AIM 1: Explain how liquidity and leverage may have played a role in the sharp losses quantitative hedge funds experienced in early 2007.

1、Which of the following statements is consistent with the “unwinding” hypotheses regarding the losses of long/short quantitative hedge funds in August 2007?

A) The third week of August exhibited a mean-reversion process with large positive gains.

B) The reversal on August 10 limited the losses of large short/term hedge funds that experienced losses earlier in the week.

C) The smallest decile market capitalization firms experienced the most volatile shifts in return the second week of August relative to larger firms.

D) Long/short equity funds de-levered their portfolios simultaneously on August 7 and 8.

The correct answer is D

Long/short equity funds de-levered their portfolios simultaneously on August 7 and 8. Margin calls were set in place on August 9 due to the decreasing net asset values of hedge funds the previous two days. Most hedge funds did not participate in the August 10 reversal because they were forced to liquidate their positions.

2、A simulated test of the unwinding hypothesis examining long/short equity strategies during August 2007 suggests:

A) portfolios constructed with the largest decile market capital firms were not impacted by the events of August 2007.

B) the largest losses were associated with portfolios constructed with middle decile market capital firms. 

C) little support for the unwinding hypothesis.

D) after large losses on August 7 and 8 the trading strategies had large profits on August 9.

The correct answer is B

The middle deciles based on market capitalization have an optimal tradeoff of liquidity and profitability and thus are more likely targets of long/short quantitative strategies. Consistent with the unwinding hypothesis, the largest losses were associated with this group.

3、The rapid liquidation of large long/short equity fund positions in August of 2007 was most likely the result of:

A) an increased use of leverage in long/short equity funds due to declining profits over the past decade.

B) a decrease in the number of market participants due to declining profits over the past decade.

C) a decrease in liquidity caused by fewer funds and competitors in the industry.

D) a growing number of hedge funds in an overcrowded market due to the increased expected returns in the industry over the past decade.

The correct answer is A

In August of 2007, a number of large long/short equity funds using increasingly higher leverage ratios were forced to liquidate quickly to satisfy margin calls with adverse market price changes.

4、Which of the following is NOT a potential factor explaining the magnitude of the large quantitative fund losses according to the unwinding hypothesis?

A) Growth in assets under management in long/short equity funds.

B) Increasing profits to quantitative equity market-neutral strategies over the past decade.

C) Increasing leverage used in quantitative long/short equity funds.

D) Lack of awareness of increased crowding of long/short equity funds.

The correct answer is B

Profits in long/short equity funds have declined over the past decade due to increased competition, technological advances, and institutional and environmental changes.

5、Which of the following is NOT a caveat associated with the hypotheses examining the August 2007 losses in long/short equity funds?

A) There has never been a similar crisis resulting in losses to a specific market sector such as long/short equity funds.

B) The hypotheses are based on indirect evidence due to the lack of proprietary data regarding hedge funds.

C) There has been little time to examine and form hypotheses regarding the August 2007 events.

D) There is a lack of transparency of hedge funds.

The correct answer is A

The market events of August 2007 are similar to the market events of August 1998 when Russia defaulted on its GKO government bonds that led to a global flight to quality and the fall of Long-Term Capital Management (LTCM).

6、Which of the following statements best describes hedge funds use of leverage?

A) No hedge funds use leverage.

B) Only statistical arbitrage funds use leverage.

C) Only equity market-neutral funds use leverage.

D) Most hedge funds use leverage.

The correct answer is D

Most hedge funds do use some form of leverage.

AIM 2: Discuss the growth of hedge funds, particularly long/short equity funds, and its effect on performance, leverage and potential for greater systemic risk.

1、A simulated long/short market neutral equity strategy using data from August 2007 reveals:

A) mean reverting losses and profits for August 7 and 8, followed by a large loss on August 9 and large profit on August 10.

B) significant losses for the entire week of August 6.

C) significant losses for August 7, 8, and 9 followed by a significant profit on August 10. 

D) significant profits for the entire week of August 6, followed by large losses the following two weeks.

The correct answer is C

The cumulative three-day loss for August 7 through August 9, 2007 for a simulated long/short market neutral equity strategy was -6.85%, followed by a 5.92% reversal on August 10, 2007 for the full sample of simulated data.

2、Which of the following statements is (are) CORRECT regarding hedge fund categories?

I.           The long/short equity is the broadest class.

II.         Statistical arbitrage entails a focused number of securities.

III.        Quantitative equity market-neutral is more focused than Statistical Arbitrage.

A) II only.

B) II and III.

C) I only.

D) I, II and III.

The correct answer is C

Statement I is correct. Long/short is the broadest class (in fact all of the strategies can be described as some form of long/short). Statistical arbitrage entails a broad number of securities. Quantitative equity market neutral is broader than statistical arbitrage.

3、Hedge funds are classified into many different categories depending upon the fund’s strategy. Evaluate which of the following statements are CORRECT regarding hedge fund trading strategies.

I.           Statistical arbitrage funds trade a large amount of securities, use extremely brief holding periods, and use large infrastructure involving calculations, computer trades and technical trading systems.

II.         Quantitative equity market-neutral is broader in scope than statistical arbitrage, as it involves more quantitative models, not as many securities, forecasts of earnings, and economic indicators.

III.        Long/short equity encompasses the most portfolios, those that use short selling, and are indiscriminate of being market-neutral, quantitative, or technology-based. This category of funds is the largest both in terms of market value and number of funds.

IV.      Quantitative-based 130/30 strategy (or active extension strategy) funds are the fastest growing. Funds in this subsection allow a limited divergence from the traditional long-only strategy. These funds are generally assembled by a quantitative mechanism.

A) I, III and IV.

B) II, III and IV.

C) I, II and III.

D) I, II, III and IV.

The correct answer is D

All of the statements are correct.

4、Empirical research on hedge funds faces some special data considerations. Which of the following statements are CORRECT regarding the difficulties in the assessment of hedge fund performance?

I.           Hedge fund returns can be both positively and negatively correlated to one anther due to the extensive use of short positions.

II.         The TASS database contains only entities that have voluntarily entered their information.

III.        Hedge fund returns are based upon an international benchmark standard.

IV.      Hedge funds are risk-free investments.

A) I, II, III and IV.

B) I and II.

C) II and III.

D) I and III.

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Statements I and II are correct. Returns can be increasing as the market moves up or down, due to the fund’s short positions. Also, hedge funds in the TASS database voluntarily provide their information.

5、Which of the following statement best describes a long/short strategy?

A) Trading an equal dollar amount of long and short positions.

B) Buying the previous periods winners.

C) Buying the previous periods losers.

D) Long firm A’s stock, short firm A’s bonds.

The correct answer is A

Although many different forms of the long/short strategy exist, long/short involves trading an equal dollar amount of long and short positions.

6、Which of the following strategies would best be described as complex?

A) Contrarian strategy.

B) Long/short strategy.

C) Statistical Arbitrage.

D) A position in cash.

The correct answer is C

Statistical arbitrage is complex. The other strategies would be considered naive.

AIM 3: Explain how the lack of transparency with respect to hedge funds necessitates other strategies for understanding and replicating historical hedge fund performance crises.

Which of the follow statements is (are) NOT correct regarding standardized risk management products and measures?

I.           Standardized risk factor models produce a market place more likely to have common exposures.

II.         Over the past 10 years managers have been using standardized products more frequently.

III.        The use of standardized risk products by hedge-fund managers has led to more overlap and similar portfolios.

A) I only.

B) None of these.

C) II only.

D) III only.

The correct answer is B

All of the statements are correct (i.e., none are incorrect).

AIM 4: Discuss how correlations between hedge fund strategies have evolved over time and the implications of those correlations today.

1、Which of the following statements is NOT an implication regarding the systemic risk in the hedge fund industry based on findings of a simulated study of long/short quantitative equity strategies?

A) The global financial system and hedge fund markets are more connected than market participants previously realized.

B) Hedge fund beta is now viewed as a reality.

C) Hedge funds are similar to banks with respect to the liquidity of their positions.

D) Hedge funds play significant roles in providing liquidity and credit to the market.

The correct answer is C

Hedge funds are becoming more like banks with respect to their role in providing liquidity and credit. However, unlike banks, hedge funds are able to quickly liquidate their positions.

2、One method for approximating a network view of the hedge-fund industry is to calculate the:

A) changes in absolute values of correlations between hedge-fund indices over time.

B) alphas of hedge fund indices over time compared to benchmark portfolios. 

C) compare the simulated returns of market-neutral and momentum strategies over time.

D) simulated returns for hedge funds over time using a boot-strap technique.

The correct answer is A

A network view of the hedge-fund industry can be approximated by calculating the changes in the absolute values of correlations between hedge-fund indices over time.

3、Examining a network view of the hedge fund industry over the past decade reveals that:

A) there is little support for the unwinding hypothesis.

B) the multi-strategy category of hedge funds had the most significant decrease in connectedness to other hedge funds over the past decade.

C) correlations between hedge funds have increased over time.

D) the unwinding of the long/short quantitative market-neutral funds in August of 2007 was strictly the result of factors within its own sector. 

The correct answer is C

Absolute correlations between hedge funds have increased over the past decade, suggesting the unwinding of the long/short quantitative market-neutral strategies was caused in part by factors outside the sector.

4、Empirical research suggests the connectedness of hedge funds has notably increased from 1998 to 2007. This increase in connectedness can be linked to which of the following factors?

I.           The increased correlation of returns between asset classes.

II.         Over the years hedge funds have increased their exposure to traditional market factors.

III.        Hedge fund managers took on less risk during the period 1998 to 2007.

IV.      The ties due to intricate strategies and multi-strategy funds have increased the correlations.

A) I and III.

B) I only.

C) II and IV.

D) None of these.

The correct answer is C

Statements II and IV are correct. Funds are investing in more and more common securities. Also, common investment groups increase connectedness among hedge funds.

5、Which of the following statement best describes the reason for increased “connectedness?”

A) Funds have increased exposure to traditional market factors.

B) Hedge-fund returns are highly correlated.

C) Network flows have improved over the past 10 years.

D) Improved communications networks have improved connectedness.

The correct answer is A

Hedge funds do have increased exposure to traditional market factors.

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