Chapter 26 - Hedge Funds

Chapter 26
Hedge Funds
Multiple Choice Questions

1. ______ are the dominant form of investing in securities markets for most individuals but
______ have enjoyed a 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 these is correct.

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. are commonly organized as private partnerships and are typically only open to wealthy or
institutional investors.

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. are commonly organized as private partnerships and are typically only open to wealthy or
institutional investors.

4. Alpha seeking 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 these is correct.

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Chapter 26 - Hedge Funds

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 these is correct.

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 these is correct.

7. Shares in hedge funds are priced

A. at NAV.
B. a significant premium to NAV.
C. a significant discount from NAV.
D. a significant premium to NAV or a significant discount from NAV.
E. None of these is correct.

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

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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 these is correct.

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

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. Hedge funds and ADRs
E. Mutual funds and ADRs

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 these is correct.

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Chapter 26 - Hedge Funds

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

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

A. transparency
B. investors
C. investment strategy
D. liquidity
E. All of these are correct.

15. Hedge funds may invest or engage in

A. distressed firms
B. convertible bonds
C. currency speculation
D. merger arbitrage
E. All of these are correct.

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 these is correct.

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Chapter 26 - Hedge Funds

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 these is correct.

18. Hedge fund strategies can be classified as ______.

A. directional and nondirectional
B. stock or bond
C. arbitrage or speculation
D. stock or bond and arbitrage or speculation
E. directional and nondirectional and stock or bond

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 these is correct.

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

misalignments in relative pricing.
A. directional
B. nondirectional
C. stock or bond
D. arbitrage or speculation
E. None of these is correct.

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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. nondirectional
C. market neutral
D. arbitrage or speculation
E. nondirectional and market neutral

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

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

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 bonds and short sell the mortgage-backed securities
B. short sell the Treasury bonds bonds and buy the mortgage-backed securities
C. buy the Treasury bonds and buy the mortgage-backed securities
D. buy the Treasury bonds and short sell the mortgage-backed securities
E. None of these is correct.

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Chapter 26 - Hedge Funds

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 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 these is correct.

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. relative play and sure thing

27. 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 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 these is correct.

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 bonds and short sell the mortgage-backed securities
B. short sell the Treasury bonds and buy the mortgage-backed securities
C. buy the Treasury bonds and buy the mortgage-backed securities
D. buy the Treasury bonds and short sell the mortgage-backed securities
E. None of these is correct.

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Chapter 26 - Hedge Funds

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

A. market neutral
B. directional
C. relative value
D. divergence
E. convergence

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

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

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

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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

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

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 these is correct.

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 these is correct.

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Chapter 26 - Hedge Funds

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 these is correct.

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 these is correct.

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 these are correct.

40. 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

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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 management fee of 1% to 2% and an annual incentive fee equal to 20% of investment
profits beyond a stipulated benchmark performance.
E. a management fee of 1% to 2% and a 12-b1 fee of 1%.

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 times
one plus the benchmark return.
E. straddles.

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 these is correct.

44. Hedge funds often employ ______ that require investors to provide ________ notice of
their desire to redeem funds.
A. redemption notices; of several weeks to several months
B. redemption notices; of several hours to several days
C. redemption notices; of several days to several weeks
D. lock-up; several years
E. lock-up; several hours

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Chapter 26 - Hedge Funds

45. Pairs trading is associated with ________.

A. triangular arbitrage
B. statistical arbitrage
C. data mining
D. triangular arbitrage and data mining
E. statistical arbitrage and data mining

46. ________ refers to sorting through huge amounts of historical data to uncover systematic
patterns in returns that can be exploited by traders.
A. Data mining
B. Pairs trading
C. Alpha transfer
D. Beta shifting
E. Pairs trading and alpha transfer

47. Hedge fund performance may reflect significant compensation for ________ risk.
A. liquidity
B. systematic
C. unsystematic
D. default
E. unsystematic and default

48. A ________ is an investment fraud in which a manager collects funds from clients, claims
to invest those funds on their behalf, reports extremely favorable investment returns, but in
fact uses the funds for his own use.
A. ponzi scheme
B. bonsai scheme
C. statistical arbitrage scheme
D. pairs trading scheme
E. None of these is correct.

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Chapter 26 - Hedge Funds

49. Sadka (2009) shows that exposure to unexpected declines in ________ is an important
determinant of average hedge fund returns and that the spreads in average returns across funds
with the highest and lowest ________ may be as much as 6% annually.
A. market risk; systematic risk
B. market liquidity; liquidity risk
C. unsystematic risk; unique risk
D. default risk; default risk
E. market risk; systematic risk and default risk; default risk

Short Answer Questions

50. Explain the five major differences between hedge funds and mutual funds.

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Chapter 26 - Hedge Funds

Chapter 26 Hedge Funds Answer Key

Multiple Choice Questions

1. ______ are the dominant form of investing in securities markets for most individuals but
______ have enjoyed a 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 these is correct
Mutual funds are the dominant form of investing in securities markets for most individuals
and hedge funds have enjoyed a far greater growth rate in the last decade.

AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Hedge funds

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. are commonly organized as private partnerships and are typically only open to wealthy or
institutional investors
Like mutual funds, hedge funds allow private investors to pool assets to be managed by a fund
manager.

AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Hedge funds

26-14

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. are commonly organized as private partnerships and are typically only open to wealthy or
institutional investors
Unlike mutual funds, hedge funds are commonly organized as private partnerships and are
typically only open to wealthy or institutional investors.

AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Hedge funds

4. Alpha seeking 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 these is correct
Alpha seeking hedge funds typically bet on relative mispricing of specific securities and
hedge broad market exposure.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-15

Chapter 26 - Hedge Funds

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 these is correct
Hedge funds can engage in market timing and can take extensive derivative positions.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: 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 these is correct
The risk profile of hedge funds can shift rapidly and substantially, making performance
evaluation challenging.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-16

Chapter 26 - Hedge Funds

7. Shares in hedge funds are priced

A. at NAV
B. a significant premium to NAV
C. a significant discount from NAV
D. a significant premium to NAV or a significant discount from NAV
E. None of these is correct
Shares in hedge funds are priced at NAV.

AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Hedge funds

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

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-17

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 these is correct
Hedge funds are less transparent than mutual funds because of less strict SEC regulation on
hedge funds.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

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

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-18

Chapter 26 - Hedge Funds

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. Hedge funds and ADRs
E. Mutual funds and ADRs
Mutual funds are subject to the Securities act of 1933 and the Investment Company Act of
1940 to protect unsophisticated investors.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: 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 these is correct
Hedge funds traditionally have less than 100 investors and do not advertise to the general
public.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-19

Chapter 26 - Hedge Funds

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 250,000 to 1 million.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

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

A. transparency
B. investors
C. investment strategy
D. liquidity
E. All of these are correct
Funds differ from mutual funds in terms of transparency, investors, investment strategy, and
liquidity.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-20

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 these are correct
Hedge funds may invest or engage in distressed firms, convertible bonds, currency
speculation, and merger arbitrage.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

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 these is correct
Hedge funds may invest or engage in distressed firms, convertible bonds, currency
speculation, and merger arbitrage.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-21

Chapter 26 - Hedge Funds

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 these is correct
Hedge funds often have lock-up provisions as long as several years, which preclude
redemption.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

18. Hedge fund strategies can be classified as ______.

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

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-22

Chapter 26 - Hedge Funds

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 these is correct
A hedge fund pursuing a directional strategy is betting one sector of the economy will
outperform other sectors.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

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

misalignments in relative pricing.
A. directional
B. nondirectional
C. stock or bond
D. arbitrage or speculation
E. None of these is correct
A hedge fund pursuing a nondirectional strategy is attempting to exploit temporary
misalignments in relative pricing.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-23

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. nondirectional
C. market neutral
D. arbitrage or speculation
E. nondirectional and market neutral
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.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

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.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-24

Chapter 26 - Hedge Funds

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.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: 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 bonds and short sell the mortgage-backed securities
B. short sell the Treasury bonds bonds and buy the mortgage-backed securities
C. buy the Treasury bonds and buy the mortgage-backed securities
D. buy the Treasury bonds and short sell the mortgage-backed securities
E. None of these is correct
If the yield on mortgage-backed securities was abnormally high compared to Treasury bonds,
a hedge fund pursuing a nondirectional strategy would short sell the Treasury bonds and buy
the mortgage-backed securities.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-25

Chapter 26 - Hedge Funds

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 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 these is correct
A hedge fund that sells 29 year bonds and buys 30 year bonds is taking a market neutral
position.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: 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. relative play and sure thing
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.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-26

Chapter 26 - Hedge Funds

27. 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 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 these is correct
A hedge fund that sells 29 year bonds and buys 30 year bonds is taking a market neutral
position.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: 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 bonds and short sell the mortgage-backed securities
B. short sell the Treasury bonds and buy the mortgage-backed securities
C. buy the Treasury bonds and buy the mortgage-backed securities
D. buy the Treasury bonds and short sell the mortgage-backed securities
E. None of these is correct
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.

AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Hedge funds

26-27

Chapter 26 - Hedge Funds

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.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

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.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-28

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 250)] 1.45 = 14.26. Thus, you would need to sell 14
contracts.

AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Hedge funds

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 250)] 1.45 = 6.18. Thus, you would need to sell 6
contracts.

AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Hedge funds

26-29

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 250)] 1.25 = 7.69. Thus, you would need to sell 8
contracts.

AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Hedge funds

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 250)] 1.3 = 6.93. Thus, you would need to sell 7 contracts.

AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Hedge funds

26-30

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 these is correct
Market neutral bets can result in considerable volatility because hedge funds use considerable
leverage.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

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 these is correct
Hedge funds exhibit a pattern known as a Santa effect.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-31

Chapter 26 - Hedge Funds

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 these is correct
Backfill bias arises because hedge funds only report returns to database publishers if they
want to.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: 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 these is correct
Survivorship bias arises when the returns of unsuccessful funds are left out of the sample.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-32

Chapter 26 - Hedge Funds

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 these are correct
Performance evaluation of hedge funds is complicated by liquidity premiums, survivorship
bias, unreliable market valuations of infrequently traded assets, and unstable risk attributes.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

40. 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.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-33

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 management fee of 1% to 2% and an annual incentive fee equal to 20% of investment
profits beyond a stipulated benchmark performance
E. a management fee of 1% to 2% and a 12-b1 fee of 1%
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.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

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 times
one plus the benchmark return
E. straddles
Hedge fund incentive fees are essentially call options on the portfolio with a strike price equal
to the current portfolio value times one plus the benchmark return.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-34

Chapter 26 - Hedge Funds

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 these is correct
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.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

44. Hedge funds often employ ______ that require investors to provide ________ notice of
their desire to redeem funds.
A. redemption notices; of several weeks to several months
B. redemption notices; of several hours to several days
C. redemption notices; of several days to several weeks
D. lock-up; several years
E. lock-up; several hours
Hedge funds often employ redemption notices that require investors to provide notice of
several weeks to several months notice of their desire to redeem funds.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-35

Chapter 26 - Hedge Funds

45. Pairs trading is associated with ________.

A. triangular arbitrage
B. statistical arbitrage
C. data mining
D. triangular arbitrage and data mining
E. statistical arbitrage and data mining
Pairs trading is associated with statistical arbitrage and is based on data mining.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

46. ________ refers to sorting through huge amounts of historical data to uncover systematic
patterns in returns that can be exploited by traders.
A. Data mining
B. Pairs trading
C. Alpha transfer
D. Beta shifting
E. Pairs trading and alpha transfer
Data mining refers to sorting through huge amounts of historical data to uncover systematic
patterns in returns that can be exploited by traders.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-36

Chapter 26 - Hedge Funds

47. Hedge fund performance may reflect significant compensation for ________ risk.
A. liquidity
B. systematic
C. unsystematic
D. default
E. unsystematic and default
Hedge fund performance may reflect significant compensation for liquidity risk.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

48. A ________ is an investment fraud in which a manager collects funds from clients, claims
to invest those funds on their behalf, reports extremely favorable investment returns, but in
fact uses the funds for his own use.
A. ponzi scheme
B. bonsai scheme
C. statistical arbitrage scheme
D. pairs trading scheme
E. None of these is correct
A ponzi scheme is an investment fraud in which a manager collects funds from clients, claims
to invest those funds on their behalf, reports extremely favorable investment returns, but in
fact uses the funds for his own use.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-37

Chapter 26 - Hedge Funds

49. Sadka (2009) shows that exposure to unexpected declines in ________ is an important
determinant of average hedge fund returns and that the spreads in average returns across funds
with the highest and lowest ________ may be as much as 6% annually.
A. market risk; systematic risk
B. market liquidity; liquidity risk
C. unsystematic risk; unique risk
D. default risk; default risk
E. market risk; systematic risk and default risk; default risk
Sadka (2009) shows that exposure to unexpected declines in market liquidity is an important
determinant of average hedge fund returns and that the spreads in average returns across funds
with the highest and lowest liquidity risk may be as much as 6% annually.

AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Hedge funds

26-38

Chapter 26 - Hedge Funds

Short Answer Questions

50. 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. 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 are 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.

AACSB: Reflective Thinking

Bloom's: Understand
Difficulty: Intermediate
Topic: Hedge funds

26-39