Chap 18 Equity Hedge Funds

Question 1

Three major types of equity hedge funds & typical systematic risk exposure

Answer 1

Equity long/short hedge funds
Equity market-neutral funds
Short-bias funds

Question 2

Role of a market maker - taking and/or providing liquidity in a market with anxious traders

Answer 2

Market maker is a market participant that offers liquidity, both on the buy side by placing bid orders and on the sell side by placing offer orders.

Meets imbalances in supply and demand for shares caused by idiosyncratic trade orders from anxious traders.

Purpose for providing liquidity is to ear the spread between the bid and offer prices by buying at the bid price and selling at offer price.

Question 3

Empirical test of informational market efficiency is a test of joint hypotheses.

Answer 3

The empirical test of informational market efficiency is:

a joint hypothesis of the appropriateness of the particular model of returns (in determining what constitutes an abnormal return) and a test of whether a particular investment has generated statistically significant abnormal returns

Question 4

Define standardized unexpected earnings and how it’s used

Answer 4

SUE is a measure of earning surprise

some measure of unexpected earnings/some measure of earning volatility

Question 5

Relationship between net stock issuance of a firm and the subsequent returns of the firm’s shareholder.

Answer 5

Empirical studies show that positive or negative net stock issuance is one of the most profitable anomalies.

Firms that issue large amounts of new shares (e.g. more than 20% of shares currently outstanding), see their stock price substantially underperform the market

Question 6

What is information coefficient?

Answer 6

Measure that describes managerial skill as the correlation between managerial return predications and realized returns

Question 7

How limits to arbitrage prevent markets from being perfectly efficient?

Answer 7

Limit to the risk that an arbitrager can tolerate and/or allowed to take - limited level of arbitrage activity by a single manager

1. to be successful in long run, must limit the risk of the fund, especially in periods where the strategy is out of favor (values managers in late 90s/early 00). prevents them from taking aggressive bets
2. market structure prevent successful arbitrage - institutional investors too large to participate in micro-cap stocks
3. limits on short selling - some countries do not allow short selling, recent IPOs/spin-offs may not have shares available to be shorted, some shares may be temp unavailable for borrowing when the demand to sell the shares short exceeds the supply of borrowable shares

Question 8

What is multiple-factor scoring model approach?

Answer 8

An approach that combines the factor scores of a number of independent anomaly signals into a single trading signal

Question 9

Skilled manager implementing a pairs trading strategy - what’s the concern that limit the size of the positions that the manager might take in attempting to increase expected alpha

Answer 9

• limits to arbitrage - inability/unwillingness of speculators (e.g. pairs traders), to hold their positions without time constraints or to increase their positions without size constraints
• very large positions with high degrees of leverage increase the probability of financial ruin/inability to survive short term displacements

Question 10

Difference between mean neutrality from variance neutrality in equity market-neutral strategies

Answer 10

Mean neutrality:
Portfolio is shown to have zero beta exposure or correlation to the underlying market index.

(market move in one direction, mean-neutral portfolios have the same chance of moving in either direction)

Variance neutrality:
Portfolio returns are uncorrelated to changes in market risk.