Setting Up a Hedge Fund

1. He parks $100 million in one-year Treasury Bills yielding 4%
2. This then allows him to sell for 10 cents on the dollar 100 million covered options, which will pay out if the S&P 500 fall by more than 20% in the coming year.
3. He takes the $10 million from the sale of the options and buys some more Treasury bills, which enables him to sell another 10 million options, which nets him another $1 million.
4. He then takes a long vacation.
5. At the end of the year the probability is 90% that the S&P 500 has not fallen by 20%, so he owes the option-holders nothing.
6. He adds up his earnings – $11 million from the sale of the options plus 4% on the $110 million of T-Bills – a handsome return of 15.4 percent before expenses
7. He pockets 2% of the funds under management ($2 million) and 20% of the returns above, say, a 4% benchmark, which comes to over $4 million gross.
8. The chances are nearly 60% that the fund will run smoothly on this basis for more than five years without the S&P falling by 20%, in which case he makes $15 million even if no new money comes into his fund, and even without leveraging his position.

page 331 of Neal Ferguson’s The Ascent of Money

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