Chapter 15 - Alternative Mutual Funds, Closed-End Funds, and Hedge Funds (Done)

Question 1

Describe the specific guidelines under regulation that permit alternative mutual funds and closed-end
funds to use derivatives for non-hedging purposes.

Answer 1

Alternative mutual funds and closed-end funds can:
* Short sell securities with a market value up to 50% of net asset value, without cash cover and with access to
the short sale proceeds for investment in other securities.
* Borrow cash up to 50% of net asset value from qualified entities.
* Short sell and borrow cash provided that the combined exposure does not exceed 50% of the fund’s net asset
value.
* Use the leverage inherent in derivatives for non-hedging purposes.
* Short sell, borrow cash, and use derivatives for non-hedging purposes, provided that the combined exposure
does not exceed 300% of the fund’s net asset value.

Question 2

Demonstrate the non-hedging ways in which alternative mutual funds, closed-end funds and hedge
funds use derivatives.

Answer 2

Like mutual funds, alternative mutual funds, closed-end funds and hedge funds will use derivatives for non-
hedging to gain investment exposure quickly, effectively and in a cost-efficient manner. Unlike mutual funds,
however, these three fund types are also able to derivatives to gain leveraged exposure to the underlying asset.

Question 3

Compare and contrast alternative mutual funds and hedge funds.

Answer 3

Compared to hedge funds, alternative mutual funds provide retail investors with:
* Access to investment strategies that were previously largely available only to high net worth and institutional
investors.
* The goal of earning absolute returns during all phases of a market cycle.
* A structure that has the degree of transparency, daily liquidity, and investor protection rights that are
associated with conventional mutual funds.
* Generally lower fees.
* Considerably lower minimum investment requirement.

Question 4

Describe the three major categories of alternative strategies.

Answer 4

• Relative value strategies attempt to profit by exploiting inefficiencies or differences in the pricing of related
  stocks, bonds, or derivatives.
• Event-driven strategies seek to profit from unique corporate structure events such as mergers, acquisitions,
  stock splits, and stock buybacks.
• Directional strategies bet on anticipated movements in the market prices of equity securities, debt securities,
  foreign currencies, and commodities.

Question 5

Demonstrate the primary potential risks associated with the use of derivatives in alternative strategies.

Answer 5

The biggest risk is the potential for loss from leverage. Other risks include:
* Transparency – how much do managers reveal about their derivatives strategies?
* Performance attribution – how do managers report the impact that derivatives had on the performance of the
fund?
* Liquidity – how easily, if at all, can the managers get out of their derivatives positions?
* Price limits – do price limits on certain exchange-traded derivatives have the potential to reduce the
effectiveness of the derivatives position?
* Manager skill – do the managers understand derivatives and are they able to use them skilfully?
* Volatility of returns – are investors prepared for the volatility in returns that can accompany a fund that uses
derivatives?

Question 6

What are directional strategies?

Answer 6

Directional strategies bet on anticipated
movements in the market prices of
equity securities, debt securities, foreign
currencies, and commodities.

Question 7

What are event-drive strategies?

Answer 7

Event-driven strategies seek to profit
from unique corporate structure
events such as mergers, acquisitions,
stock splits, and stock buybacks.

Question 8

What are relative value strategies?

Answer 8

Relative value strategies attempt to
profit by exploiting inefficiencies or
differences in the pricing of related
stocks, bonds, or derivatives.

Question 9

What maximum combined exposure can alternative mutual funds have from short selling, cash borrowing and
derivatives used for non-hedging purposes?

Answer 9

Alternative mutual funds can have a combined 300% of its net asset value in exposures from short selling,
cash borrowing and derivatives used for non-hedging purposes.

Question 10

How do alternative mutual funds generally differ from traditional hedge funds?

Answer 10

Compared to hedge funds, alternative mutual funds:
* Provide access to investment strategies that were previously largely available only to high net worth and
institutional investors.
* Have a goal of earning absolute returns during all phases of a market cycle.
* Are a structure that has the degree of transparency, daily liquidity, and investor protection rights that are
associated with conventional mutual funds.
* Have lower fees.
* Have a considerably lower minimum investment requirement.

Question 11

A hedge fund manager expects the price of gold to decline in U.S. dollar terms but appreciate in terms of
the Swiss franc. Which of the following futures positions will allow the hedge fund manager to profit from
this view?
a. Long gold futures and long Swiss franc futures.
b. Long gold futures and short Swiss franc futures.
c. Short gold futures and long Swiss franc futures.
d. Short gold futures and short Swiss franc futures.

Answer 11

d. Short gold futures and short Swiss franc futures.
If the price of gold is expected to fall in U.S. dollar terms, the only way to profit from this is to sell gold
futures. If at the same time the price of gold is expected to increase in terms of the Swiss franc, then it must
be the case that the Swiss franc is declining even faster than the price of gold in U.S. dollar terms. Therefore,
Swiss franc futures should be sold as well.