Relative Value Hedge Funds

Question 1

What are Relative value strategies?

Answer 1

They attempt to take advantage of relative pricing discrepancies between 2 securities.

Question 2

What is the classic Relative Value Strategy Trade?

Answer 2

It identifies abnormal spreads between 2 RELATED PRICES OR RATES and establishes a position anticipating a convergence to normal levels. A long position is established in the security that is undervalued and a short position is established in the security that is overvalued

Question 3

What is the classic Convertible Bond Arbitrage trade?

Answer 3

Buy the convertible bond and short sell the common stock.

By short selling the stock, the hedge fund manager eliminates some or all of the equity exposure in the convertible bond.

The Manager receives any interest paid by the bond in excess of dividends paid to the lender of the shorted common stock.

Question 4

Moneyness of convertible

Answer 4

Depends on conversion premium

High conversion premium, stock options are far out of the money, it is called a busted convertible.

Moderate premium, close to being-in- the money, it is called a hybrid convertible.

Negatvie conversion premium, Equity-like convertible bonds are in the money. Interest rates and credits have very little impact.:

Busted, huybrid and equity like

Question 5

Under what circumstances does the Classic Relative Value Strategy Trade work?

Answer 5

Because the positions are set to converge to normal levels, the strategies perform well under normal market conditions with low volatility.

Question 6

What is delta, what is gamma and what is theta?

Answer 6

Delta = Change in the value of the option for a$ change in the value of the stock.

Gamma is the rate of change of delta.

Theta is the first derivative of an option price with respect to the time to expiration for the option

Question 7

What is realized volatility?

What is implied volatility?

Answer 7

Realized volatility refers to the actual observed volatiity or standard deviation of returns.

Implied volatility refers to embedded option. This refers to the standard deviation of returns based on observed options market price.

Question 8

What is the key to traditional convertible bond arbitrage?

Answer 8

Buy convertible bonds with low implied volatility, they have overpriced conversion premium

Sell convertible bonds with high implied volatility, they have underpriced conversion premum,

and maintain hedges with offsetting positions in the underlying equity to control for market risk

Question 9

What is short stock rebate?

Answer 9

Relates to short sales and the interest on the short sale proceeds.

Question 10

What is a complexity premium?

Answer 10

Excess return that compensates the investor for analyzing and managing position that require expertise and time.

Question 11

What are Volatility arbitrage strategies?

Answer 11

They attempt to capitalize on differences in the implied volatility that exists beween option prices on a particular stock.

Question 12

What is Vega?

Answer 12

The first derivative of the option price with respect to the implied volaitility of the underlying asset in the option.

Question 13

What are variance swaps?

Answer 13

Variance swaps are forward contracts based on the variance of a price or rate.

Question 14

Variance swap payoff formula

Answer 14

vega notional value x (realized variance - strike variance)/ (2 x sq-root of strike variance)

Question 15

Volatility swaps

Answer 15

Less common than variance swaps, they use volatility rather than variance.

Question 16

Why are exchange traded securities less risky than OTC derivatives?

Answer 16

1. Less counterparty risk;
2. Less pricing risk
3. Higher liquidity

cpl

Question 17

Tail risk

Answer 17

Probability of a large loss due to an unusual event

Question 18

What is meant by ‘Correlations go to one’

Answer 18

The notion that during a market crisis, assets that are normally uncorrelated have correlations that approach one.

Question 19

What is a fixed income arbitrage strategy?

Answer 19

A manager buys one fixed income security and sells a similar fixed income security in an attemp to profit as the spread between their prices converge over time.

Question 20

What are relative value multi-strategy funds?

Answer 20

They contain a combination of mutiple arbitrage strategies.

They are formed to increase fund capacity, increase dviersifcation, and increase opportunities for investment due to the cyclical nature of markets.

Question 21

What does term structure of interest rates refer to?

Answer 21

The yield curve for zero coupon Bonds.

Question 22

What is classic dispersion trade?

Answer 22

Loia and SORI

Short correlation tade, profits when realized correlationsa are low

A market-neutral, short correlation trade that arbitrages differences between realized correlations among assets and the correlation implied in the options of a market index (by going long options on individual assets and shorting options on a related index). As a short correlation trade, it profits when realized correlations are low, which tends to occur when realized volatilities on the index are relatively low and on the individual assets are relatively high.