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Chapter 26 - Hedge Funds

Chapter 26
Hedge Funds
Multiple Choice Questions
1. ______ are the dominant form of investing in securities markets for most individuals and
______ have enjoyed far greater growth rate in the last decade.
A. Hedge funds; hedge funds
B. Mutual funds; hedge funds
C. Hedge funds; mutual funds
D. Mutual funds; mutual funds
E. none of the above
Mutual funds are the dominant form of investing in securities markets for most individuals
and hedge funds have enjoyed far greater growth rate in the last decade.

Difficulty: Easy

2. Like mutual funds, hedge funds


A. allow private investors to pool assets to be managed by a fund manager.
B. are commonly organized as private partnerships.
C. are subject to extensive SEC regulations.
D. are typically only open to wealthy or institutional investors.
E. B and D
Like mutual funds, hedge funds allow private investors to pool assets to be managed by a fund
manager.

Difficulty: Easy

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Chapter 26 - Hedge Funds

3. Unlike mutual funds, hedge funds


A. allow private investors to pool assets to be managed by a fund manager.
B. are commonly organized as private partnerships.
C. are subject to extensive SEC regulations.
D. are typically only open to wealthy or institutional investors.
E. B and D
Unlike mutual funds, hedge funds are commonly organized as private partnerships and are
typically only open to wealthy or institutional investors.

Difficulty: Easy

4. Hedge funds typically ______ relative mispricing of specific securities and ______ broad
market exposure.
A. bet on; bet on
B. hedge; hedge
C. hedge; bet on
D. bet on; hedge
E. none of the above
Hedge funds typically bet on relative mispricing of specific securities and hedge broad market
exposure.

Difficulty: Moderate

5. Hedge funds ______ engage in market timing ______ take extensive derivative positions.
A. cannot; and cannot
B. cannot; but can
C. can; and can
D. can; but cannot
E. none of the above
Hedge funds can engage in market timing and can take extensive derivative positions.

Difficulty: Moderate

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Chapter 26 - Hedge Funds

6. The risk profile of hedge funds ______, making performance evaluation ______.
A. can shift rapidly and substantially; challenging
B. can shift rapidly and substantially; straightforward
C. is stable; challenging
D. is stable; straightforward
E. none of the above
The risk profile of hedge funds can shift rapidly and substantially,making performance
evaluation challenging.

Difficulty: Moderate

7. Shares in hedge funds are priced


A. at NAV
B. a significant premium to NAV
C. a significant discount from NAV
D. B or C
E. none of the above
Shares in hedge funds are priced at NAV.

Difficulty: Easy

8. Hedge funds are typically set up as ______ and provide ______ information about portfolio
composition and strategy to their investors.
A. limited partnerships; minimal
B. limited partnerships; extensive
C. investment trusts; minimal
D. investment trusts; extensive
E. none of the above
Hedge funds are typically set up as limited partnerships and provide minimal information
about portfolio composition and strategy to their investors.

Difficulty: Moderate

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Chapter 26 - Hedge Funds

9. Hedge funds are ______ transparent than mutual funds because of ______ strict SEC
regulation on hedge funds.
A. more; more
B. more; less
C. less; less
D. less; more
E. none of the above
Hedge funds are less transparent than mutual funds because of less strict SEC regulation on
hedge funds.

Difficulty: Moderate

10. ______ must periodically provide the public with information on portfolio composition.
A. Hedge funds
B. Mutual funds
C. ADRs
D. A and C
E. A and B
Mutual funds must periodically provide the public with information on portfolio composition.

Difficulty: Moderate

11. ______ are subject to the Securities act of 1933 and the Investment Company Act of 1940
to protect unsophisticated investors.
A. Hedge funds
B. Mutual funds
C. ADRs
D. A and C
E. B and C
Mutual funds are subject to the Securities act of 1933 and the Investment Company Act of
1940 to protect unsophisticated investors.

Difficulty: Moderate

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Chapter 26 - Hedge Funds

12. Hedge funds traditionally have ______ than 100 investors and ______ to the general
public.
A. more; advertise
B. more; do not advertise
C. less; advertise
D. less; do not advertise
E. none of the above
Hedge funds traditionally have less than 100 investors and do not advertise to the general
public.

Difficulty: Moderate

13. The minimum investment in some new hedge funds is as low as $______, compared to a
traditional minimum of $______.
A. 50,000; 500,000 to 1 million
B. 25,000; 250,000 to 1 million
C. 175,000; 400,000 to 1 million
D. 10,000; 750,000
E. 5,000; 2 million
The minimum investment in some new hedge funds is as low as 25,000 compared to a
traditional minimum of 500,000 to 1million.

Difficulty: Moderate

14. Hedge funds differ from mutual funds in terms of ______.


A. transparency
B. investors
C. investment strategy
D. liquidity
E. all of the above
funds differ from mutual funds in terms of transparency, investors, investment strategy, and
liquidity.

Difficulty: Moderate

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Chapter 26 - Hedge Funds

15. Hedge funds may invest or engage in


A. distressed firms
B. convertible bonds
C. currency speculation
D. merger arbitrage
E. all of the above
Hedge funds may invest or engage in distressed firms, convertible bonds, currency
speculation, and merger arbitrage.

Difficulty: Moderate

16. Hedge funds are prohibited from investing or engaging in


A. distressed firms
B. convertible bonds
C. currency speculation
D. merger arbitrage
E. none of the above
Hedge funds may invest or engage in distressed firms, convertible bonds, currency
speculation, and merger arbitrage.

Difficulty: Moderate

17. Hedge funds often have ______ provisions as long as ______, which preclude
redemption.
A. crackdown, 2 months
B. lock-up; 2 months
C. crackdown; several years
D. lock-up; several years
E. none of the above
Hedge funds often have lock-up provisions as long as several years, which preclude
redemption.

Difficulty: Moderate

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Chapter 26 - Hedge Funds

18. Hedge fund strategies can be classified as ______.


A. directional and non-directional
B. stock or bond
C. arbitrage or speculation
D. B and C
E. A and B
Hedge fund strategies can be classified as directional and non-directional.

Difficulty: Moderate

19. A hedge fund pursuing a ______ strategy is betting one sector of the economy will
outperform other sectors.
A. directional
B. non-directional
C. stock or bond
D. arbitrage or speculation
E. none of the above
A hedge fund pursuing a directional strategy is betting one sector of the economy will
outperform other sectors.

Difficulty: Moderate

20. A hedge fund pursuing a ______ strategy is attempting to exploit temporary


misalignments in relative pricing.
A. directional
B. non-directional
C. stock or bond
D. arbitrage or speculation
E. none of the above
A hedge fund pursuing a non-directional strategy is attempting to exploit temporary
misalignments in relative pricing.

Difficulty: Moderate

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Chapter 26 - Hedge Funds

21. A hedge fund pursuing a ______ strategy is trying to exploit relative mispricing within a
market, but is hedged to avoid taking a stance on the direction of the broad market.
A. directional
B. non-directional
C. market neutral
D. arbitrage or speculation
E. none of the above
A hedge fund pursuing a market neutral strategy is trying to exploit relative mispricing within
a market, but is hedged to avoid taking a stance on the direction of the broad market.

Difficulty: Moderate

22. An example of a ______ strategy is the mispricing of a futures contract that must be
corrected by contract expiration.
A. market neutral
B. directional
C. relative value
D. divergence
E. convergence
An example of a convergence strategy is the mispricing of a futures contract that must be
corrected by contract expiration.

Difficulty: Moderate

23. A hedge fund attempting to profit from a change in the spread between mortgages and
Treasuries is using a ______ strategy.
A. market neutral
B. directional
C. relative value
D. divergence
E. convergence
A hedge fund attempting to profit from a change in the spread between mortgages and
Treasuries is using a relative value strategy.

Difficulty: Moderate

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Chapter 26 - Hedge Funds

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Chapter 26 - Hedge Funds

24. If the yield on mortgage-backed securities was abnormally high compared to Treasury
bonds, a hedge fund pursuing a relative value strategy would _______.
A. short sell the Treasury and short sell the mortgage-backed securities
B. short sell the Treasury and buy the mortgage-backed securities
C. buy the Treasury and buy the mortgage-backed securities
D. buy the Treasury and short sell the mortgage-backed securities
E. C only since short sales are prohibited
If the yield on mortgage-backed securities was abnormally high compared to Treasury bonds,
a hedge fund pursuing a non-directional strategy would short sell the Treasury and buy the
mortgage-backed securities.

Difficulty: Moderate

25. Assume newly issued 30-year-on-the-run bonds sell at higher yields (lower prices) than 29
year bonds with a nearly identical duration. A hedge fund that buys 29 year bonds and
sells 30 year bonds is taking a ______.
A. market neutral position
B. conservative position
C. bullish position
D. bearish position
E. none of the above
Assume newly issued 30-year-on-the-run bonds sell at higher yields (lower prices) than 29
year bonds with a nearly identical duration. A hedge fund that buys 29 year bonds and sells
30 year bonds is taking a market neutral position.

Difficulty: Moderate

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Chapter 26 - Hedge Funds

26. A bet on particular mispricing across two or more securities, with extraneous sources of
risk such as general market exposure hedged away is a ______.
A. pure play
B. relative play
C. long shot
D. sure thing
E. B and D
A bet on particular mispricing across two or more securities, with extraneous sources of risk
such as general market exposure hedged away is a pure play.

Difficulty: Moderate

27. Assume newly issued 30-year-on-the-run bonds sell at lower yields (higher prices) than 29
year bonds with a nearly identical duration. A hedge fund that sells 29 year bonds and
buys 30 year bonds is taking a ______.
A. market neutral position
B. conservative position
C. bullish position
D. bearish position
E. none of the above
A hedge fund that sells 29 year bonds and buys 30 year bonds is taking a market neutral
position.

Difficulty: Moderate

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Chapter 26 - Hedge Funds

28. If the yield on mortgage-backed securities was abnormally low compared to Treasury
bonds, a hedge fund pursuing a relative value strategy would _______.
A. short sell the Treasury and short sell the mortgage-backed securities
B. short sell the Treasury and buy the mortgage-backed securities
C. buy the Treasury and buy the mortgage-backed securities
D. buy the Treasury and short sell the mortgage-backed securities
E. C only since short sales are prohibited
If the yield on mortgage-backed securities was abnormally low compared to Treasury bonds, a
hedge fund pursuing a non-directional strategy would buy the Treasury and short sell the
mortgage-backed securities.

Difficulty: Moderate

29. Statistical arbitrage is a version of a ______ strategy.


A. market neutral
B. directional
C. relative value
D. divergence
E. convergence
Statistical arbitrage is a version of a market neutral strategy.

Difficulty: Moderate

30. ______ uses quantitative techniques and often automated trading systems to seek out
many temporary misalignments among securities.
A. Covered interest arbitrage
B. Locational arbitrage
C. Triangular arbitrage
D. Statistical arbitrage
E. All arbitrage
Statistical arbitrage uses quantitative techniques and often automated trading systems to seek
out many temporary misalignments among securities.

Difficulty: Moderate

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Chapter 26 - Hedge Funds

31. Assume that you manage a $3 million portfolio that pays no dividends, has a beta of 1.45
and an alpha of 1.5% per month. Also, assume that the risk-free rate is 0.025% (per month)
and the S&P 500 is at 1220. If you expect the market to fall within the next 30 days you can
hedge your portfolio by ______ S&P 500 futures contracts (the futures contract has a
multiplier of $250).
A. selling 1
B. selling 14
C. buying 1
D. buying 14
E. selling 6
The hedge ratio is [$3M/(1220 x 250)] x 1.45 = 14.26. Thus, you would need to sell 14
contracts.

Difficulty: Difficult

32. Assume that you manage a $1.3 million portfolio that pays no dividends, has a beta of
1.45 and an alpha of 1.5% per month. Also, assume that the risk-free rate is 0.025% (per
month) and the S&P 500 is at 1220. If you expect the market to fall within the next 30 days
you can hedge your portfolio by ______ S&P 500 futures contracts (the futures contract has a
multiplier of $250).
A. selling 1
B. selling 6
C. buying 1
D. buying 6
E. selling 4
The hedge ratio is [$1.3M/(1220 x 250)] x 1.45 = 6.18. Thus, you would need to sell 6
contracts.

Difficulty: Difficult

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Chapter 26 - Hedge Funds

33. Assume that you manage a $2 million portfolio that pays no dividends, has a beta of 1.25
and an alpha of 2% per month. Also, assume that the risk-free rate is 0.05% (per month) and
the S&P 500 is at 1300. If you expect the market to fall within the next 30 days you can hedge
your portfolio by ______ S&P 500 futures contracts (the futures contract has a multiplier of
$250).
A. selling 1
B. selling 8
C. buying 1
D. buying 8
E. selling 6
The hedge ratio is [$2M/(1300 x 250)] x 1.25 = 7.69. Thus, you would need to sell 8
contracts.

Difficulty: Difficult

34. Assume that you manage a $2 million portfolio that pays no dividends, has a beta of 1.3
and an alpha of 2% per month. Also, assume that the risk-free rate is 0.05% (per month) and
the S&P 500 is at 1500. If you expect the market to fall within the next 30 days you can hedge
your portfolio by ______ S&P 500 futures contracts (the futures contract has a multiplier of
$250).
A. selling 1
B. selling 7
C. buying 1
D. buying 7
E. selling 11
The hedge ratio is [$2M/(1500 x 250)] x 1.3 = 6.93. Thus, you would need to sell 7 contracts.

Difficulty: Difficult

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Chapter 26 - Hedge Funds

35. Market neutral bets can result in ______ volatility because hedge funds use ______.
A. very low; hedging techniques to eliminate risk
B. low; risk management techniques to reduce risk
C. considerable; risk management techniques to reduce risk
D. considerable; considerable leverage
E. none of the above
Market neutral bets can result in considerable volatility because hedge funds use considerable
leverage.

Difficulty: Moderate

36. Hedge funds exhibit a pattern known as a


A. January effect
B. Santa effect
C. size effect
D. book-to-market
E. none of the above
Hedge funds exhibit a pattern known as a Santa effect.

Difficulty: Moderate

37. ______ bias arises because hedge funds only report returns to database publishers if they
want to.
A. Survivorship
B. Backfill
C. Omission
D. Incubation
E. none of the above
Backfill bias arises because hedge funds only report returns to database publishers if they
want to.

Difficulty: Moderate

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Chapter 26 - Hedge Funds

38. ______ bias arises when the returns of unsuccessful funds are left out of the sample.
A. Survivorship
B. Backfill
C. Omission
D. Incubation
E. none of the above
Survivorship bias arises when the returns of unsuccessful funds are left out of the sample.

Difficulty: Moderate

39. Performance evaluation of hedge funds is complicated by ______.


A. liquidity premiums
B. survivorship bias
C. unreliable market valuations of infrequently traded assets
D. unstable risk attributes
E. all of the above
Performance evaluation of hedge funds is complicated by liquidity premiums, survivorship
bias, unreliable market valuations of infrequently traded assets, and unstable risk attributes.

Difficulty: Moderate

40. Lo (2201) examined up and down betas of hedge funds and concluded that up market
betas were ______ down market betas.
A. generally larger than
B. generally smaller than
C. the same size as
D. twice the size of
E. half the size of
Lo (2201) examined up and down betas of hedge funds and concluded that up market betas
were generally smaller than down market betas.

Difficulty: Difficult

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Chapter 26 - Hedge Funds

41. The typical hedge fund fee structure is


A. a management fee of 1% to 2%
B. an annual incentive fee equal to 20% of investment profits beyond a stipulated benchmark
performance
C. a 12-b1 fee of 1%
D. A and B
E. A and C
The typical hedge fund fee structure is a management fee of 1% to 2% and annual incentive
fee equal to 20% of investment profits beyond a stipulated benchmark performance.

Difficulty: Moderate

42. Hedge fund incentive fees are essentially


A. put options on the portfolio with a strike price equal to the current portfolio value
B. put options on the portfolio with a strike price equal to the expected future portfolio value
C. call options on the portfolio with a strike price equal to the expected future portfolio value
D. call options on the portfolio with a strike price equal to the current portfolio value
E. straddles
Hedge fund incentive fees are essentially call options on the portfolio with a strike price equal
to the current portfolio value.

Difficulty: Moderate

43. Regarding hedge fund incentive fees, hedge fund managers ______ if the portfolio return
is very large and ______ if the portfolio return is negative.
A. get nothing; get nothing
B. refund the fee; get the fee
C. get the fee; lose nothing except the incentive fee
D. get the fee; lose the management fee
E. none of the above
Regarding hedge fund incentive fees, hedge fund managers get the fee if the portfolio return is
very large and lose nothing except the incentive fee if the portfolio return is negative.

Difficulty: Moderate

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Chapter 26 - Hedge Funds

44. The previous value of a portfolio that must be reattained before a hedge fund can charge
incentive fees is known as a ______.
A. benchmark
B. water stain
C. water mark
D. high water mark
E. low water mark
The previous value of a portfolio that must be reattained before a hedge fund can charge
incentive fees is known as a high water mark.

Difficulty: Moderate

Short Answer Questions


45. Explain the five major differences between hedge funds and mutual funds.
The five major categories of differences are transparency, investors, investment strategies,
liquidity, and compensation structure. Mutual funds are more highly regulated by the SEC and
thus are required to be far more transparent. However, hedge funds provide only minimal
information about portfolio composition or strategy. Investors in hedge funds differ in that
investment minimums were traditionally set at $250,000 to $1,000,000. While newer hedge
funds are starting to reduce the minimum investment to $25,000, this minimum is outside the
reach of many mutual fund investors. Mutual funds must provide an investment strategy and
are restricted in the use of leverage, short selling, and in their use of derivatives. However,
hedge funds are less restricted and frequently make large bets that can results in large losses
over the short term. Mutual funds are liquid and investors can redeem shares at NAV and have
proceeds within seven business days. Conversely, hedge funds often impose lock-up periods
as long as several years and require redemption notices of several months even after the lockup period is over. Thus, hedge funds a re far less liquid. While mutual funds charge a
management fee, hedge funds add an incentive fee as well. This incentive fee is similar to a
call option and the portfolio manager receives a "performance" bonus if the portfolio
outperforms the chosen benchmark.
Feedback: This question tests the students understanding of the major differences between
hedge funds and mutual funds.

Difficulty: Moderate

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