AIM 1: Describe various hedge fund strategies, including equity long/short, market-neutral, pair trading, market timing, short-selling, event-driven, distressed securities, Regulation D, and global macro as well as arbitrage strategies, including convertible, fixed-income, volatility, capital structure, merger.

1、A hedge fund that focuses on earning returns from mergers, spin-offs, and takeovers would be most accurately placed in which style category?

A) Equity market neutral. 

B) Hedged equity.

C) Global macro. 

D) Merger arbitrage. 

The correct answer is D

Merger arbitrage focuses on returns from mergers, spin-offs, takeovers, etc... For example, if company X announces it will acquire company Y, the manager might buy shares in Y and short X.

2、The largest category of hedge funds in terms of asset size is:

A) market-neutral funds.

B) long/short funds.

C) global macro funds.

D) event-driven funds.

The correct answer is B

Long/short funds are considered to be the “traditional” type of hedge funds, and they represent the largest category of hedge funds.

3、Which of the following statements regarding hedge funds is least accurate?

A) Market-neutral hedge funds may have long and/or short positions.

B) Event-driven hedge funds seek to capitalize on a unique opportunity in the market.

C) Global macro funds make bets on the direction of a market, currency or interest rate.

D) Long/short funds have a net market neutral position.

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Long/short funds, by definition, are not market-neutral and usually maintain a net positive or net negative market exposure.

4、A popular hedge fund strategy is a long/short equity strategy. What would be the typical target “net” exposure in such a hedge fund strategy?

A) net short.

B) close to perfectly hedged.

C) core long positions with a near total hedge overlay using short index futures.

D) net long.

The correct answer is D

While this is not always the cases, most managers would maintain a net long position, or at least have a long bias. It is not as common, but some hedge fund managers have core long positions with a partial hedge overlay using short index futures, long puts (out-of-the-money), or short covered calls.

5、A hedge fund manager generally has more flexibility and freedom to make investment “bets” and uses this flexibility to sell short and thus create opportunities for gains. Which of the following would NOT be a purpose for taking short positions?

A) To earn significant beta.

B) To hedge overall broad market risk.

C) To earn the short rebate interest.

D) To earn a profit when the stock declines.

The correct answer is A

To hedge overall broad market risk, to earn the short rebate interest, and to earn a profit when the stock declines are all legitimate, different purposes for taking short positions. Such “shorting” is generally not available to traditional investment managers who may have regulatory constraints or internal compliance rules, particularly within financial institutions. The term “short rebate” is interest earned on the proceeds from short selling. To earn significant beta is not a legitimate purpose of taking short positions. In fact, the majority of long/ short equity managers also claim to return a large amount of alpha.

6、Hedge fund managers that follow equity market neutral strategies generally try to profit from market inefficiencies related to:

A) value or momentum factors.

B) pricing discrepancies due to mispriced volatility.

C) pricing discrepancies between the stocks of the parties to a merger.

D) the January effect.

The correct answer is A

Market neutral strategies that exploit market inefficiencies are generally based on the findings of academic research which demonstrates that value stocks and momentum strategies earn positive excess returns.

7、William Jones, CFA, has a client who wants to invest in a hedge fund that has the strategy of investing in equities and has among its goals the elimination of systematic risk. Jones has found two funds that he thinks are well run: the Marius Fund that uses an equity market neutral strategy and the Hera Fund that uses a hedged equity strategy. Given the client’s stated preferences, Jones should recommend:

A) the Hera Fund only. 

B) neither the Hera nor the Marius Fund.

C) either fund. 

D) the Marius Fund only.

The correct answer is D

Equity market neutral is usually the attempt to exploit price discrepancies through long and short positions. This strategy also has the goal of the systematic risks canceling because of the long and short positions. Hedged equity strategies take long and short positions in under and overvalued securities, respectively, like equity market neutral strategies. The difference is that hedged equity strategies do not focus on balancing the positions to eliminate systematic risks.

8、A hedge fund that takes perfectly offsetting long and short positions is best described as a(n):

A) long/short fund.

B) event-driven fund.

C) market-neutral fund.

D) global macro fund.

The correct answer is C

Market-neutral funds take long and short positions but attempt to offset them to hedge against market moves. Long/short funds take both long and short positions but do not try to offset them. Global macro funds bet on the direction of a market, currency, interest rate, or other factor; they don’t try to offset positions to cancel out market effects. Event-driven funds focus on unique market opportunities, not offsetting positions.

9、Equity market neutral strategies involve being both long and short in matched stock positions, thus taking advantage of an expected outperformance of the long position. There are two sub-classifications of equity market neutral strategies, which are:

A) merger arbitrage and statistical arbitrage trading.

B) fair valuation and long/short matching.

C) market neutral long/short equity and statistical arbitrage trading.

D) convertible arbitrage and market neutral long/short equity. 

The correct answer is C

These are both sub-classifications of equity market neutral strategies. Statistical arbitrage is short-term trading based on modeling, and market neutral long/short strategies involve longer holding periods, during which time pricing disparities presumably correct themselves.

10、Which of the following statements regarding pair trading is INCORRECT? Pair trading:

A) is a form of statistical arbitrage.

B) involves taking long and short position in two stocks that are related.

C) identifies overvalued and undervalued stocks of firms that are related.

D) heavily relies on fundamental analysis.

The correct answer is D

Pair trading relies more on technical, quantitative analysis than “fundamental” analysis. Some criticize this technical approach as being a “black box” in the sense that investors are not given details regarding the statistical model used to create the strategy.

11、Which of the following strategies involves purchasing equities of small-cap firms and simultaneously selling equities of large-cap firms?

A) SUE.

B) HML.

C) UMD.

D) SMB.

The correct answer is D

SMB (“small minus big”) strategy involves purchasing small firms’ stock and also selling large-cap stocks. HML is “high minus low”—buying value stocks and shorting growth stocks. UMD (“up minus down”) is investing in recent winners and shorting recent losers.

12、Which of the following statements regarding equity market timing strategies as applied by hedge funds is FALSE?

A) The strategy is usually based on fundamental analysis.

B) The strategy often focuses on one particular sector, industry, or geographic region.

C) The strategy involves switching between holdings of money market securities and a long equity portfolio.

D) A key part of the strategy is keeping transactions costs low.

The correct answer is A

Equity market timing strategies use stock-screening models based on simple technical trading models.

13、Managers following a short-selling hedge fund strategy commonly search global equity markets in an attempt to find firms that:

A) use aggressive accounting methods.

B) are the target of an acquisition proposal.

C) are emerging from Chapter 11 bankruptcy.

D) can profit from operational efficiencies.

The correct answer is A

Seeking firms that use aggressive accounting techniques is a frequent short-seller theme. The short seller would also look at something additional, such as weak fundamentals.

14、Which of the following activities has the greatest influence when determining a short-selling manager’s success?

A) Psychological barriers of others.

B) Technical analysis.

C) Regulatory oversight.

D) Security selection.

The correct answer is D

Selection of the correct security itself is the most important contributing factor to the short seller’s return. While others have a psychological aversion to short selling, and many banks and other portfolio managers are restricted from short selling, the short seller helps contribute to efficient capital allocation within an economy.

15、Hedge fund managers following a convertible arbitrage strategy are said to be:

A) long gamma and short vega.

B) short gamma and short vega.

C) short gamma and long vega.

D) long gamma and long vega.

The correct answer is D

Convertible arbitrage managers hedge their equity exposure by shorting stocks using the delta hedge ratio. Because they are exposed to changes in the hedge ratio, they are said to be long gamma. They are also exposed to changes in the price volatility of the stock underlying the option embedded in the convertible security, so they are said to be long vega.

16、A hedge fund that takes positions in convertible bonds or convertible preferred stock and then takes other positions in the underlying stock would be most accurately placed in the style category:

A) equity market neutral. 

B) convertible arbitrage. 

C) fixed income arbitrage.

D) distressed securities. 

The correct answer is B

Convertible arbitrage usually takes positions in convertible bonds or preferred stock as well as warrants, etc..., and then takes other positions in the underlying stock.

17、Which of the following combinations of investment positions reflects the most common form of convertible arbitrage strategy?

A) Short position in a convertible; long position in put options on the issuer’s stock.

B) Long position in a convertible bond; long position in put options on stock of a similar firm.

C) Short position in a firm’s stock; long position in futures on the same stock.

D) Short position in a firm’s stock; long position in a convertible issued by the same firm.

The correct answer is D

This is the most “basic” convertible arbitrage strategy.

18、Which of the following is NOT a category of pricing inefficiencies that are likely to be exploited through fixed-income arbitrage strategies?

A) Agency biases.

B) Economic biases.

C) Segmentation biases.

D) Structural biases.

The correct answer is B

Agency biases result from money managers who, on behalf of their clients, invest in securities with recent positive performance. Structural biases occur when tax concerns, regulatory issues, and accounting rules motivate investor purchases of certain securities. Segmentation biases are the result of institutional investors’ liquidity preferences and trading restrictions that cause pricing relationships between securities to temporarily break down.

19、Which of the following would NOT likely be a suitable market neutral, fixed-income arbitrage spread trade?

A) Butterfly, or yield-curve arbitrage.

B) Asset swap trade.

C) T-bill and Eurodollar futures spread trade.

D) Arbitrage between dissimilar bonds.

The correct answer is D

The correct “market neutral” spread trade, or fixed-income arbitrage trade, is an arbitrage between similar bonds. The other choices are all examples of different forms of spread trades. Other market-neutral, fixed-income arbitrage trades include basis trades and yield-spread trades between on-the-run and off-the-run bonds.

20、Which of the following statements regarding fixed-income arbitrage strategies is NOT correct?

A) The strategy is always neutral with respect to duration and credit risk.

B) The strategy attempts to trade the spread relationship between similar fixed-income securities and their derivatives.

C) Leverage is typically high.

D) Profits are from positive carry returns or from relative changes in the prices of long and short positions.

The correct answer is A

Fixed-income arbitrage strategies may be market neutral or non-market neutral. Market neutral strategies are neutral with respect to duration and credit risk. Non-market neutral strategies are formed around expectations of yield curve or credit spread changes, so they are exposed to duration and/or credit risk.

21、Capital structure arbitrage strategies attempt to capitalize on relative price-movement discrepancies observed between the debt and equity securities of an individual company. Such strategies are most effective during periods of:

A) high volatility and falling equity markets.

B) high volatility and rising equity markets.

C) low volatility and falling equity markets.

D) low volatility and rising equity markets.

The correct answer is A

During periods of high volatility and falling equity markets, debt holders tend to realize the gravity of a company’s debt load before equity holders and adjust the prices of the company’s bonds before equityholders adjust the company’s stock price.

22、Which type of arbitrage strategy seeks to take advantage of discrepancies in the movements of an individual firm’s equity and bond prices?

A) Event-driven strategy.

B) Volatility arbitrage strategy.

C) Opportunistic merger arbitrage strategy.

D) Capital structure arbitrage strategy.

The correct answer is D

Capital structure arbitrage involves exploiting pricing inefficiencies on the right side of a firm’s actual balance sheet.

23、Event-driven hedge fund strategies leave the:

A) unsystematic risk of individual positions unhedged, so that the individual positions have high correlations with each other. 

B) systematic risk of individual positions unhedged, so that the individual positions have low correlations with each other. 

C) systematic risk of individual positions unhedged, so that the individual positions have high correlations with each other. 

D) unsystematic risk of individual positions unhedged, so that the individual positions have low correlations with each other. 

The correct answer is D

Event-driven strategies are based on company specific events that will impact the values of securities. Risks unrelated to the events are hedged, leaving only unsystematic risk in the positions. Since the remaining risks are company specific, the individual positions should have low correlations with each other.

24、Which of the following combinations of investment positions is a hedge fund manager utilizing a merger arbitrage strategy most likely to establish?

A) Short position in the acquirer; long position in the acquisition target.

B) Long position in the acquirer; short position in the acquisition target.

C) Short position in both the acquirer and the acquisition target.

D) Long position in both the acquirer and the acquisition target.

The correct answer is A

While there is deal risk in the sense that the proposed merger may never happen, the combination of a short position in the acquirer and long position in the acquisition target has the best chance of positive net return, assuming careful fundamental analysis has been performed.

25、Which of the following would most likely NOT be a reason that a merger arbitrage strategy might fail?

A) Lack of agreement between senior management and line staff.

B) Negative earnings report from target firm.

C) Uncooperative regulatory agencies.

D) Failure to obtain shareholder approval.

The correct answer is A

A merger arbitrage strategy would more likely fail due to a lack of agreement between senior managers. Line staff is typically not consulted. There are many more reasons a merger arbitrage strategy may fail, including time to completion and miscalculation of overall merger likelihood and conditions.

26、A typical distressed security investment strategy would involve purchasing:

A) the debt of a distressed company, allowing the company to utilize the infusion of capital to avoid bankruptcy.

B) a controlling equity position in a company experiencing financial difficulties and replacing management with a team of turnaround specialists.

C) the debt of a struggling company, with the goal of ending up with an equity position in the reorganized company.

D) an equity position in order to dilute the position of the company’s creditors.

The correct answer is C

A typical strategy is to invest in the debt of a company, continue to hold the position throughout the bankruptcy negotiations, and ultimately end up with equity in the new, revitalized operation.

27、The securities of companies that are either close to bankruptcy or have already filed for bankruptcy protection are called:

A) inactively traded securities.

B) illiquid securities.

C) discount securities.

D) distressed securities.

The correct answer is D

Inactively traded securities are infrequently traded, but the name “inactively traded” does not imply anything about the financial condition of the company. “Illiquid” and “discount” are descriptions that may be applied to any of number of investment vehicles available. Distressed securities are the securities of companies in the midst of financial difficulties.

28、What is the most common maturity range associated with private placement convertibles negotiated as part of a Regulation D strategy?

A) 3 – 6 months.

B) 30 – 90 months.

C) 18 – 60 months.

D) 30 – 90 days.

The correct answer is C

Regulation D investments are made possible through an SEC registration exemption as part of the U.S. Securities Act of 1933. The most common maturity range of privately placed convertible bonds negotiated as part of a Regulation D strategy is 1.5 to 5 years, or, equivalently, 18 to 60 months.

29、Global macro hedge fund strategies generally have significant exposures to:

I.           Credit risk.

II.         Liquidity risk.

III.        Term structure risk.

IV.      Foreign exchange risk.

A) III and IV only.

B) I, II, and IV only.

C) I, III, and IV only.

D) I, II, III, and IV.

The correct answer is A

Global macro strategies bear systematic risk exposure to term structure risk and foreign exchange risk. They generally do not have significant exposure to credit or liquidity risk.

30、Which of the following statements regarding various hedge fund strategies least accurately reflects a source of return for the strategy?

A) Equity long/short strategies earn returns from their exposure to systematic risk factors related to value and small-cap stocks.

B) Volatility arbitrage strategies earn returns from mispricings on fixed-income options resulting in accurate implied volatility estimates.

C) Regulation D strategies earn returns from their exposure to unsystematic risk factors related to credit and liquidity risk resulting from private placement.

D) Event-driven strategies earn returns from their exposure to unsystematic risk factors such as an expected merger or the expected outcome of a lawsuit.

The correct answer is C

Regulation D strategies are exposed systematic risk factors related to credit risk and liquidity risk. These risks arise as a result of the lower credit quality of private convertible debt issuers and the fact that private convertible debt securities are not tradable in the public market for some time after the issuance.

AIM 3: Differentiate between systematic and discretionary managed futures strategy.

Which of the following statements correctly describe characteristics of a systematic managed futures hedge fund strategy? Systematic managed futures strategies:

      I. include trend following that utilizes a high volume of trades, many of which are unprofitable.

     II. base trading decisions on fundamental changes such as an anticipated disequilibrium in commodity prices.

    III. are exposed to the risk of over-fitting the optimization model used to select trades.

    IV. select trades based on computer models that incorporate technical factors.

A) I, II and III.

B) I and II.

C) I only.

D) I, III and IV.

The correct answer is D

Systematic managed futures strategies use computer-based optimization models that incorporate technical factors and indicators to select a high number of trades across many different markets. The high volume results in diversification for the fund and is profitable overall even though it may generate many unprofitable individual trades. Discretionary managed futures strategies base trading decisions on fundamental factors such as anticipated disequilibrium in commodity prices.