Reading 19

Question 1

Name the types of hedge fund strategies

Answer 1

SEEMRO

1. specialist
2. equity
3. event
4. Multi-manager
5. Relative value
6. Opportunistic

Question 2

Activist Short Selling

Answer 2

The fund manager not only takes a short position in a stock, but also presents research that contends that the stock is overpriced

Question 3

Merger Arbitrage

Answer 3

Event Driven Strategy

Involves simultaneously purchasing and selling the stocks of 2 merging companies to create “riskless” profits

Question 4

Convertible Bond Arbitrage

Answer 4

Relative Value Strategy

Buy the relatively undervalued convertible bond and take a short position in the relatively overvalued underlying stock

Question 5

If an investor is concerned about low volatility and thinks it is more important than negative correlation, which HF strategy should they avoid?

Answer 5

Dedicated short selling and short biased

Have return goals that are typically less than those for most other hedge fund strategies but with a negative correlation benefit.

They are also more volatile than a typical long/short equity hedge fund because of their short beta exposure.

Question 6

Describe Carry Trades

Answer 6

going long a higher yielding security and shorting a lower yielding security with the expectation of receiving the positive carry and of profiting on long and short sides of the trade when the temporary relative mispricing reverts to normal.

A classic example of a fixed-income arbitrage trade involves buying lower-liquidity, off-the-run government securities and selling higher-liquidity, duration-matched, on-the-run government securities. Interest rate and credit risks are hedged because long and short positions have the same duration and credit exposure. So, the key concern is liquidity risk. Under normal conditions, as time passes, the more (less) expensive on-the-run (off-the-run) securities will decrease (increase) in price as the current on-the-runs are replaced by a more liquid issue of new on-the-run bonds that then become off-the-run bonds.

Question 7

Which hedge fund strategy helps to maintain a high Sharpe ratio even in a crisis when equity markets fall?

Answer 7

Managed futures

Buying longer-dated out-of-the-money options on VIX index futures is a long equity volatility position that works as a protective hedge, particularly in an equity market crisis when volatility spikes and equity prices fall. A long volatility strategy is a useful potential diversifier for long equity investments (albeit at the cost of the option premium paid by the volatility buyer). Because equity volatility is approximately 80% negatively correlated with equity market returns, a long position in equity volatility can substantially reduce the portfolio’s standard deviation, which would serve to increase its Sharpe ratio. Longer-dated options will have more absolute exposure to volatility levels (i.e., vega exposure) than shorter-dated options, and out-of-the-money options will typically trade at higher implied volatility levels than at-the-money options.

Question 8

Sortino ratio

Answer 8

Measures risk adjusted performance, where risk is defined as downside deviation, so it penalizes only downside variability below a minimum target return.