Chapter 26 Hedge Funds

Chapter 26 - Hedge Funds Chapter 26 Hedge FundsMultiple Choice Questions1. ______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 Funds5. 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.26-2 Chapter 26 - Hedge Funds9. 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 funds11. ______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 ADRs12. 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.26-3 Chapter 26 - Hedge Funds13. 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 million14. 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.26-4 Chapter 26 - Hedge Funds17. 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 bond19. 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.26-5 Chapter 26 - Hedge Funds21. 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 neutral22. 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. convergence23. 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. convergence24. 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.26-6 Chapter 26 - Hedge Funds25. 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 thing27. 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.26-7 Chapter 26 - Hedge Funds29. Statistical arbitrage is a version of a ______strategy. A. market neutral B. directional C. relative value D. divergence E. convergence30. ______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 arbitrage31. 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 632. 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 426-8 Chapter 26 - Hedge Funds33. 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 634. Assume that you manage a $2 million portfolio that pays no dividends, has a beta of 1.3 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 1500. 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 7 C. buying 1 D. buying 7 E. selling 1135. 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.26-9 Chapter 26 - Hedge Funds37. ______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 mark26-10 Chapter 26 - Hedge Funds41. 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 hours26-11 Chapter 26 - Hedge Funds45. 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 mining46. ______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 transfer47. Hedge fund performance may reflect significant compensation for ______risk. A. liquidity B. systematic C. unsystematic D. default E. unsystematic and default48. 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.26-12 Chapter 26 - Hedge Funds49. 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 riskShort Answer Questions50. Explain the five major differences between hedge funds and mutual funds. 26-13 Chapter 26 - Hedge FundsChapter 26 Hedge Funds Answer KeyMultiple Choice Questions1. ______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 correctMutual 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 funds2. 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 investorsLike mutual funds, hedge funds allow private investors to pool assets to be managed by a fund manager.AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: Hedge funds26-14 Chapter 26 - Hedge Funds3. 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 investorsUnlike mutual funds, hedge funds are commonly organized as private partnerships and are typically only open to wealthy or institutional investors.AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: Hedge funds4. 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 correctAlpha 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 funds26-15 Chapter 26 - Hedge Funds5. 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 correctHedge funds can engage in market timing and can take extensive derivative positions.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds6. 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 correctThe risk profile of hedge funds can shift rapidly and substantially, making performance evaluation challenging.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-16 Chapter 26 - Hedge Funds7. 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 correctShares in hedge funds are priced at NAV.AACSB: Analytic Bloom's: Remember Difficulty: Basic Topic: Hedge funds8. 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 correctHedge funds are typically set up as limited liability partnerships and provide minimal information about portfolio composition and strategy to their investors.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-17 Chapter 26 - Hedge Funds9. 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 correctHedge funds are less transparent than mutual funds because of less strict SEC regulation on hedge funds.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds10. ______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 fundsMutual funds must periodically provide the public with information on portfolio composition.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-18 Chapter 26 - Hedge Funds11. ______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 ADRsMutual funds are subject to the Securities act of 1933 and the Investment Company Act of 1940 to protect unsophisticated investors.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds12. 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 correctHedge funds traditionally have less than 100 investors and do not advertise to the general public.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-19 Chapter 26 - Hedge Funds13. 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 millionThe minimum investment in some new hedge funds is as low as 25,000 compared to a traditional minimum of 250,000 to 1 million.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds14. Hedge funds differ from mutual funds in terms of ______. A. transparency B. investors C. investment strategy D. liquidity E. All of these are correctFunds differ from mutual funds in terms of transparency, investors, investment strategy, and liquidity.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-20 Chapter 26 - Hedge Funds15. Hedge funds may invest or engage in A. distressed firms B. convertible bonds C. currency speculation D. merger arbitrage E. All of these are correctHedge funds may invest or engage in distressed firms, convertible bonds, currency speculation, and merger arbitrage.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds16. 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 correctHedge funds may invest or engage in distressed firms, convertible bonds, currency speculation, and merger arbitrage.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-21 Chapter 26 - Hedge Funds17. 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 correctHedge funds often have lock-up provisions as long as several years, which preclude redemption.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds18. 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 bondHedge fund strategies can be classified as directional and nondirectional.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-22 Chapter 26 - Hedge Funds19. 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 correctA hedge fund pursuing a directional strategy is betting one sector of the economy will outperform other sectors.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds20. 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 correctA hedge fund pursuing a nondirectional strategy is attempting to exploit temporary misalignments in relative pricing.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-23 Chapter 26 - Hedge Funds21. 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 neutralA 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.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds22. 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. convergenceAn example of a convergence strategy is the mispricing of a futures contract that must be corrected by contract expiration.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-24 Chapter 26 - Hedge Funds23. 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. convergenceA hedge fund attempting to profit from a change in the spread between mortgages and Treasuries is using a relative value strategy.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds24. 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 correctIf 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.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-25 Chapter 26 - Hedge Funds25. 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 correctA hedge fund that sells 29½ year bonds and buys 30 year bonds is taking a market neutral position.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26. 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 thingA 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.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-26 Chapter 26 - Hedge Funds27. 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 correctA hedge fund that sells 29½ year bonds and buys 30 year bonds is taking a market neutral position.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds28. 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 correctIf 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 funds26-27 Chapter 26 - Hedge Funds29. Statistical arbitrage is a version of a ______strategy. A. market neutral B. directional C. relative value D. divergence E. convergenceStatistical arbitrage is a version of a market neutral strategy.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds30. ______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 arbitrageStatistical arbitrage uses quantitative techniques and often automated trading systems to seek out many temporary misalignments among securities.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-28 Chapter 26 - Hedge Funds31. 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 6The hedge ratio is [$3M/(1220 × 250)] × 1.45 = 14.26. Thus, you would need to sell 14 contracts.AACSB: Analytic Bloom's: Apply Difficulty: Challenge Topic: Hedge funds32. 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 4The hedge ratio is [$1.3M/(1220 × 250)] × 1.45 = 6.18. Thus, you would need to sell 6 contracts.AACSB: Analytic Bloom's: Apply Difficulty: Challenge Topic: Hedge funds26-29 Chapter 26 - Hedge Funds33. 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 6The hedge ratio is [$2M/(1300 × 250)] × 1.25 = 7.69. Thus, you would need to sell 8 contracts.AACSB: Analytic Bloom's: Apply Difficulty: Challenge Topic: Hedge funds34. Assume that you manage a $2 million portfolio that pays no dividends, has a beta of 1.3 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 1500. 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 7 C. buying 1 D. buying 7 E. selling 11The hedge ratio is [$2M/(1500 × 250)] × 1.3 = 6.93. Thus, you would need to sell 7 contracts.AACSB: Analytic Bloom's: Apply Difficulty: Challenge Topic: Hedge funds26-30 Chapter 26 - Hedge Funds35. 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 correctMarket neutral bets can result in considerable volatility because hedge funds use considerable leverage.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds36. 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 correctHedge funds exhibit a pattern known as a Santa effect.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-31 Chapter 26 - Hedge Funds37. ______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 correctBackfill bias arises because hedge funds only report returns to database publishers if they want to.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds38. ______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 correctSurvivorship bias arises when the returns of unsuccessful funds are left out of the sample.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-32 Chapter 26 - Hedge Funds39. 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 correctPerformance evaluation of hedge funds is complicated by liquidity premiums, survivorship bias, unreliable market valuations of infrequently traded assets, and unstable risk attributes.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds40. 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 markThe previous value of a portfolio that must be reattained before a hedge fund can charge incentive fees is known as a high water mark.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-33 Chapter 26 - Hedge Funds41. 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.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds42. 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. straddlesHedge 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.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-34 Chapter 26 - Hedge Funds43. 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 correctRegarding 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.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds44. 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 hoursHedge funds often employ redemption notices that require investors to provide notice of several weeks to several months notice of their desire to redeem funds.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-35 Chapter 26 - Hedge Funds45. 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 miningPairs trading is associated with statistical arbitrage and is based on data mining.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds46. ______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 transferData mining refers to sorting through huge amounts of historical data to uncover systematic patterns in returns that can be exploited by traders.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-36 Chapter 26 - Hedge Funds47. Hedge fund performance may reflect significant compensation for ______risk. A. liquidity B. systematic C. unsystematic D. default E. unsystematic and defaultHedge fund performance may reflect significant compensation for liquidity risk.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds48. 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 correctA 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.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-37 Chapter 26 - Hedge Funds49. 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 riskSadka (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.AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Hedge funds26-38 Chapter 26 - Hedge FundsShort Answer Questions50. 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 funds26-39

Chapter 26 Hedge Funds

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