Deck 20: Hedge Funds

Question 1

The difference between market-neutral and long-short hedges is that market-neutral hedge funds ________.

A) establish long and short positions on both sides of the market to eliminate risk and to benefit from security asset mispricing whereas long-short hedges establish positions only on one side of the market
B) allocate money to several other funds while long-short funds do not
C) invest in relatively stable proportions of stocks and bonds while the proportions may vary dramatically for long-short funds
D) invest only in equities and bonds while long-short funds use only derivatives

Answer 1

A

Question 2

Hedge fund managers are compensated by ________.

A) deducting management fees from fund assets and receiving incentive bonuses for beating index benchmarks
B) deducting a percentage of any gains in asset value
C) selling shares in the trust at a premium to the cost of acquiring the underlying assets
D) charging portfolio turnover fees

Answer 2

A

Question 3

A typical traditional initial investment in a hedge fund generally is in the range between ________ and ________.

A) $1,000; $5,000
B) $5,000; $25,000
C) $25,000; $250,000
D) $500,000; $1,000,000

Answer 3

D

Question 4

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 pool
B) unit trust
C) hedge fund
D) money market fund

Question 5

As of 2017, hedge funds had approximately ________ under management.

A) $.5 trillion
B) $6.6 trillion
C) $4 trillion
D) $3.2 trillion

Question 6

______ are private partnerships of a small number of wealthy investors, are often subject to lock-up periods, and are allowed to pursue a wide range of investment activities.

A) Hedge funds
B) Closed-end funds
C) REITs
D) Mutual funds

Question 7

A 1-year oil futures contract is selling for $74.50. Spot oil prices are $68, and the 1-year risk-free rate is 3.25%.
The arbitrage profit implied by these prices is ________.

A) $6.50
B) $5.44
C) $4.29
D) $3.25

Question 8

A 1-year oil futures contract is selling for $74.50. Spot oil prices are $68, and the 1-year risk-free rate is 3.25%.
The 1-year oil futures price should be equal to ________.

A) $68
B) $70.21
C) $71.25
D) $74.88

Question 9

You believe that the spread between the September S&P 500 future and the S&P 500 Index is too large and will soon correct. This is an example of ________.

A) pairs trading
B) convergence play
C) statistical arbitrage
D) a long-short equity hedge

Question 10

An example of a neutral pure play is ________.

A) pairs trading
B) statistical arbitrage
C) convergence arbitrage
D) directional strategy

Question 11

Management fees for hedge funds typically range between ________ and ________.

A) )5%; 1.5%
B) 1%; 2%
C) 2%; 5%
D) 5%; 8%

Question 12

Hedge funds can invest in various investment options that are not generally available to mutual funds. These include:
I) Futures and options
II) Merger arbitrage
III) Currency contracts
IV) Companies undergoing Chapter 11 restructuring and reorganization

A) I only
B) I and II only
C) I, II, and III only
D) I, II, III, and IV

Question 13

A(n) ________ hedge fund attempts to profit from situations such as mergers, acquisitions, restructuring, bankruptcy, or reorganization.

A) multistrategy
B) managed futures
C) dedicated short bias
D) event-driven

Question 14

Which of the following are characteristics of a hedge fund?
I) Pooling of assets
II) Strict regulatory oversight by the SEC
III) Investing in equities, debt instruments, and derivative instruments
IV) Professional management of assets

A) I and II only
B) II and III only
C) III and IV only
D) I, III, and IV only

Question 15

Assuming positive basis and negligible borrowing cost, which of the following transactions could yield positive arbitrage profits if pursued by a hedge fund?

A) Buy gold in the spot market, and sell the futures contract.
B) Buy the futures contract, and sell the gold spot and invest the money earned.
C) Buy gold spot with borrowed money, and buy the futures contract.
D) Buy the futures contract, and buy the gold spot using borrowed money.

Question 16

Convertible arbitrage hedge funds ________.

A) attempt to profit from mispriced interest-sensitive securities
B) hold long positions in convertible bonds and offsetting short positions in stocks
C) establish long and short positions in global capital markets
D) use derivative products to hedge their short positions in convertible bonds

Question 17

You believe that the spread between the September S&P 500 future and the 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 Index
B) sell all the stocks in the S&P 500 and buy call options on the S&P 500 Index
C) sell S&P 500 Index futures and buy all the stocks in the S&P 500
D) sell short all the stocks in the S&P 500 and buy S&P 500 Index futures

Question 18

Hedge funds are typically set up as ________.

A) limited liability partnerships
B) corporations
C) REITs
D) mutual funds

Question 19

A restriction under which investors cannot withdraw their funds for as long as several months or years is called ________.

A) transparency
B) a lock-up period
C) a back-end load
D) convertible arbitrage

Question 20

Which of the following typically employ(s) significant amounts of leverage?
I) Hedge funds
II) Equity mutual funds
III) Money market funds
IV) Income mutual funds

A) I only
B) I and II only
C) III and IV only
D) I, II, and III only

Question 21

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 a .1% incentive bonus.
What was the annual return on this fund?

A) 16.5%
B) 18.04%
C) 18.55%
D) 21%

Question 22

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.
How many shares did you purchase?

A) 13,333
B) 25,000
C) 50,000
D) 66,000

Question 23

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.
If the share price after 3 years increases to $15.28, what is the value of your investment?

A) $553,600
B) $625,000
C) $733,800
D) $764,000

Question 24

You manage a $15 million hedge fund portfolio with beta = 1.2 and alpha = 2% per quarter. Assume the risk-free rate is 2% per quarter and the current value of the S&P 500 Index is 1,200. You want to exploit the positive alpha, but you are afraid that the stock market may fall and you want to hedge your portfolio by selling 3-month S&P 500 future contracts. The S&P contract multiplier is $250.
How many S&P 500 contracts do you need to sell to hedge your portfolio?

A) 25
B) 35
C) 50
D) 60

Question 25

You manage a $15 million hedge fund portfolio with beta = 1.2 and alpha = 2% per quarter. Assume the risk-free rate is 2% per quarter and the current value of the S&P 500 Index is 1,200. You want to exploit the positive alpha, but you are afraid that the stock market may fall and you want to hedge your portfolio by selling 3-month S&P 500 future contracts. The S&P contract multiplier is $250.
How much is the portfolio expected to be worth 3 months from now?

A) $15,000,000
B) $15,450,000
C) $15,600,000
D) $16,000,000

Question 26

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.
What is your annualized return over the 3-year holding period?

A) 14.45%
B) 15.18%
C) 16%
D) 17.73%

Question 27

A 1-year oil futures contract is selling for $74.50. Spot oil prices are $68, and the 1-year risk-free rate is 3.25%.
Based on the above data, which of the following sets of transactions will yield positive riskless arbitrage profits?

A) Buy oil in the spot market with borrowed money, and sell the futures contract.
B) Buy the futures contract, and sell the oil spot and invest the money earned.
C) Buy the oil spot with borrowed money, and buy the futures contract.
D) Buy the futures contract, and buy the oil spot using borrowed money.

Question 28

You manage a $15 million hedge fund portfolio with beta = 1.2 and alpha = 2% per quarter. Assume the risk-free rate is 2% per quarter and the current value of the S&P 500 Index is 1,200. You want to exploit the positive alpha, but you are afraid that the stock market may fall and you want to hedge your portfolio by selling 3-month S&P 500 future contracts. The S&P contract multiplier is $250.
Hedging this portfolio by selling S&P 500 futures contracts is an example of ________.

A) statistical arbitrage
B) pure play
C) a short equity hedge
D) fixed-income arbitrage

Question 29

You manage a $15 million hedge fund portfolio with beta = 1.2 and alpha = 2% per quarter. Assume the risk-free rate is 2% per quarter and the current value of the S&P 500 Index is 1,200. You want to exploit the positive alpha, but you are afraid that the stock market may fall and you want to hedge your portfolio by selling 3-month S&P 500 future contracts. The S&P contract multiplier is $250.
What is the expected quarterly return on the hedged portfolio?

A) 0%
B) 2%
C) 3%
D) 4%

Question 30

Consider a hedge fund with $400 million in assets, $60 million in debt, and 16 million shares at the start of the year and with $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 $.75 per share. Assuming 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%

Question 31

You manage a $15 million hedge fund portfolio with beta = 1.2 and alpha = 2% per quarter. Assume the risk-free rate is 2% per quarter and the current value of the S&P 500 Index is 1,200. You want to exploit the positive alpha, but you are afraid that the stock market may fall and you want to hedge your portfolio by selling 3-month S&P 500 future contracts. The S&P contract multiplier is $250.
When you hedge your stock portfolio with futures contracts, the value of your portfolio beta is ________.

A) 0
B) 1
C) 1.2
D) The answer cannot be determined from the information given.

Question 32

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 a .1% incentive bonus.
What was the management cost for the year?

A) $4,877,000
B) $4,900,000
C) $5,929,000
D) $6,446,000

Question 33

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) 15.5%
C) 17.25%
D) 18%

Question 34

Which of the following are not managed investment companies?

A) hedge funds
B) unit investment trusts
C) closed-end funds
D) open-end funds

Question 35

When a short-selling hedge fund advertises in a prospectus that it is a 120/20 fund, this means that the fund may sell short up to ________ for every $100 in net assets and increase the long position to ________ of net assets.

A) $120; $20
B) $20; $120
C) $20; $20
D) $120; $120

Question 36

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 a 3% management fee on the assets. The fee is imposed on year-end asset values. What is the end-of-year NAV for the fund?

A) $15
B) $15.60
C) $16.30
D) $17.55

Question 37

The collapse of the Long Term Capital Management hedge fund in 1998 was a case of an extremely unlikely statistical event called ________.

A) statistical arbitrage
B) an unhedged play
C) a tail event
D) a liquidity trap

Question 38

Which of the following investment styles could be the best description of the Long Term Capital Management market-neutral strategies?

A) convergence arbitrage
B) statistical arbitrage
C) pairs trading
D) convertible arbitrage

Question 39

Hedge funds that change strategies and types of securities invested and also vary the proportions of assets invested in particular market sectors according to the fund manager's outlook are called ________.

A) asset allocation funds
B) multistrategy funds
C) event-driven funds
D) market-neutral funds

Question 40

Market-neutral hedge funds may experience considerable volatility. The source of volatile returns is the use of ________.

A) pure play
B) leverage
C) directional bests
D) net short positions

Question 41

Portfolio A has a beta of 1.3 and an expected return of 21%. Portfolio B has a beta of .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; A
B) A; B
C) B; A
D) B; B

Question 42

In a 2011 study, Agarwal, Daniel, and Naik documented that hedge funds tend to report average returns in ________ that are ________ than their average returns in other months.

A) September; lower
B) January; higher
C) January; lower
D) December; higher

Question 43

To attract new clients, hedge funds often include past returns of funds only if they were successful. This is called ________.

A) long-short bias
B) survivorship bias
C) backfill bias
D) incentive bias

Question 44

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 bias
B) survivorship bias
C) backfill bias
D) incentive bias

Question 45

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

A) )2; S0
B) 1; S0(1 + rf)
C) 1.2; S0
D) )2; S0(1 + rf)

Question 46

Hedge fund managers receive incentive bonuses when they increase portfolio assets beyond a stipulated benchmark but lose nothing when they fail to perform. This is equivalent to ________.

A) writing a call option
B) receiving a free call option
C) writing a put option
D) receiving a free put option

Question 47

According to a model that was estimated using monthly excess returns over a 5 year period, ending in October of 2014, average returns of equity hedge funds are ________ the S&P 500 Index.

A) equal to
B) considerably higher than
C) slightly lower than
D) slightly higher than

Question 48

The fastest-growing category of hedge funds is feeder funds. These funds invest in ________.

A) other hedge funds
B) convertible securities and preferred stock
C) equities and bonds
D) managed futures and options

Question 49

Unlike market-neutral hedge funds, which have betas near ________, directional long funds exhibit highly ________ betas.

A) zero; positive
B) positive; negative
C) positive; zero
D) negative; positive

Question 50

Higher returns of equity hedge funds as compared to the S&P 500 Index reflect positive compensation for ________ risk.

A) market
B) liquidity
C) systematic
D) interest rate

Question 51

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 flat
B) when a fund falls and does not recover to its previous high value
C) when a fund falls by 10% or more
D) none of these options. (Managers can always charge incentive fees.)

Question 52

Malkiel and Saha (2005) estimate that the survivorship bias for hedge funds equals 4.4%, which is ________ the survivorship bias for mutual funds.

A) about the same as
B) much lower than
C) much higher than
D) only slightly lower than

Question 53

Research by Aragon (2007) indicates that lock-up restrictions tend to hold ________ portfolios.

A) less liquid
B) more liquid
C) event-driven
D) shorter-maturity

Question 54

You pay $216,000 to the Capital Hedge Fund, which has a price of $18 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%

Question 55

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

A) $100
B) $105
C) $110
D) $115

Question 56

Portfolio A has a beta of .2 and an expected return of 14%. Portfolio B has a beta of .5 and an expected return of 16%. The risk-free rate of return is 10%. If you manage a long-short equity fund and want to take advantage of an arbitrage opportunity, you should take a short position in portfolio ________ and a long position in portfolio ________.

A) A; A
B) A; B
C) B; A
D) B; B

Question 57

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 available only 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) 143
B) 157
C) 196
D) 218

Question 58

A 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%

Question 59

Assume the risk-free interest rate is 10% and is equal to the fund's benchmark, the portfolio's net asset value is $100, and the fund's standard deviation is 20%. Also assume a time horizon of 1 year.
Assuming a 2% management fee and a 20% incentive bonus, what is the expected management compensation per share if the fund's net asset value exceeds the stated benchmark?

A) $4.24
B) $4
C) $3.84
D) $2.20

Question 60

Assume the risk-free interest rate is 10% and is equal to the fund's benchmark, the portfolio's net asset value is $100, and the fund's standard deviation is 20%. Also assume a time horizon of 1 year.
What is the Black-Scholes value of the call option on the management incentive fee?

A) $6.67
B) $8.18
C) $9.74
D) $10.22

Question 61

What strategy might a hedge fund use to take advantage of positive alpha in a long equity position?

A) short sell the security with positive alpha
B) leverage and use the proceeds to go long in the alpha security
C) create a neutral position and gain from the alpha value increase
D) reduce reliance on margin

Question 62

If a long-short hedge fund were banned by government regulation from short selling, which statement would no longer be true?

A) they are not market neutral.
B) they may establish a concentrated focus on economic regions.
C) they are equity oriented.
D) derivatives may be used.

Question 63

You manage a hedge fund with $300 million in assets. Your fee structure provides for a 1% annual management fee with a 20% incentive on returns over a 12% benchmark. If the fund value, before fees, is $345 million at the end of the year, what is the net return to the investors?

A) 13.33%
B) 13.40%
C) 14.00%
D) 14.42%

Question 64

A market neutral hedge fund is likely to have ________.

A) various derivative strategies designed to create stability
B) a low beta compared to other equity only investments
C) a beta well above 1.0 compared to other equity investments
D) a beta near 1.0

Question 65

You manage a hedge fund with $400 million in assets. Your fee structure provides for a 1% annual management fee with a 20% incentive on returns over an 8% benchmark. If the fund value is $445 million at the end of the year, what is your fee?

A) $2,600,000
B) $4,000,000
C) $6,600,000
D) $8,400,000