Securities such as stocks, bonds, and trade or financial claims of companies which are in or close to financial distress. In anticipation of the financial distress, the prices of these securities drop as their holders choose to sell rather than remain invested in a financially unsound company. It happens, sometimes, that distressed sellers overlook or underestimate the company’s true value in their rush to avoid being in the middle of a looming bankruptcy.
Researching distressed securities is a hedge fund trading strategy that involves buying securities issued by companies which are currently in or close to bankruptcy, in order to unearth truly underestimated holdings based on risk analysis and business evaluation. As a result, hedge fund’s sharp-eyed professionals can pick up such securities or claims at reduced prices, reaping great value in the process.
A distressed opportunity typically presents itself when a company, unable to meet all its obligations, files for reorganization bankruptcy (known in the US as Chapter 11) or liquidation bankruptcy (known as Chapter 7). Chapter 7 involves closing a company’s doors and putting its assets at the disposal of its creditors. Chapter 11 bestow upon the company legal protection to continue its operations while crafting a reorganization plan, meant to repay its debts, under the surveillance of a committee of its major creditors.
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