Hedge Funds

Question 1

Hedge funds

Answer 1

Private, much less regulated investment vehicles, and not available to the general public.

They are highly leveraged, and managers obtain profits from both long and short positions.

Question 2

Characteristics of hedge funds

Answer 2

1. Private
2. Less regulated
3. Not available to general public
4. Highly leveraged
5. Long and short
6. Large bets
7. less transparency

Question 3

Fund of funds

Answer 3

Investor invests in a fund of funds, which is actually a fund of multiple hedge funds

Investor gets diversification benefits.

Question 4

Which biases do we see in hedge funds?

Answer 4

Selection bias and self reporting bias, also survivorship bias

Question 5

Impact of institutional investors

Answer 5

1. Greater demands on hedge funds for operational integrity and governance.
2. Some were asking for absolute performance, while others were seeking alternative sources of return beyond equities.

Question 6

Alpha beta separation

Answer 6

Alpha»Risk adjusted measure of return to assess performance of active managers.

We identify how much of a strategy’s return is attributable from beta, and how much from alpha. This is distinguishing alpha and beta.

Question 7

Separating alpha and beta

Answer 7

The firm may manage beta exposure separately while separately managing the portfolio’s alpha. This is separating alpha and beta.

Question 8

Managed future funds

Answer 8

1. Focus on bonds, equity, commodity futures and currency markets.
2. No net long or short bias
3. High degree of leverage

Question 9

Payoff of a managed future fund

Answer 9

When both long and short positions are considered, it is equivalent to a look back straddle.

Question 10

Lookback call option

Answer 10

Gives the owner the right to purchase the underlying at lower price during call option’s life.

Question 11

Lookback put option

Answer 11

Gives the owner the right to sell the underlying at the highest price during the put option’s life.

Question 12

Global macro funds

Answer 12

Make large bets on directional movements in interest rates, exchange rates, commodities and stock indices.

Question 13

Managed futures and global macro funds

Answer 13

1. Have trend following behavior
2. Do better during extreme moves in currency markets.
3. Both are asset allocation strategies
4. Low return correlation to equities.

Question 14

Merger risk arbitrage

Answer 14

Tries to capture spreads in merger/ acquisition transactions following the public announcement of a transaction. Exposed to deal risk. (risk that deal will not close)

Question 15

Distressed hedge funds

Answer 15

Funds that invest in distressed companies, which are in operational or financial distress, or are in the middle of bankruptcy.

Long exposure to credit risk of companies with low credit ratings.

Question 16

Merger arbitrage and distressed securities

Answer 16

1. Both show non linear return characteristics
2. These are hurt by extreme market movements, unlike trend following strategies.

Question 17

Fixed income arbitrage funds

Answer 17

Attempt to obtain profits by exploiting inefficiencies and price anomalies between related fixed income securities.

Interest rate risk is hedged.

Question 18

Sectors traded under fixed income arbitrage

Answer 18

1. Credit yield curve related value trading of swaps, govt securities and futures
2. Volatility trading using options
3. MBS arbitrage

Question 19

Swap spread trade

Answer 19

Trade on the hope that fixed leg of the swap will stay higher than the floating leg.

Question 20

Yield curve spread trades

Answer 20

Hope that bond curve will deviate overall yield curve only.

Question 21

Mortgage Spread trades

Answer 21

Bets on prepayment rates

Question 22

Fixed income volatility trades

Answer 22

implied volatility of interest rates will be higher than realized volatility

Question 23

Capital structure or capital arbitrage

Answer 23

try to capitalize on mispricing among different types of securities

Question 24

Other hedge fund strategies

Answer 24

1. convertible arbitrage: purchase of convertibles, and selling corresponding stock
2. long short equity
3. Dedicated short bias
4. Emerging markets
5. Equity market neutral

Question 25

Hedge funds performance

Answer 25

Analysis of large hedge funds show that managers are still delivering alpha return relative to peers, and have low exposure to the U.S. equity market. These factors continue to attract institutional investors.

Question 26

Risk sharing asymmetry

Answer 26

Risk sharing asymmetry between the principal and the agent is a concern due to variable compensation. This happens when a manager takes a lot of risks in order to earn the incentive profit. Investors may be best served to invest in funds for which the fund managers invest a good portion of their own wealth in.

Question 27

How was the monthly alpha in the period of 2002 to 2010 compared to prior periods?

Answer 27

Alpha was lower in this period