Finding and Backtesting strategy

Question 1

What are the two profit sources for active trading?

Answer 1

Compensation for Liquidity Risk: Market liquidity risk, funding liquidity risk, providing liquidity to demand pressure
Compensation for information: production of Information, Access to information, New that travel slowly

Question 2

Production of Information

Answer 2

Fundamental analysis
Purchase company with strong and underappreciate business prospect
Research on consumer demands and industry dynamics
short sell fraudulent firm
trader seek to trade on new information and insight, hedge fund may also create information more directly by providing management with ideas on how to improve the company or cut costs.

Question 3

Behaviour finance and the limits of arbitrage?

Answer 3

Noise trader suffer from behavioural biases and make common mistake such as initially under reaction and delayed overreaction that push price away from fundamental. These distortion is correct party by arbitrage,but in the real world arbitrage trade are risky so it occur only to a limit extent

Question 4

What are the risk of arbitrage trading?

Answer 4

Fundamental risk: meaning that if hedge fund buy a cheap security, there still a risk that the security will under perform due to random event
Noise Trader risk: meaning that when hedge fund buying cheap securities, it might get even cheaper before price approaches the fundamental value.
This can lead to short term lost and capital redemption and the fund might not stay for the upside

Question 5

What is liquidity risk?

Answer 5

liquidity risk consist of rising transaction costs ( market liquidity risk)
the risk of running out of cash, especially for a leveraged hedge fund (funding liquidity risk)
the risk of accommodating demand pressure
liquidity risk limit the ability for trader to correct mispricing, it also affect market prices directly as it create a liquidity risk premium