, if the fund invests in commodities, that part of the investing cannot be done through a prime broker. Also, very large funds ($500 million and up) do not use a prime broker because it is not cost efficient. Investment Manager Is the investment manager registered as an investment adviser with SEC? If yes, review Form ADV. Review entire form and, in particular, look for number of personnel employed, number of clients, and funds under management. Also look for whether any advisee clients are SEC registered investment companies or nonregistered funds, and whether the adviser has had problems with regulators, has other business activities, etc. Is the investment manager registered with any state regulatory authority as an investment adviser? If so, review forms. If not registered as investment adviser with SEC, or state level, higher level of scrutiny required. Examine investment manager's Articles of Organization and Certificates of Formation for form of entity, jurisdiction of organization, location of office, and EIN letter from the IRS. Note that it is very rare for the investment manager of an onshore fund to be organized in a foreign jurisdiction Examine the Operating Agreement of the investment manager. What licenses do individuals employed at the investment manager possess? Many management personnel possess a securities license, such as Series 7 (registered representative of a broker-dealer) because the manager is itself registered with the SEC as a broker-dealer. If individuals are investment advisers, they will be required to have the Series 65 or equivalent. What are the educational and professional credentials of the personnel? Verifycredentials listed. What institutions of higher learning did they attend? Do they have a graduate degree in business or economics; sometimes, engineering, or mathematics, medicine, can be relevant? Are they a CFA (Certified Financial Analyst), which is the standard industry credential for professional investment managers? What are the employment histories of the personnel? Were they employed at other hedge funds? If so, verify employment and review the history of those funds. Were they employed at major financial institutions, and, if so, in what capacity? Examine the investment manager's past performance (if applicable). Obtain photo identification from the manager (driver's licen | |
