chap 020

Chapter 20 - Hedge Funds

Chapter 20Hedge Funds

Multiple Choice Questions

1. Which of the following are characteristics of a hedge fund?I. Pooling of assetsII. Strict regulatory oversight by the SECIII. Investing in equities, debt instruments, and derivative instrumentsIV. Professional management of assets A. I and II onlyB. II and III onlyC. III and IV onlyD. I, III, and IV only

2. A __________ is a private investment pool open only to wealthy or institutional investors that is exempt from SEC regulation and can therefore pursue more speculative policies than mutual funds. A. commingled poolB. unit trustC. hedge fundD. money market fund

3. ______ are partnerships of wealthy investors but too small to warrant managing on a separate basis. A. Commingled fundsB. Hedge fundsC. REITsD. Mutual funds

4. Advantages of hedge funds include all but which one of the following? A. Record keeping and administrationB. Low transaction costsC. Professional managementD. Consistently high rates of return

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5. ______ are private partnerships of small number of wealthy investors who are organized as private partnerships, often subject to lock-up period, and allowed to pursue a wide range of investment activities. A. Hedge fundsB. Closed-end fundsC. REITsD. Mutual funds

6. Which of the following typically employ significant amounts of leverage?I. Hedge fundsII. Equity mutual fundsIII. Money market fundsIV. Income mutual funds A. I onlyB. I and II onlyC. III and IV onlyD. I, II and III only

7. As of late 2008, hedge funds had approximately _____ under management. A. $0.5 trillionB. $1 trillionC. $1.6 trillionD. $2.3 trillion

8. A restriction where investors cannot withdraw their funds for as long as several months or years is called __________. A. transparencyB. a lock up periodC. a back end loadD. convertible arbitrage

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9. Hedge funds managers are compensated by ___________________. A. deducting management fees from fund assets and receiving incentive bonuses for beating index benchmarksB. deducting a percentage of any gains in asset valueC. selling shares in the trust at a premium to the cost of acquiring the underlying assetsD. charging portfolio turnover fees

10. Management fees for hedge funds, typically range between _____ and _____. A. 0.5%; 1.5%B. 1%; 3%C. 2%; 5%D. 5%; 8%

11. Hedge funds can invest in various investment options which not generally available to mutual funds. These include _____________. I. futures and optionsII. merger arbitrageIII. currency contractsIV. companies undergoing Chapter 11 restructuring and reorganization A. I onlyB. I and II onlyC. I, II, and III onlyD. I, II, III, and IV

12. Typical initial investment in a hedge fund generally is in the range between _____ and _____. A. $1,000; $5000B. $5,000; $25,000C. $25,000; $250,000D. $250,000; $1,000,000

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13. The difference between market neutral and long/short hedges is that market neutral hedge funds _________. A. establish long and short position on both sides of the market to eliminate risk and to benefit from security asset mispricing, whereas long/short hedge establish positions only on one side of the marketB. allocate money to several other funds while long/short funds do notC. invest in relatively stable proportions of stocks and bonds while the proportions may vary dramatically for long/short fundsD. invest only in equities and bonds while long/short funds use only derivatives

14. Convertible arbitrage hedge funds _________. A. attempt to profit from mispriced interest sensitive securitiesB. hold long positions in convertible bonds and offsetting short positions in stocksC. establish long and short positions in global capital marketsD. use derivative products to hedge their short positions in convertible bonds

15. Assuming positive basis and negligible borrowing cost, which of the following set of transactions could yield positive arbitrage profits a hedge fund might pursue? A. Buy gold in the spot market and sell the futures contractB. Buy the futures contract and sell the gold spot and invest the money earnedC. Buy gold spot with borrowed money and buy the futures contractD. Buy the futures contract and buy the gold spot using borrowed money

16. An example of a neutral pure play is _______. A. pairs tradingB. statistical arbitrageC. convergence arbitrageD. directional strategy

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17. You believe that the spread between the September S&P 500 future and S&P 500 index is too large and will soon correct. To take advantage of this mispricing a hedge fund should ______________. A. buy all the stocks in the S&P 500 and write put options on the S&P 500 indexB. sell all the stocks in the S&P 500 and buy call options on S&P 500 indexC. sell S&P 500 index futures and buy all the stocks in the S&P 500D. sell short all the stocks in the S&P 500 and buy S&P 500 index futures

18. You believe that the spread between the September S&P 500 future and S&P 500 index is too large and will soon correct. This is an example of ______________. A. pairs tradingB. convergence playC. statistical arbitrageD. long/short equity hedge

A one-year oil futures contract is selling for $74.50. Spot oil prices are $68 and the one year risk free rate is 3.25%.

19. The one-year oil futures price should be equal to __________. A. $68.00B. $70.21C. $71.25D. $74.88

20. The arbitrage profit implied by these prices is _____________. A. $6.50B. $5.44C. $4.29D. $3.25

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21. Based on the above data, which of the following set of transactions will yield positive riskless arbitrage profits? A. Buy oil in the spot market with borrowed money and sell the futures contractB. Buy the futures contract and sell the oil spot and invest the money earnedC. Buy the oil spot with borrowed money and buy the futures contractD. Buy the futures contract and buy the oil spot using borrowed money

Assume that you have invested $500,000 to purchase shares in a hedge fund reporting $800 million in assets, $100 million in liabilities, and 70 million shares outstanding. Your initial lockout period is 3 years.

22. How many shares did you purchase? A. 13,333B. 25,000C. 50,000D. 66,000

23. If the share price after 3 years increases to $15.28, what is the value of your investment? A. $553,600B. $625,000C. $733,800D. $764,000

24. What is your annualized return over the 3-year holding period? A. 14.45%B. 15.18%C. 16.00%D. 17.73%

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25. Which of the following are not managed investment companies? A. Hedge fundsB. Unit investment trustsC. Closed-end fundsD. Open-end funds

You manage $15 million hedge fund portfolio with beta = 1.2 and alpha = 2% per quarter. Assume the risk free rate 2% per quarter and the current value of the S&P 500 index = 1200. You want to exploit positive alpha but you are afraid are afraid that the stock market may fall and want to hedge your portfolio by selling the 3-month S&P 500 future contracts. The S&P contract multiplier is $250.

26. How many S&P 500 contracts do you need to sell to hedge your portfolio? A. 25B. 30C. 40D. 50

27. When you hedge your stock portfolio with futures contracts the value of your portfolio beta is __________. A. 0B. 1C. 1.2D. Beta cannot be determined from information given

28. What is expected quarterly return on the hedged portfolio? A. 0%B. 2%C. 3%D. 4%

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29. How much is the portfolio expected to be worth 3 months from now? A. $15,000,000B. $15,450,000C. $15,600,000D. $16,000,000

30. Hedging this portfolio by selling S&P 500 futures contracts is an example of ___________. A. statistical arbitrageB. pure playC. short equity hedgeD. fixed income arbitrage

31. Hedge funds that change strategies and types of securities invested and also vary the proportions of assets and invested in particular market sectors according to the fund manager's outlook are called ____________________. A. asset allocation fundsB. multi strategy fundsC. event driven fundsD. market neutral funds

32. When a short-selling hedge fund advertises in a prospectus that it is a 120/20 fund, it means that this fund may sell short up to ______ every $100 in net assets and increase the long position to __________ of net assets. A. $120; $20B. $20; $120C. $20; $20D. $120; $120

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33. The collapse of the Long Term Capital Management hedge fund in 1998 was a case of an extreme unlikely statistical event called ________. A. statistical arbitrageB. an unhedged playC. a tail eventD. a liquidity trap

34. Which of the following investment style could be the best description of the Long Term Capital Management market neutral strategies? A. Convergence arbitrageB. Statistical arbitrageC. Pairs tradingD. Convertible arbitrage

35. Consider a hedge fund with $250 million in assets at the start of the year. If the gross return on assets is 18% and the total expense ratio is 2.5% of the year end value, what is the rate of return on the fund? A. 15.05%B. 15.50%C. 17.25%D. 18.00%

Consider a hedge fund with $200 million at the start of the year. The benchmark S&P 500 index was up 16.5% during the same period. The gross return on assets is 21% and the expense ratio is 2%. For each 1% above the benchmark return the fund managers receive 0.1% incentive bonus.

36. What was the management cost for the year? A. $4,877,000B. $4,900,000C. $5,929,000D. $6,446,000

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37. What was the annual return on this fund? A. 16.50%B. 18.04%C. 18.55%D. 21.00%

38. Consider a hedge fund with $400 million in assets, 60 million in debt, and 16 million shares at the start of the year; and $500 million in assets, 40 million in debt, and 20 million shares at the end of the year. During the year investors have received an income dividend of $0.75 per share. Assuming that the fund carries no debt, and that the total expense ratio is 2.75%, what is the rate of return on the fund? A. 6.45%B. 8.52%C. 8.95%D. 9.46%

39. Market neutral hedge funds may experience considerable volatility. The source of volatile returns is the use of _________. A. pure playB. leverageC. directional bestsD. net short positions

40. A hedge fund has $150 million in assets at the beginning of the year and 10 million shares outstanding throughout the year. Throughout the year assets grow at 12%. The fund charges 3% management fee on assets. The fee is imposed on year end asset values. What is the end of year NAV for the fund? A. $15.00B. $15.60C. $16.30D. $17.55

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41. You pay $216,000 to the Capital Hedge Fund which has a price of $18.00 per share at the beginning of the year. The fund deducted a front-end commission of 4%. The securities in the fund increased in value by 15% during the year. The fund's expense ratio is 2% and is deducted from year end asset values. What is your rate of return on the fund if you sell your shares at the end of the year? A. 5.35%B. 7.23%C. 8.19%D. 10.00%

42. A hedge fund owns a $15 million bond portfolio with a modified duration of 11 years and needs to hedge risk but T-bond futures are only available with a modified duration of the deliverable instrument of 10 years. The futures are priced at $105,000. The proper hedge ratio to use is ______. A. 143B. 157C. 196D. 218

43. Unlike market-neutral hedge funds which have betas near ________, directional long funds exhibit highly _______ betas. A. zero; positiveB. positive; negativeC. positive; zeroD. negative; positive

44. Portfolio A has a beta of 0.2 and an expected return of 14%. Portfolio B has a beta of 0.5 and an expected return of 16%. The risk-free rate of return is 10%. If you manage a long/short equity fund and wanted to take advantage of an arbitrage opportunity, you should take a short position in portfolio ______ and a long position in portfolio __________. A. A; AB. A; BC. B; AD. B; B

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45. According to research conducted by Hasanhodic and Lo (2007), average returns of equity hedge funds are __________ the S&P 500 index. A. equal toB. considerably higher thanC. slightly lower thanD. slightly higher than

46. Research by Aragon (2007) indicates that lock up restrictions on redemptions and positive serial correlations of returns indicate that hedge funds often face __________ problems. A. liquidityB. maturityC. event drivenD. hedging

47. Higher returns of equity hedge funds as compared to the S&P 500 index reflect positive compensation for __________ risk. A. marketB. liquidityC. systematicD. interest rate

48. Portfolio A has a beta of 1.3 and an expected return of 21%. Portfolio B has a beta of 0.7 and an expected return of 17%. The risk-free rate of return is 9%. If a hedge fund manager wants to take advantage of an arbitrage opportunity, she should take a short position in portfolio __________ and a long position in portfolio __________. A. A; AB. A; BC. B; AD. B; B

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49. Hedge funds report average returns in December that are higher than their average returns in other months. This phenomenon __________. I. is called the Santa effectII. often results from over generous valuation of illiquid assetsIII. appears stronger for lower-liquidity fundsIV. can be explained by managers' attempts to inflate assets to collect higher performance bonuses A. I onlyB. I and II onlyC. I, II, and III onlyD. I, II, III, and IV

50. To attract new clients hedge funds often select reporting periods which show abnormally high returns. This is called __________. A. long/short biasB. survivorship biasC. backfill biasD. incentive bias

51. Some argue that abnormally high returns of hedge funds are tainted by __________, which arises when unsuccessful funds cease operations leaving only successful ones. A. reporting biasB. survivorship biasC. backfill biasD. incentive bias

52. Malkiel and Saha(2005) estimate that the survivorship bias for hedge funds equals 4.4%, which is __________ than the survivorship bias for mutual funds. A. about the same asB. much lowerC. much higherD. only slightly lower

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53. Hedge fund managers receive incentive bonuses when they increase portfolio assets beyond a stipulated benchmark but lose nothing when they fail to perform. This equivalent to __________. A. writing a call optionB. receiving a free call optionC. writing a put optionD. receiving a free put option

54. Typical hedge fund incentive bonus is usually equal to ________ of investment profits beyond a predetermined benchmark index. A. 5%B. 10%C. 20%D. 25%

55. The fastest growing category of hedge funds are feeder funds. These funds invest in ________. A. other hedge fundsB. convertible securities and preferred stockC. equities and bondsD. managed futures and options

56. A high water mark is a limiting factor of hedge fund manager compensation. This means that managers can't charge incentive fees ________. A. when a fund stays flatB. when a fund falls and does not recover to its previous high valueC. when a fund falls by 10% or moreD. None of the above occurs. Managers can always charge incentive fee

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57. If the risk-free interest rate is rf and equals the fund's benchmark, the portfolio net asset value is S0, and a hedge fund manager incentive fee is 20% of profit beyond that, the incentive fee is equivalent to receiving ______ call(s) with exercise price ________. A. 0.2; S0

B. 1; S0(1 + rf)C. 1.2; S0

D. 0.2; S0(1 + rf)

Assume the risk-free interest rate is 10% and is equal to fund's benchmark, the portfolio net asset value is $100, and the fund's standard deviation is 20%. Also assume time horizon of 1 year.

58. What is the exercise price on the incentive fee? A. $100B. $105C. $110D. $115

59. What is the Black-Scholes value of the call option on management incentive fee? A. $6.67B. $8.20C. $9.74D. $10.22

60. Assuming 2% management fee, what is the expected management compensation per share if the fund net asset value exceeds the stated benchmark? A. $4.24B. $4.00C. $3.84D. $2.20

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Chapter 20 Hedge Funds Answer Key

Multiple Choice Questions

1. Which of the following are characteristics of a hedge fund?I. Pooling of assetsII. Strict regulatory oversight by the SECIII. Investing in equities, debt instruments, and derivative instrumentsIV. Professional management of assets A. I and II onlyB. II and III onlyC. III and IV onlyD. I, III, and IV only

Difficulty: Easy

2. A __________ is a private investment pool open only to wealthy or institutional investors that is exempt from SEC regulation and can therefore pursue more speculative policies than mutual funds. A. commingled poolB. unit trustC. hedge fundD. money market fund

Difficulty: Easy

3. ______ are partnerships of wealthy investors but too small to warrant managing on a separate basis. A. Commingled fundsB. Hedge fundsC. REITsD. Mutual funds

Difficulty: Medium

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4. Advantages of hedge funds include all but which one of the following? A. Record keeping and administrationB. Low transaction costsC. Professional managementD. Consistently high rates of return

Difficulty: Easy

5. ______ are private partnerships of small number of wealthy investors who are organized as private partnerships, often subject to lock-up period, and allowed to pursue a wide range of investment activities. A. Hedge fundsB. Closed-end fundsC. REITsD. Mutual funds

Difficulty: Easy

6. Which of the following typically employ significant amounts of leverage?I. Hedge fundsII. Equity mutual fundsIII. Money market fundsIV. Income mutual funds A. I onlyB. I and II onlyC. III and IV onlyD. I, II and III only

Difficulty: Easy

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7. As of late 2008, hedge funds had approximately _____ under management. A. $0.5 trillionB. $1 trillionC. $1.6 trillionD. $2.3 trillion

Difficulty: Medium

8. A restriction where investors cannot withdraw their funds for as long as several months or years is called __________. A. transparencyB. a lock up periodC. a back end loadD. convertible arbitrage

Difficulty: Easy

9. Hedge funds managers are compensated by ___________________. A. deducting management fees from fund assets and receiving incentive bonuses for beating index benchmarksB. deducting a percentage of any gains in asset valueC. selling shares in the trust at a premium to the cost of acquiring the underlying assetsD. charging portfolio turnover fees

Difficulty: Easy

10. Management fees for hedge funds, typically range between _____ and _____. A. 0.5%; 1.5%B. 1%; 3%C. 2%; 5%D. 5%; 8%

Difficulty: Easy

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11. Hedge funds can invest in various investment options which not generally available to mutual funds. These include _____________. I. futures and optionsII. merger arbitrageIII. currency contractsIV. companies undergoing Chapter 11 restructuring and reorganization A. I onlyB. I and II onlyC. I, II, and III onlyD. I, II, III, and IV

Difficulty: Easy

12. Typical initial investment in a hedge fund generally is in the range between _____ and _____. A. $1,000; $5000B. $5,000; $25,000C. $25,000; $250,000D. $250,000; $1,000,000

Difficulty: Medium

13. The difference between market neutral and long/short hedges is that market neutral hedge funds _________. A. establish long and short position on both sides of the market to eliminate risk and to benefit from security asset mispricing, whereas long/short hedge establish positions only on one side of the marketB. allocate money to several other funds while long/short funds do notC. invest in relatively stable proportions of stocks and bonds while the proportions may vary dramatically for long/short fundsD. invest only in equities and bonds while long/short funds use only derivatives

Difficulty: Medium

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14. Convertible arbitrage hedge funds _________. A. attempt to profit from mispriced interest sensitive securitiesB. hold long positions in convertible bonds and offsetting short positions in stocksC. establish long and short positions in global capital marketsD. use derivative products to hedge their short positions in convertible bonds

Difficulty: Medium

15. Assuming positive basis and negligible borrowing cost, which of the following set of transactions could yield positive arbitrage profits a hedge fund might pursue? A. Buy gold in the spot market and sell the futures contractB. Buy the futures contract and sell the gold spot and invest the money earnedC. Buy gold spot with borrowed money and buy the futures contractD. Buy the futures contract and buy the gold spot using borrowed money

Difficulty: Medium

16. An example of a neutral pure play is _______. A. pairs tradingB. statistical arbitrageC. convergence arbitrageD. directional strategy

Difficulty: Medium

17. You believe that the spread between the September S&P 500 future and S&P 500 index is too large and will soon correct. To take advantage of this mispricing a hedge fund should ______________. A. buy all the stocks in the S&P 500 and write put options on the S&P 500 indexB. sell all the stocks in the S&P 500 and buy call options on S&P 500 indexC. sell S&P 500 index futures and buy all the stocks in the S&P 500D. sell short all the stocks in the S&P 500 and buy S&P 500 index futures

Difficulty: Medium

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18. You believe that the spread between the September S&P 500 future and S&P 500 index is too large and will soon correct. This is an example of ______________. A. pairs tradingB. convergence playC. statistical arbitrageD. long/short equity hedge

Difficulty: Medium

A one-year oil futures contract is selling for $74.50. Spot oil prices are $68 and the one year risk free rate is 3.25%.

19. The one-year oil futures price should be equal to __________. A. $68.00B. $70.21C. $71.25D. $74.88

Parity F0 = S0(1 + rf - d)T = $68(1 + .0325 - .0)1 = $70.21

Difficulty: Medium

20. The arbitrage profit implied by these prices is _____________. A. $6.50B. $5.44C. $4.29D. $3.25

Arbitrage profit 74.50 - 70.21 = $4.29

Difficulty: Medium

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21. Based on the above data, which of the following set of transactions will yield positive riskless arbitrage profits? A. Buy oil in the spot market with borrowed money and sell the futures contractB. Buy the futures contract and sell the oil spot and invest the money earnedC. Buy the oil spot with borrowed money and buy the futures contractD. Buy the futures contract and buy the oil spot using borrowed money

Difficulty: Medium

Assume that you have invested $500,000 to purchase shares in a hedge fund reporting $800 million in assets, $100 million in liabilities, and 70 million shares outstanding. Your initial lockout period is 3 years.

22. How many shares did you purchase? A. 13,333B. 25,000C. 50,000D. 66,000

500,000/10 = 50,000

Difficulty: Easy

23. If the share price after 3 years increases to $15.28, what is the value of your investment? A. $553,600B. $625,000C. $733,800D. $764,000

(50,000)($15.28) = $764,000

Difficulty: Medium

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24. What is your annualized return over the 3-year holding period? A. 14.45%B. 15.18%C. 16.00%D. 17.73%

Difficulty: Medium

25. Which of the following are not managed investment companies? A. Hedge fundsB. Unit investment trustsC. Closed-end fundsD. Open-end funds

Difficulty: Easy

You manage $15 million hedge fund portfolio with beta = 1.2 and alpha = 2% per quarter. Assume the risk free rate 2% per quarter and the current value of the S&P 500 index = 1200. You want to exploit positive alpha but you are afraid are afraid that the stock market may fall and want to hedge your portfolio by selling the 3-month S&P 500 future contracts. The S&P contract multiplier is $250.

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26. How many S&P 500 contracts do you need to sell to hedge your portfolio? A. 25B. 30C. 40D. 50

Difficulty: Hard

27. When you hedge your stock portfolio with futures contracts the value of your portfolio beta is __________. A. 0B. 1C. 1.2D. Beta cannot be determined from information given

Difficulty: Medium

28. What is expected quarterly return on the hedged portfolio? A. 0%B. 2%C. 3%D. 4%

E(rp) = E[rf + (rM - rf) + e + ] = rf + = 2% + 2% = 4%

Difficulty: Medium

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29. How much is the portfolio expected to be worth 3 months from now? A. $15,000,000B. $15,450,000C. $15,600,000D. $16,000,000

S1 = S0(1 + rp) = $15,000,000(1.04) = $15,600,000

Difficulty: Medium

30. Hedging this portfolio by selling S&P 500 futures contracts is an example of ___________. A. statistical arbitrageB. pure playC. short equity hedgeD. fixed income arbitrage

Difficulty: Medium

31. Hedge funds that change strategies and types of securities invested and also vary the proportions of assets and invested in particular market sectors according to the fund manager's outlook are called ____________________. A. asset allocation fundsB. multi strategy fundsC. event driven fundsD. market neutral funds

Difficulty: Easy

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32. When a short-selling hedge fund advertises in a prospectus that it is a 120/20 fund, it means that this fund may sell short up to ______ every $100 in net assets and increase the long position to __________ of net assets. A. $120; $20B. $20; $120C. $20; $20D. $120; $120

Difficulty: Medium

33. The collapse of the Long Term Capital Management hedge fund in 1998 was a case of an extreme unlikely statistical event called ________. A. statistical arbitrageB. an unhedged playC. a tail eventD. a liquidity trap

Difficulty: Medium

34. Which of the following investment style could be the best description of the Long Term Capital Management market neutral strategies? A. Convergence arbitrageB. Statistical arbitrageC. Pairs tradingD. Convertible arbitrage

Difficulty: Medium

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35. Consider a hedge fund with $250 million in assets at the start of the year. If the gross return on assets is 18% and the total expense ratio is 2.5% of the year end value, what is the rate of return on the fund? A. 15.05%B. 15.50%C. 17.25%D. 18.00%

Difficulty: Medium

Consider a hedge fund with $200 million at the start of the year. The benchmark S&P 500 index was up 16.5% during the same period. The gross return on assets is 21% and the expense ratio is 2%. For each 1% above the benchmark return the fund managers receive 0.1% incentive bonus.

36. What was the management cost for the year? A. $4,877,000B. $4,900,000C. $5,929,000D. $6,446,000

$200,000,000(1.21) = $242,000,00021% - 16.5% = 4.5%; 2% + 4.5%(0.1) = 2.45%.0245(242,000,000) = $5,929,000

Difficulty: Hard

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37. What was the annual return on this fund? A. 16.50%B. 18.04%C. 18.55%D. 21.00%

Difficulty: Hard

38. Consider a hedge fund with $400 million in assets, 60 million in debt, and 16 million shares at the start of the year; and $500 million in assets, 40 million in debt, and 20 million shares at the end of the year. During the year investors have received an income dividend of $0.75 per share. Assuming that the fund carries no debt, and that the total expense ratio is 2.75%, what is the rate of return on the fund? A. 6.45%B. 8.52%C. 8.95%D. 9.46%

Net return =

Difficulty: Hard

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39. Market neutral hedge funds may experience considerable volatility. The source of volatile returns is the use of _________. A. pure playB. leverageC. directional bestsD. net short positions

Difficulty: Easy

40. A hedge fund has $150 million in assets at the beginning of the year and 10 million shares outstanding throughout the year. Throughout the year assets grow at 12%. The fund charges 3% management fee on assets. The fee is imposed on year end asset values. What is the end of year NAV for the fund? A. $15.00B. $15.60C. $16.30D. $17.55

Difficulty: Hard

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41. You pay $216,000 to the Capital Hedge Fund which has a price of $18.00 per share at the beginning of the year. The fund deducted a front-end commission of 4%. The securities in the fund increased in value by 15% during the year. The fund's expense ratio is 2% and is deducted from year end asset values. What is your rate of return on the fund if you sell your shares at the end of the year? A. 5.35%B. 7.23%C. 8.19%D. 10.00%

Difficulty: Hard

42. A hedge fund owns a $15 million bond portfolio with a modified duration of 11 years and needs to hedge risk but T-bond futures are only available with a modified duration of the deliverable instrument of 10 years. The futures are priced at $105,000. The proper hedge ratio to use is ______. A. 143B. 157C. 196D. 218

Difficulty: Hard

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43. Unlike market-neutral hedge funds which have betas near ________, directional long funds exhibit highly _______ betas. A. zero; positiveB. positive; negativeC. positive; zeroD. negative; positive

Difficulty: Medium

44. Portfolio A has a beta of 0.2 and an expected return of 14%. Portfolio B has a beta of 0.5 and an expected return of 16%. The risk-free rate of return is 10%. If you manage a long/short equity fund and wanted to take advantage of an arbitrage opportunity, you should take a short position in portfolio ______ and a long position in portfolio __________. A. A; AB. A; BC. B; AD. B; B

Portfolio A has higher return per unit of risk.

Difficulty: Medium

45. According to research conducted by Hasanhodic and Lo (2007), average returns of equity hedge funds are __________ the S&P 500 index. A. equal toB. considerably higher thanC. slightly lower thanD. slightly higher than

Difficulty: Medium

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46. Research by Aragon (2007) indicates that lock up restrictions on redemptions and positive serial correlations of returns indicate that hedge funds often face __________ problems. A. liquidityB. maturityC. event drivenD. hedging

Difficulty: Medium

47. Higher returns of equity hedge funds as compared to the S&P 500 index reflect positive compensation for __________ risk. A. marketB. liquidityC. systematicD. interest rate

Difficulty: Medium

48. Portfolio A has a beta of 1.3 and an expected return of 21%. Portfolio B has a beta of 0.7 and an expected return of 17%. The risk-free rate of return is 9%. If a hedge fund manager wants to take advantage of an arbitrage opportunity, she should take a short position in portfolio __________ and a long position in portfolio __________. A. A; AB. A; BC. B; AD. B; B

Portfolio B has higher return per unit of risk

Difficulty: Medium

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49. Hedge funds report average returns in December that are higher than their average returns in other months. This phenomenon __________. I. is called the Santa effectII. often results from over generous valuation of illiquid assetsIII. appears stronger for lower-liquidity fundsIV. can be explained by managers' attempts to inflate assets to collect higher performance bonuses A. I onlyB. I and II onlyC. I, II, and III onlyD. I, II, III, and IV

Difficulty: Medium

50. To attract new clients hedge funds often select reporting periods which show abnormally high returns. This is called __________. A. long/short biasB. survivorship biasC. backfill biasD. incentive bias

Difficulty: Medium

51. Some argue that abnormally high returns of hedge funds are tainted by __________, which arises when unsuccessful funds cease operations leaving only successful ones. A. reporting biasB. survivorship biasC. backfill biasD. incentive bias

Difficulty: Medium

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52. Malkiel and Saha(2005) estimate that the survivorship bias for hedge funds equals 4.4%, which is __________ than the survivorship bias for mutual funds. A. about the same asB. much lowerC. much higherD. only slightly lower

Difficulty: Medium

53. Hedge fund managers receive incentive bonuses when they increase portfolio assets beyond a stipulated benchmark but lose nothing when they fail to perform. This equivalent to __________. A. writing a call optionB. receiving a free call optionC. writing a put optionD. receiving a free put option

Difficulty: Medium

54. Typical hedge fund incentive bonus is usually equal to ________ of investment profits beyond a predetermined benchmark index. A. 5%B. 10%C. 20%D. 25%

Difficulty: Medium

55. The fastest growing category of hedge funds are feeder funds. These funds invest in ________. A. other hedge fundsB. convertible securities and preferred stockC. equities and bondsD. managed futures and options

Difficulty: Easy

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56. A high water mark is a limiting factor of hedge fund manager compensation. This means that managers can't charge incentive fees ________. A. when a fund stays flatB. when a fund falls and does not recover to its previous high valueC. when a fund falls by 10% or moreD. None of the above occurs. Managers can always charge incentive fee

Difficulty: Medium

57. If the risk-free interest rate is rf and equals the fund's benchmark, the portfolio net asset value is S0, and a hedge fund manager incentive fee is 20% of profit beyond that, the incentive fee is equivalent to receiving ______ call(s) with exercise price ________. A. 0.2; S0

B. 1; S0(1 + rf)C. 1.2; S0

D. 0.2; S0(1 + rf)

Difficulty: Medium

Assume the risk-free interest rate is 10% and is equal to fund's benchmark, the portfolio net asset value is $100, and the fund's standard deviation is 20%. Also assume time horizon of 1 year.

58. What is the exercise price on the incentive fee? A. $100B. $105C. $110D. $115

Strike price = S0(1 + rf) = 100(1 + 0.1) = $110

Difficulty: Medium

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59. What is the Black-Scholes value of the call option on management incentive fee? A. $6.67B. $8.20C. $9.74D. $10.22

d2 = d1 - 0.2(1)0.5 = 0.1234 - 0.2 = - 0.766; N(d2) = 0.4697Call value = S0N(d1) - Xe-rTN(d2) = (100)(0.5495) - (110)e-(.1)(0.4697) = $8.20

Difficulty: Hard

60. Assuming 2% management fee, what is the expected management compensation per share if the fund net asset value exceeds the stated benchmark? A. $4.24B. $4.00C. $3.84D. $2.20

Expected incentive fee is 2% of year-end NAV + 20% of the value of $110 call option = .02(110) + .2(8.20) = $3.84

Difficulty: Hard

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chap 020

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