Hedge Funds by Luis A. Seco and Chen Fangyuan

Hedge Funds by Luis A. Seco and Chen Fangyuan

intermediary in the swap, and collects a commission for its services. The dealer has
no risk exposure to snow precipitation because it is exchanging offsetting payments
between the two parties.
The snow swap did not succeed, however, because there was no agreement
between the city and the ski resort as to where the measurements for snow pre-

cipitation should be taken. Specifically, ski resorts are mostly located in suburban
areas while majority of the city is located in urban areas. Therefore, ski resorts
would like to measure the snow precipitation at suburban areas, while the city
would like it be at urban areas. The snow amount in suburban and urban areas do
not always agree, giving rise to the geographical spread of snow precipitation. The
snow financial risk seemed to be solved by the snow swap, but the geographical
spread risk could not be absorbed by anyone.
Let us consider the hypothetical following proposition: a group of investors (a
fund) gets together, puts up some money upfront as collateral, and decides to take
the geographical spread risk. It will pay the city in the case of out-of-season snow
falls in the city, and will pay the ski resort in case of no out-of-season snow falls
at the resort (See Table 1). By contrast, it will receive payments from both if the
opposite occurs. With an nominal payment of $1M, and an nominal fee of 10%
($100,000), cash flows for the fund is shown in Table 2. The difference with the
previous, unsuccessful snow swap is that in this case, both the city as well as the
ski resort get to measure the snow precipitation at the place of their choice, with
the fund taking the geographical risk.
Table 1.

To move ahead with our example, let us assume the snow events in both places
are correlated at 50%, and the fund will charge the same $100,000 fee from both
counter-parties for its risk: this means that the cash-flows for the fund will be:
Table 2.

1.1.1. Earning perspective of the fund. To get an idea of the quality of these
funds, we look at two basic properties: expected return and standard deviation.
Suppose the investors need to put down the maximum amount that the fund needs
to pay out, $2M, in the case of snow falls in the city, but not in the ski resort. Then

Hedge Funds by Luis A. Seco and Chen Fangyuan