manchester88

A hedge fund with a fixed-income arbitrage strategy is most likely to suffer a loss when:

A) credit spreads widen quickly.

B) leverage becomes less expensive.

C) markets for lower quality debt become more liquid.

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Fixed-income arbitrage generally involves buying high-yielding (low quality) bonds while selling low-yielding (high quality) bonds. Leverage can be used in place of selling high quality bonds. This strategy can suffer great losses when credit spreads widen quickly, when leverage becomes more expensive, or when the markets for low-quality debt become less liquid.

manchester88

A “risk arbitrage” (or “merger arbitrage”) strategy:

A) is considered a “long volatility” strategy.

B) experiences losses when a planned merger is cancelled.

C) involves purchasing the stock of an acquiring company.

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A merger arbitrage strategy is considered a “short volatility” strategy: this strategy will experience a loss if the expected merger is cancelled. This strategy involves purchasing the stock of the target company and shorting the stock of the acquiring company.

manchester88

Which of the following is most accurate in describing the problems of survivorship bias and backfill bias in the performance evaluation of hedge funds?

A) Survivorship bias and backfill bias both result in downwardly biased hedge fund index returns.

B) Survivorship bias and backfill bias both result in upwardly biased hedge fund index returns.

C) Survivorship bias results in upwardly biased hedge fund index returns, but backfill bias results in downwardly biased hedge fund index returns.

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The problem in survivorship bias is that only the returns for survivors will be reported and the index return will be biased upwards. Backfill bias results when a new hedge fund is added to an index and the fund's historical performance is added to the index's historical performance. The problem is that only funds that survived will have their performance added to the index, resulting in an upward bias in index returns.

manchester88

A hedge fund investor is most likely to express a preference for returns distribution that has:

A) a negative skew.

B) low kurtosis.

C) high variance.

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Investors prefer a return distribution with low kurtosis, low variance, a high mean and positive skewness.

manchester88

Adding long volatility hedge fund strategies to a portfolio of short volatility hedge fund strategies is most likely to increase the attractiveness of the portfolio return’s:

A) Sharpe ratio.

B) skewness and kurtosis exposures.

C) reported volatility.

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Adding long volatility strategies to a portfolio of short volatility strategies would increase the volatility of portfolio returns and decrease the portfolio’s Sharpe ratio. However, the resulting portfolio returns distribution will be more normally distributed and skewness and kurtosis characteristics of the return distribution will be more attractive to investors.

manchester88

Studies using factor models have generally found the largest contributor to hedge fund returns to be:

A) traditional market factor exposures.

B) manager skill.

C) exotic beta exposures.

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Studies have found that the majority of hedge fund styles can be relatively closely replicated using traditional market exposures such as stock and bond indices, currency, and commodity market returns. These traditional market risk factors have been found to explain 50%–80% of hedge fund returns.

manchester88

A misspecification of a hedge fund factor model that omits relevant risk factors is most likely to cause alpha to be:

A) underestimated.

B) overestimated.

C) negative.

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Hedge fund factor models generally attribute hedge fund return to the sum of alpha, the risk-free rate, and the sum of the impacts of the relevant risk factors. If some of the relevant risk factors are omitted from the model, the alpha (return due to manager skill) is likely to be over-estimated.

manchester88

Which of the following most accurately describes the distribution of hedge fund returns? Hedge fund returns:

A) are lognormally distributed.

B) have fat tails in the distribution.

C) are normally distributed.

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Investors should be concerned about hedge fund risk because hedge fund returns have fat tails on the left hand side of their distribution. In other words, the probability of large losses is greater than that expected from a normal distribution. For this reason, it is imperative that investors evaluate a downside measure of risk, such as maximum drawdown and/or value at risk.

manchester88

The return distribution of a merger arbitrage strategy, in which the fund manager purchases the target company and shorts the acquiring company stock, is best described as:

A) normally distributed.

B) positively skewed.

C) highly kurtotic.

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The returns of many hedge fund strategies – including merger arbitrage trades – are not normally distributed; rather they are highly kurtotic and negatively skewed.

manchester88

Non-normality in hedge fund returns is most likely to cause performance to be:

A) underestimated.

B) zero.

C) overestimated.

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Non-normality of hedge fund returns necessitates consideration of higher order moments of the return distribution—specifically skewness and kurtosis. For most hedge funds, the return distribution is negatively skewed and highly kurtocic. These are undesirable qualities from the perspective of an investor. Ignoring these higher-order moments leads to overestimation of performance.