CFA Level 2 - Corporate Finance: Buyers Beware

Session 13-Reading 52 Buyers Beware: Evaluating and Managing the Many (Practice Questions, Sample Questions) 1. Which of the following most accurately describes the distribution of hedge fund returns? Hedge fund returns: A) are lognormally distributed. B) are normally distributed. C) have fat tails in the distribution. Explanation: 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 2. Which of the following most accurately describes the maximum drawdown measure of risk? Maximum drawdown is the: A) ratio of the portfolio’s expected return to some measure of risk. B) largest percentage decrease in value from peak to valley. C) ratio of excess return to risk using the minimum acceptable portfolio return Explanation: Drawdown is the percentage decrease in investment value from its peak to its valley. Maximum drawdown is just the largest drawdown that has ever occurred for a fund within a specified time period. The maximum drawdown is quoted so that investors can have an idea of the largest loss they can expect from a hedge fund investment. It measures left tail risk. For example, a maximum drawdown of 15% would imply less risk than a maximum drawdown of 25% 3. Which of the following most accurately describes the risks for fixed income hedge funds? The largest risk factor is: A) a widening of credit spreads, although during the 1990s credit spreads were fairly stable. B) interest rate risk, although during the 1990s interest rates were fairly stable. C) a widening of credit spreads, although during the 1990s credit spreads were fairly volatile Explanation: For fixed income hedge funds, it has been found that the largest risk factor is a widening of credit spreads. During the 1990s, which represents the largest span of data available for hedge funds, credit spreads were fairly stable. So the risk of fixed income hedge funds may be greater in the future. The widening of credit spreads can persist for several periods 4. Which of the following most accurately describes the equity market risk exposure of fixed income arbitrage hedge funds? Most fixed income arbitrage hedge funds have: A) an equity market risk exposure because they are short Treasuries and long higher credit risk issues that have an equity market risk exposure. B) little or no equity market risk exposure. C) an equity market risk exposure because they are long Treasuries and short higher credit risk issues that have an equity market risk exposure Explanation: Most fixed income arbitrage hedge funds have an equity market risk exposure because they are short Treasuries and long higher credit risk issues. When economies slow, credit spreads widen and the loss from the short Treasury position creates a net loss for a fixed income hedge fund, especially if the bond issuers on the long side experience financial difficulty 5. Which of the following is most accurate in describing the betas of emerging market arbitrage hedge funds? These funds have: A) high betas in up markets and low betas in down markets. B) low betas in up markets and positive betas in down markets. C) high betas in both up and down markets Explanation: Examining emerging market arbitrage hedge funds in up and down markets, it has been found that emerging markets arbitrage funds actually have low betas in up markets and positive betas in down markets. This indicates that they don’t fully participate in bull markets while also producing losses in bear markets. Thus, not only are they not market neutral, but their performance pattern is disadvantageous 6. Which of the following is least accurate regarding the risk of hedge funds? A) Most historical data for hedge funds consists of a stable period in the financial markets. B) Risk management should be performed on a periodic basis. C) Counterparty risk is a problem for securities traded on the NASDAQ exchange Explanation: Counterparty risk is a problem when securities are traded off an exchange because there is no exchange to limit credit risk. Risk management is not just assessed before the investment, it is an ongoing process. Most data for hedge funds only goes back as far as the late 1980s or early 1990s. Coincidentally, the historical period in the interim consists of a fairly stable period in the financial markets, so it is difficult to understand what the future risks from a hedge fund might be