Reading 5.1 Flashcards
4 conclusion that can be drawn from the fund failures discussed in the CAIA reference material?
- Risk of leverage
- Danger of overconfidence in trading (prime brokers exacerbate liquidity issues during market crises)
- Unpredictability of all risks
- Importance of due diligence
4 key issues with the Lancer Hedge fund?
1) Manager valuation
2) Lack of transparency
3) Window dressing
4) Failed auditing and regulatory safeguards
What is Anchoring?
Anchoring is the tendency to excessively rely on a reference point which is irrelevant for the decision at hand.
If the analyst believes that the price will increase because it was much higher in the recent past, he is anchoring his expectations to an irrelevant reference point (i.e., the past stock price).
What compounded the loss effect of long/short equity position unwinding during the August 2007 quant crisis, according the Khandani and La’s unwind hypothesis?
quant fund equity positions were liquidated in August 2007 to raise cash for margin calls resulting from losses in non-equity positions.
However, these liquidations led to higher risk spreads in quant fund portfolios, many of which held similar ( crowded) positions. This, in turn, triggered further risk-adjustment driven liquidations across quant funds and a liquidity spiral causing sharp short-term losses. Also, the risk of crowded trades was compounded by rapid trading techniques.
Describe the strategy of Amaranth Advisors, LLC in the years prior to 2007?
They went long winter natural gas contracts and short non-winter contracts, betting on a widening of the spread.
Describe the practice of painting the tape and that hedge fund that engaged in this practice?
trading a security for the sole purpose of changing its price; Lancer Group
3 key factors that led to Amaranth’s collapse:
1) narrowing of the natural gas calendar spreads in its
strategies,
2) the enormous size of its positions,
3) its prime brokers not providing collateral when the fund needed it (the fund did not maintain a most favored client status with its prime brokers)
Amaranth’s trading strategy would have been profitable if what occurred? and why?
if weather conditions had become extremely harsh
Amaranth’s trading strategy involved buying contracts with winter deliveries and selling contracts with non-winter deliveries, so the strategy would have benefited under extreme weather conditions (e.g., hurricanes and coldshocks).
The strategy was essentially looking for spreads to widen, but they instead tightened.
Which fund suffered significant short-term losses due to a trading glitch? Why?
Knight Capital suffered significant losses due to a glitch in their trading software that resulted in them inadvertently buying and selling large quantities of stocks in a short period of time in a single day. The company lost over $400 million on that day.
Khandani and Lo’s unwind hypothesis explains which event?
the quant meltdown of August 2007 as unexpected, forced liquidations of large equity market-neutral hedge funds (needing cash or to delever) that caused similar hedge funds to delever in a crowded market
Major lesson from Bayou Case and what would a DD have reveled
A lesson from the Bayou case is that some fund managers are dishonest.
Due diligence would have revealed that -
1. Bayou’s founder (Samuel Israel) misrepresented his prior experience: he overstated his position and tenure at a previous firm.
2. Bayou’s inception date was late 1996, not early 1997 as Israel claimed (to conceal significant losses during the fund’s first few months).
Describe the strategy that Bernie Madoff claimed to implement
a split strike conversion strategy (i.e., a collar): 1) buy underlying asset, 2) write a call at the higher of two strikes , and 3) buy a put at the lower of two strikes
what hedge fund strategy was implemented by Long-Term Capital Management?
relative value arbitrage
