Chap 17 Relative Value Hedge Funds

Question 1

Describe the positions utilized in a classic convertible bond arbitrage trade.

Answer 1

Purchase a convertible bond that is undervalued and hedge its risk using a short position in the underlying equity.

Question 2

Three terms used to describe convertible bonds differentiated by implicit option in the bond is:

• in the money
• at the money
• out of the money

Answer 2

• equity-like convertible
• hybrid convertible
• busted convertible

Question 3

Difference between delta and theta in measuring price sensitivity of an option.

Answer 3

delta - change in the value of the option with respect to a change in the value of the underlying.

theta - change in value of the option with respect to the time to expiration of the option (passage of time).

Question 4

What is Dilution?

Answer 4

Additional equity issued at below market values causing the per share value of the holdings of existing shareholders to be diminished.

Question 5

Components of the returns of a traditional convertible arbitage strategy

Answer 5

Convertible bond arbitrage income:
(bond int + short stock rebate - stock dividends - financing expenses)

Convertible bond and stock net capital gains and losse:
(capital gains on stock and bond - capital losses on stock and bond)

Question 6

Key difference between a variance swap and a volatility swap

Answer 6

Variance swap:
Forward contracts, one party agrees to make a cash payment to the other party linearly based on the realized variance of a price or rate in exchange for receiving a predetermined cash flow.

Volatility swap:
Mirrors a variance swap, but payoff of the contract is linearly based on the standard deviation of a return series rather than the variance.

realized variance vs. std. dev. of a return series

Question 7

What is portfolio insurance?

Answer 7

Primary term for financial arrangements that protect an investor’s portfolio from tail risk

Question 8

Differences between duration, modified duration and effective duration.

Answer 8

Duration:
Measure of sensitivity of a fixed income security to a change in general level of interest rates. Traditionally, viewed as a weighted average of the longevity of the cash flows of a sixed income security.

Modified duration:
Scales duration to adjust compounding in int rate computation.
Duration/[l + (y/m)]
y = stated annual yield
m = number of compounding periods per year
y/m = periodic yield

modified duration = duration, with continuous compounding (m = infinity)

Effective duration:
Interest rate sensitivity of a position that includes the effects of embedded option characteristics. Not equal to weighted average longevity of the cash flow

Question 9

Difference between a yield curve and a term structure of interest rate

Answer 9

Yield curve:
Yields vs maturity of the coupon bonds

Term structure of int rate:
denote actual/hypothetical yields of zero-coupon bonds

Question 10

When is a duration-neutral position best protected?

relative to interest rate shift

Answer 10

This position is protect from value changes when shifts in yield curve that are small, immediate and parallel

infinitesimal, instantaneous, additive

SIP
IIA