Chapter 26 Hedge Funds

Chapter 26 - Hedge Funds Chapter 26 Hedge Funds

Multiple Choice Questions

1. ______are the dominant form of investing in securities markets for most individuals but ______have enjoyed a far greater growth rate in the last decade. A. Hedge funds; hedge funds B. Mutual funds; hedge funds C. Hedge funds; mutual funds D. Mutual funds; mutual funds E. None of these is correct.

2. Like mutual funds, hedge funds A. allow private investors to pool assets to be managed by a fund manager. B. are commonly organized as private partnerships. C. are subject to extensive SEC regulations. D. are typically only open to wealthy or institutional investors. E. are commonly organized as private partnerships and are typically only open to wealthy or institutional investors.

3. Unlike mutual funds, hedge funds A. allow private investors to pool assets to be managed by a fund manager. B. are commonly organized as private partnerships. C. are subject to extensive SEC regulations. D. are typically only open to wealthy or institutional investors. E. are commonly organized as private partnerships and are typically only open to wealthy or institutional investors.

4. Alpha seeking hedge funds typically ______relative mispricing of specific securities and ______broad market exposure. A. bet on; bet on B. hedge; hedge C. hedge; bet on D. bet on; hedge E. None of these is correct.

26-1 Chapter 26 - Hedge Funds

5. Hedge funds ______engage in market timing ______take extensive derivative positions. A. cannot; and cannot B. cannot; but can C. can; and can D. can; but cannot E. None of these is correct.

6. The risk profile of hedge funds ______, making performance evaluation ______. A. can shift rapidly and substantially; challenging B. can shift rapidly and substantially; straightforward C. is stable; challenging D. is stable; straightforward E. None of these is correct.

7. Shares in hedge funds are priced A. at NAV. B. a significant premium to NAV. C. a significant discount from NAV. D. a significant premium to NAV or a significant discount from NAV. E. None of these is correct.

8. Hedge funds are typically set up as ______and provide ______information about portfolio composition and strategy to their investors. A. limited liability partnerships; minimal B. limited liability partnerships; extensive C. investment trusts; minimal D. investment trusts; extensive E. None of these is correct.

9. Hedge funds are ______transparent than mutual funds because of ______strict SEC regulation on hedge funds. A. more; more B. more; less C. less; less D. less; more E. None of these is correct.

10. ______must periodically provide the public with information on portfolio composition. A. Hedge funds B. Mutual funds C. ADRs D. Hedge funds and ADRs E. Hedge funds and mutual funds

11. ______are subject to the Securities act of 1933 and the Investment Company Act of 1940 to protect unsophisticated investors. A. Hedge funds B. Mutual funds C. ADRs D. Hedge funds and ADRs E. Mutual funds and ADRs

12. Hedge funds traditionally have ______than 100 investors and ______to the general public. A. more; advertise B. more; do not advertise C. less; advertise D. less; do not advertise E. None of these is correct.

13. The minimum investment in some new hedge funds is as low as $______, compared to a traditional minimum of $______. A. 50,000; 500,000 to 1 million B. 25,000; 250,000 to 1 million C. 175,000; 400,000 to 1 million D. 10,000; 750,000 E. 5,000; 2 million

14. Hedge funds differ from mutual funds in terms of ______. A. transparency B. investors C. investment strategy D. liquidity E. All of these are correct.

15. Hedge funds may invest or engage in A. distressed firms B. convertible bonds C. currency speculation D. merger arbitrage E. All of these are correct.

16. Hedge funds are prohibited from investing or engaging in A. distressed firms B. convertible bonds C. currency speculation D. merger arbitrage E. None of these is correct.

17. Hedge funds often have ______provisions as long as ______, which preclude redemption. A. crackdown; 2 months B. lock-up; 2 months C. crackdown; several years D. lock-up; several years E. None of these is correct.

18. Hedge fund strategies can be classified as ______. A. directional and nondirectional B. stock or bond C. arbitrage or speculation D. stock or bond and arbitrage or speculation E. directional and nondirectional and stock or bond

19. A hedge fund pursuing a ______strategy is betting one sector of the economy will outperform other sectors. A. directional B. non-directional C. stock or bond D. arbitrage or speculation E. None of these is correct.

20. A hedge fund pursuing a ______strategy is attempting to exploit temporary misalignments in relative pricing. A. directional B. nondirectional C. stock or bond D. arbitrage or speculation E. None of these is correct.

21. A hedge fund pursuing a ______strategy is trying to exploit relative mispricing within a market, but is hedged to avoid taking a stance on the direction of the broad market. A. directional B. nondirectional C. market neutral D. arbitrage or speculation E. nondirectional and market neutral

22. An example of a ______strategy is the mispricing of a futures contract that must be corrected by contract expiration. A. market neutral B. directional C. relative value D. divergence E. convergence

23. A hedge fund attempting to profit from a change in the spread between mortgages and Treasuries is using a ______strategy. A. market neutral B. directional C. relative value D. divergence E. convergence

24. If the yield on mortgage-backed securities was abnormally high compared to Treasury bonds, a hedge fund pursuing a relative value strategy would ______. A. short sell the Treasury bonds and short sell the mortgage-backed securities B. short sell the Treasury bonds bonds and buy the mortgage-backed securities C. buy the Treasury bonds and buy the mortgage-backed securities D. buy the Treasury bonds and short sell the mortgage-backed securities E. None of these is correct.

25. Assume newly issued 30-year-on-the-run bonds sell at higher yields (lower prices) than 29 ½ year bonds with a nearly identical duration. A hedge fund that sells 29 ½ year bonds and buys 30 year bonds is taking a ______. A. market neutral position B. conservative position C. bullish position D. bearish position E. None of these is correct.

26. A bet on particular mispricing across two or more securities, with extraneous sources of risk such as general market exposure hedged away is a ______. A. pure play B. relative play C. long shot D. sure thing E. relative play and sure thing

27. Assume newly issued 30-year-on-the-run bonds sell at higher yields (lower prices) than 29 ½ year bonds with a nearly identical duration. A hedge fund that sells 29 ½ year bonds and buys 30 year bonds is taking a ______. A. market neutral position B. conservative position C. bullish position D. bearish position E. None of these is correct.

28. If the yield on mortgage-backed securities was abnormally low compared to Treasury bonds, a hedge fund pursuing a relative value strategy would ______. A. short sell the Treasury bonds and short sell the mortgage-backed securities B. short sell the Treasury bonds and buy the mortgage-backed securities C. buy the Treasury bonds and buy the mortgage-backed securities D. buy the Treasury bonds and short sell the mortgage-backed securities E. None of these is correct.

29. Statistical arbitrage is a version of a ______strategy. A. market neutral B. directional C. relative value D. divergence E. convergence

30. ______uses quantitative techniques and often automated trading systems to seek out many temporary misalignments among securities. A. Covered interest arbitrage B. Locational arbitrage C. Triangular arbitrage D. Statistical arbitrage E. All arbitrage

31. Assume that you manage a $3 million portfolio that pays no dividends, has a beta of 1.45 and an alpha of 1.5% per month. Also, assume that the risk-free rate is 0.025% (per month) and the S&P 500 is at 1220. If you expect the market to fall within the next 30 days you can hedge your portfolio by ______S&P 500 futures contracts (the futures contract has a multiplier of $250). A. selling 1 B. selling 14 C. buying 1 D. buying 14 E. selling 6

32. Assume that you manage a $1.3 million portfolio that pays no dividends, has a beta of 1.45 and an alpha of 1.5% per month. Also, assume that the risk-free rate is 0.025% (per month) and the S&P 500 is at 1220. If you expect the market to fall within the next 30 days you can hedge your portfolio by ______S&P 500 futures contracts (the futures contract has a multiplier of $250). A. selling 1 B. selling 6 C. buying 1 D. buying 6 E. selling 4

33. Assume that you manage a $2 million portfolio that pays no dividends, has a beta of 1.25 and an alpha of 2% per month. Also, assume that the risk-free rate is 0.05% (per month) and the S&P 500 is at 1300. If you expect the market to fall within the next 30 days you can hedge your portfolio by ______S&P 500 futures contracts (the futures contract has a multiplier of $250). A. selling 1 B. selling 8 C. buying 1 D. buying 8 E. selling 6

35. Market neutral bets can result in ______volatility because hedge funds use ______. A. very low; hedging techniques to eliminate risk B. low; risk management techniques to reduce risk C. considerable; risk management techniques to reduce risk D. considerable; considerable leverage E. None of these is correct.

36. Hedge funds exhibit a pattern known as a A. January effect. B. Santa effect. C. size effect. D. book-to-market. E. None of these is correct.

37. ______bias arises because hedge funds only report returns to database publishers if they want to. A. Survivorship B. Backfill C. Omission D. Incubation E. None of these is correct.

38. ______bias arises when the returns of unsuccessful funds are left out of the sample. A. Survivorship B. Backfill C. Omission D. Incubation E. None of these is correct.

39. Performance evaluation of hedge funds is complicated by ______. A. liquidity premiums B. survivorship bias C. unreliable market valuations of infrequently traded assets D. unstable risk attributes E. All of these are correct.

40. The previous value of a portfolio that must be reattained before a hedge fund can charge incentive fees is known as a ______. A. benchmark B. water stain C. water mark D. high water mark E. low water mark

41. The typical hedge fund fee structure is A. a management fee of 1% to 2%. B. an annual incentive fee equal to 20% of investment profits beyond a stipulated benchmark performance. C. a 12-b1 fee of 1%. D. a management fee of 1% to 2% and an annual incentive fee equal to 20% of investment profits beyond a stipulated benchmark performance. E. a management fee of 1% to 2% and a 12-b1 fee of 1%.

42. Hedge fund incentive fees are essentially A. put options on the portfolio with a strike price equal to the current portfolio value. B. put options on the portfolio with a strike price equal to the expected future portfolio value. C. call options on the portfolio with a strike price equal to the expected future portfolio value. D. call options on the portfolio with a strike price equal to the current portfolio value times one plus the benchmark return. E. straddles.

43. Regarding hedge fund incentive fees, hedge fund managers ______if the portfolio return is very large and ______if the portfolio return is negative. A. get nothing; get nothing B. refund the fee; get the fee C. get the fee; lose nothing except the incentive fee D. get the fee; lose the management fee E. None of these is correct.

44. Hedge funds often employ ______that require investors to provide ______notice of their desire to redeem funds. A. redemption notices; of several weeks to several months B. redemption notices; of several hours to several days C. redemption notices; of several days to several weeks D. lock-up; several years E. lock-up; several hours

45. Pairs trading is associated with ______. A. triangular arbitrage B. statistical arbitrage C. data mining D. triangular arbitrage and data mining E. statistical arbitrage and data mining

46. ______refers to sorting through huge amounts of historical data to uncover systematic patterns in returns that can be exploited by traders. A. Data mining B. Pairs trading C. Alpha transfer D. Beta shifting E. Pairs trading and alpha transfer

47. Hedge fund performance may reflect significant compensation for ______risk. A. liquidity B. systematic C. unsystematic D. default E. unsystematic and default

48. A ______is an investment fraud in which a manager collects funds from clients, claims to invest those funds on their behalf, reports extremely favorable investment returns, but in fact uses the funds for his own use. A. ponzi scheme B. bonsai scheme C. statistical arbitrage scheme D. pairs trading scheme E. None of these is correct.

49. Sadka (2009) shows that exposure to unexpected declines in ______is an important determinant of average hedge fund returns and that the spreads in average returns across funds with the highest and lowest ______may be as much as 6% annually. A. market risk; systematic risk B. market liquidity; liquidity risk C. unsystematic risk; unique risk D. default risk; default risk E. market risk; systematic risk and default risk; default risk

Short Answer Questions

50. Explain the five major differences between hedge funds and mutual funds.

Chapter 26 Hedge Funds Answer Key

Multiple Choice Questions

1. ______are the dominant form of investing in securities markets for most individuals but ______have enjoyed a far greater growth rate in the last decade. A. Hedge funds; hedge funds B. Mutual funds; hedge funds C. Hedge funds; mutual funds D. Mutual funds; mutual funds E. None of these is correct

Mutual funds are the dominant form of investing in securities markets for most individuals and hedge funds have enjoyed a far greater growth rate in the last decade.

AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: Hedge funds

2. Like mutual funds, hedge funds A. allow private investors to pool assets to be managed by a fund manager. B. are commonly organized as private partnerships. C. are subject to extensive SEC regulations. D. are typically only open to wealthy or institutional investors. E. are commonly organized as private partnerships and are typically only open to wealthy or institutional investors

Like mutual funds, hedge funds allow private investors to pool assets to be managed by a fund manager.

3. Unlike mutual funds, hedge funds A. allow private investors to pool assets to be managed by a fund manager. B. are commonly organized as private partnerships. C. are subject to extensive SEC regulations. D. are typically only open to wealthy or institutional investors. E. are commonly organized as private partnerships and are typically only open to wealthy or institutional investors

Unlike mutual funds, hedge funds are commonly organized as private partnerships and are typically only open to wealthy or institutional investors.

4. Alpha seeking hedge funds typically ______relative mispricing of specific securities and ______broad market exposure. A. bet on; bet on B. hedge; hedge C. hedge; bet on D. bet on; hedge E. None of these is correct

Alpha seeking hedge funds typically bet on relative mispricing of specific securities and hedge broad market exposure.

AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds

5. Hedge funds ______engage in market timing ______take extensive derivative positions. A. cannot; and cannot B. cannot; but can C. can; and can D. can; but cannot E. None of these is correct

Hedge funds can engage in market timing and can take extensive derivative positions.

6. The risk profile of hedge funds ______, making performance evaluation ______. A. can shift rapidly and substantially; challenging B. can shift rapidly and substantially; straightforward C. is stable; challenging D. is stable; straightforward E. None of these is correct

The risk profile of hedge funds can shift rapidly and substantially, making performance evaluation challenging.

7. Shares in hedge funds are priced A. at NAV B. a significant premium to NAV C. a significant discount from NAV D. a significant premium to NAV or a significant discount from NAV E. None of these is correct

Shares in hedge funds are priced at NAV.

8. Hedge funds are typically set up as ______and provide ______information about portfolio composition and strategy to their investors. A. limited liability partnerships; minimal B. limited liability partnerships; extensive C. investment trusts; minimal D. investment trusts; extensive E. None of these is correct

Hedge funds are typically set up as limited liability partnerships and provide minimal information about portfolio composition and strategy to their investors.

9. Hedge funds are ______transparent than mutual funds because of ______strict SEC regulation on hedge funds. A. more; more B. more; less C. less; less D. less; more E. None of these is correct

Hedge funds are less transparent than mutual funds because of less strict SEC regulation on hedge funds.

10. ______must periodically provide the public with information on portfolio composition. A. Hedge funds B. Mutual funds C. ADRs D. Hedge funds and ADRs E. Hedge funds and mutual funds

Mutual funds must periodically provide the public with information on portfolio composition.

11. ______are subject to the Securities act of 1933 and the Investment Company Act of 1940 to protect unsophisticated investors. A. Hedge funds B. Mutual funds C. ADRs D. Hedge funds and ADRs E. Mutual funds and ADRs

Mutual funds are subject to the Securities act of 1933 and the Investment Company Act of 1940 to protect unsophisticated investors.

12. Hedge funds traditionally have ______than 100 investors and ______to the general public. A. more; advertise B. more; do not advertise C. less; advertise D. less; do not advertise E. None of these is correct

Hedge funds traditionally have less than 100 investors and do not advertise to the general public.

13. The minimum investment in some new hedge funds is as low as $______, compared to a traditional minimum of $______. A. 50,000; 500,000 to 1 million B. 25,000; 250,000 to 1 million C. 175,000; 400,000 to 1 million D. 10,000; 750,000 E. 5,000; 2 million

The minimum investment in some new hedge funds is as low as 25,000 compared to a traditional minimum of 250,000 to 1 million.

14. Hedge funds differ from mutual funds in terms of ______. A. transparency B. investors C. investment strategy D. liquidity E. All of these are correct

Funds differ from mutual funds in terms of transparency, investors, investment strategy, and liquidity.

15. Hedge funds may invest or engage in A. distressed firms B. convertible bonds C. currency speculation D. merger arbitrage E. All of these are correct

Hedge funds may invest or engage in distressed firms, convertible bonds, currency speculation, and merger arbitrage.

16. Hedge funds are prohibited from investing or engaging in A. distressed firms B. convertible bonds C. currency speculation D. merger arbitrage E. None of these is correct

Hedge funds may invest or engage in distressed firms, convertible bonds, currency speculation, and merger arbitrage.

17. Hedge funds often have ______provisions as long as ______, which preclude redemption. A. crackdown, 2 months B. lock-up; 2 months C. crackdown; several years D. lock-up; several years E. None of these is correct

Hedge funds often have lock-up provisions as long as several years, which preclude redemption.

18. Hedge fund strategies can be classified as ______. A. directional and nondirectional B. stock or bond C. arbitrage or speculation D. stock or bond and arbitrage or speculation E. directional and nondirectional and stock or bond

Hedge fund strategies can be classified as directional and nondirectional.

19. A hedge fund pursuing a ______strategy is betting one sector of the economy will outperform other sectors. A. directional B. non-directional C. stock or bond D. arbitrage or speculation E. None of these is correct

A hedge fund pursuing a directional strategy is betting one sector of the economy will outperform other sectors.

20. A hedge fund pursuing a ______strategy is attempting to exploit temporary misalignments in relative pricing. A. directional B. nondirectional C. stock or bond D. arbitrage or speculation E. None of these is correct

A hedge fund pursuing a nondirectional strategy is attempting to exploit temporary misalignments in relative pricing.

21. A hedge fund pursuing a ______strategy is trying to exploit relative mispricing within a market, but is hedged to avoid taking a stance on the direction of the broad market. A. directional B. nondirectional C. market neutral D. arbitrage or speculation E. nondirectional and market neutral

A hedge fund pursuing a market neutral strategy is trying to exploit relative mispricing within a market, but is hedged to avoid taking a stance on the direction of the broad market.

22. An example of a ______strategy is the mispricing of a futures contract that must be corrected by contract expiration. A. market neutral B. directional C. relative value D. divergence E. convergence

An example of a convergence strategy is the mispricing of a futures contract that must be corrected by contract expiration.

23. A hedge fund attempting to profit from a change in the spread between mortgages and Treasuries is using a ______strategy. A. market neutral B. directional C. relative value D. divergence E. convergence

A hedge fund attempting to profit from a change in the spread between mortgages and Treasuries is using a relative value strategy.

24. If the yield on mortgage-backed securities was abnormally high compared to Treasury bonds, a hedge fund pursuing a relative value strategy would ______. A. short sell the Treasury bonds and short sell the mortgage-backed securities B. short sell the Treasury bonds bonds and buy the mortgage-backed securities C. buy the Treasury bonds and buy the mortgage-backed securities D. buy the Treasury bonds and short sell the mortgage-backed securities E. None of these is correct

If the yield on mortgage-backed securities was abnormally high compared to Treasury bonds, a hedge fund pursuing a nondirectional strategy would short sell the Treasury bonds and buy the mortgage-backed securities.

25. Assume newly issued 30-year-on-the-run bonds sell at higher yields (lower prices) than 29 ½ year bonds with a nearly identical duration. A hedge fund that sells 29 ½ year bonds and buys 30 year bonds is taking a ______. A. market neutral position B. conservative position C. bullish position D. bearish position E. None of these is correct

A hedge fund that sells 29½ year bonds and buys 30 year bonds is taking a market neutral position.

26. A bet on particular mispricing across two or more securities, with extraneous sources of risk such as general market exposure hedged away is a ______. A. pure play B. relative play C. long shot D. sure thing E. relative play and sure thing

A bet on particular mispricing across two or more securities, with extraneous sources of risk such as general market exposure hedged away is a pure play.

27. Assume newly issued 30-year-on-the-run bonds sell at higher yields (lower prices) than 29 ½ year bonds with a nearly identical duration. A hedge fund that sells 29 ½ year bonds and buys 30 year bonds is taking a ______. A. market neutral position B. conservative position C. bullish position D. bearish position E. None of these is correct

A hedge fund that sells 29½ year bonds and buys 30 year bonds is taking a market neutral position.

28. If the yield on mortgage-backed securities was abnormally low compared to Treasury bonds, a hedge fund pursuing a relative value strategy would ______. A. short sell the Treasury bonds and short sell the mortgage-backed securities B. short sell the Treasury bonds and buy the mortgage-backed securities C. buy the Treasury bonds and buy the mortgage-backed securities D. buy the Treasury bonds and short sell the mortgage-backed securities E. None of these is correct

If the yield on mortgage-backed securities was abnormally low compared to Treasury bonds, a hedge fund pursuing a non-directional strategy would buy the Treasury and short sell the mortgage-backed securities.

AACSB: Analytic Bloom's: Understand Difficulty: Intermediate Topic: Hedge funds

29. Statistical arbitrage is a version of a ______strategy. A. market neutral B. directional C. relative value D. divergence E. convergence

Statistical arbitrage is a version of a market neutral strategy.

30. ______uses quantitative techniques and often automated trading systems to seek out many temporary misalignments among securities. A. Covered interest arbitrage B. Locational arbitrage C. Triangular arbitrage D. Statistical arbitrage E. All arbitrage

Statistical arbitrage uses quantitative techniques and often automated trading systems to seek out many temporary misalignments among securities.

31. Assume that you manage a $3 million portfolio that pays no dividends, has a beta of 1.45 and an alpha of 1.5% per month. Also, assume that the risk-free rate is 0.025% (per month) and the S&P 500 is at 1220. If you expect the market to fall within the next 30 days you can hedge your portfolio by ______S&P 500 futures contracts (the futures contract has a multiplier of $250). A. selling 1 B. selling 14 C. buying 1 D. buying 14 E. selling 6

The hedge ratio is [$3M/(1220 × 250)] × 1.45 = 14.26. Thus, you would need to sell 14 contracts.

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32. Assume that you manage a $1.3 million portfolio that pays no dividends, has a beta of 1.45 and an alpha of 1.5% per month. Also, assume that the risk-free rate is 0.025% (per month) and the S&P 500 is at 1220. If you expect the market to fall within the next 30 days you can hedge your portfolio by ______S&P 500 futures contracts (the futures contract has a multiplier of $250). A. selling 1 B. selling 6 C. buying 1 D. buying 6 E. selling 4

The hedge ratio is [$1.3M/(1220 × 250)] × 1.45 = 6.18. Thus, you would need to sell 6 contracts.

35. Market neutral bets can result in ______volatility because hedge funds use ______. A. very low; hedging techniques to eliminate risk B. low; risk management techniques to reduce risk C. considerable; risk management techniques to reduce risk D. considerable; considerable leverage E. None of these is correct

Market neutral bets can result in considerable volatility because hedge funds use considerable leverage.

36. Hedge funds exhibit a pattern known as a A. January effect B. Santa effect C. size effect D. book-to-market E. None of these is correct

Hedge funds exhibit a pattern known as a Santa effect.

37. ______bias arises because hedge funds only report returns to database publishers if they want to. A. Survivorship B. Backfill C. Omission D. Incubation E. None of these is correct

Backfill bias arises because hedge funds only report returns to database publishers if they want to.

38. ______bias arises when the returns of unsuccessful funds are left out of the sample. A. Survivorship B. Backfill C. Omission D. Incubation E. None of these is correct

Survivorship bias arises when the returns of unsuccessful funds are left out of the sample.

39. Performance evaluation of hedge funds is complicated by ______. A. liquidity premiums B. survivorship bias C. unreliable market valuations of infrequently traded assets D. unstable risk attributes E. All of these are correct

Performance evaluation of hedge funds is complicated by liquidity premiums, survivorship bias, unreliable market valuations of infrequently traded assets, and unstable risk attributes.

40. The previous value of a portfolio that must be reattained before a hedge fund can charge incentive fees is known as a ______. A. benchmark B. water stain C. water mark D. high water mark E. low water mark

The previous value of a portfolio that must be reattained before a hedge fund can charge incentive fees is known as a high water mark.

41. The typical hedge fund fee structure is A. a management fee of 1% to 2% B. an annual incentive fee equal to 20% of investment profits beyond a stipulated benchmark performance C. a 12-b1 fee of 1% D. a management fee of 1% to 2% and an annual incentive fee equal to 20% of investment profits beyond a stipulated benchmark performance E. a management fee of 1% to 2% and a 12-b1 fee of 1%

The typical hedge fund fee structure is a management fee of 1% to 2% and annual incentive fee equal to 20% of investment profits beyond a stipulated benchmark performance.

42. Hedge fund incentive fees are essentially A. put options on the portfolio with a strike price equal to the current portfolio value B. put options on the portfolio with a strike price equal to the expected future portfolio value C. call options on the portfolio with a strike price equal to the expected future portfolio value D. call options on the portfolio with a strike price equal to the current portfolio value times one plus the benchmark return E. straddles

Hedge fund incentive fees are essentially call options on the portfolio with a strike price equal to the current portfolio value times one plus the benchmark return.

43. Regarding hedge fund incentive fees, hedge fund managers ______if the portfolio return is very large and ______if the portfolio return is negative. A. get nothing; get nothing B. refund the fee; get the fee C. get the fee; lose nothing except the incentive fee D. get the fee; lose the management fee E. None of these is correct

Regarding hedge fund incentive fees, hedge fund managers get the fee if the portfolio return is very large and lose nothing except the incentive fee if the portfolio return is negative.

44. Hedge funds often employ ______that require investors to provide ______notice of their desire to redeem funds. A. redemption notices; of several weeks to several months B. redemption notices; of several hours to several days C. redemption notices; of several days to several weeks D. lock-up; several years E. lock-up; several hours

Hedge funds often employ redemption notices that require investors to provide notice of several weeks to several months notice of their desire to redeem funds.

45. Pairs trading is associated with ______. A. triangular arbitrage B. statistical arbitrage C. data mining D. triangular arbitrage and data mining E. statistical arbitrage and data mining

Pairs trading is associated with statistical arbitrage and is based on data mining.

46. ______refers to sorting through huge amounts of historical data to uncover systematic patterns in returns that can be exploited by traders. A. Data mining B. Pairs trading C. Alpha transfer D. Beta shifting E. Pairs trading and alpha transfer

Data mining refers to sorting through huge amounts of historical data to uncover systematic patterns in returns that can be exploited by traders.

47. Hedge fund performance may reflect significant compensation for ______risk. A. liquidity B. systematic C. unsystematic D. default E. unsystematic and default

Hedge fund performance may reflect significant compensation for liquidity risk.

48. A ______is an investment fraud in which a manager collects funds from clients, claims to invest those funds on their behalf, reports extremely favorable investment returns, but in fact uses the funds for his own use. A. ponzi scheme B. bonsai scheme C. statistical arbitrage scheme D. pairs trading scheme E. None of these is correct

A ponzi scheme is an investment fraud in which a manager collects funds from clients, claims to invest those funds on their behalf, reports extremely favorable investment returns, but in fact uses the funds for his own use.

49. Sadka (2009) shows that exposure to unexpected declines in ______is an important determinant of average hedge fund returns and that the spreads in average returns across funds with the highest and lowest ______may be as much as 6% annually. A. market risk; systematic risk B. market liquidity; liquidity risk C. unsystematic risk; unique risk D. default risk; default risk E. market risk; systematic risk and default risk; default risk

Sadka (2009) shows that exposure to unexpected declines in market liquidity is an important determinant of average hedge fund returns and that the spreads in average returns across funds with the highest and lowest liquidity risk may be as much as 6% annually.

Short Answer Questions

50. Explain the five major differences between hedge funds and mutual funds.

The five major categories of differences are transparency, investors, investment strategies, liquidity, and compensation structure. Mutual funds are more highly regulated by the SEC and thus are required to be far more transparent. Hedge funds provide only minimal information about portfolio composition or strategy. Investors in hedge funds differ in that investment minimums were traditionally set at $250,000 to $1,000,000. While newer hedge funds are starting to reduce the minimum investment to $25,000, this minimum is outside the reach of many mutual fund investors. Mutual funds must provide an investment strategy and are restricted in the use of leverage, short selling, and in their use of derivatives. However, hedge funds are less restricted and frequently make large bets that can results in large losses over the short term. Mutual funds are liquid and investors can redeem shares at NAV and have proceeds within seven business days. Conversely, hedge funds often impose lock-up periods as long as several years and require redemption notices of several months even after the lock- up period is over. Thus, hedge funds are far less liquid. While mutual funds charge a management fee, hedge funds add an incentive fee as well. This incentive fee is similar to a call option and the portfolio manager receives a "performance" bonus if the portfolio outperforms the chosen benchmark.

Feedback: This question tests the students understanding of the major differences between hedge funds and mutual funds.

AACSB: Reflective Thinking Bloom's: Understand Difficulty: Intermediate Topic: Hedge funds