CAIA CHAPTER 16 PRACTICE QUESTIONS AND ANSWERS.

List the 3 primary elements that differentiate a hedge fund from other investment pools 1) Privately organized in most jurisdictions 2) Usually offers performance-based fees to its managers 3) Usually can apply leverage, use derivatives or utilize other investment felxibility List 6 investment flexibilities of hedge funds 1) Hedge fund strategies often invest in nonpublic, unlisted securities 2) Hedge funds often use leverage, at times very large amounts 3) Hedge funds often use derivative strategies much more predominantly than do traditional investment vehicles 4) Hedge funds take short positions in securities to increase return or reduce risk 5) Hedge funds sometimes trade in more esoteric or riskier underlying investments 6) Hedge funds tend to be more actively managed than traditional investment vehicles What are the growth drivers for hedge fund industry? 1) Hedge fund returns can offer low correlation with traditional investments and therefore serves as diversifiers 2) Many investors recognize the advantage that hedge funds have with regard investment flexibility 3) Many investors sought the potential double-digit returns of the hedge funds What are the 2 components of typical hedge funds fee arrangement? 1) Management fee (typically 2%) 2) Incentive fee (typically 20%) Describe consolidation in the hedge fund industry in recent years Consolidation in the hedge fund industry has been manifested in much higher percentages of assets being invested with the biggest funds which shows institutional investor's preferences Define high-water-mark in the context of hedge fund fee computation. The high-water mark (HWM) is the highest NAV of the fund on which an incentive fee has been paid How can managerial coinvesting contribute to optima contracting The idea is that by having their own money in the fund, managers will work hard to generate high returns and control risk What is the formula of a total fee as a percentage of fund assets? Annual fee = mgmt fee + {Max[0, Incentive fee * (gross return above HWM - mgmt fee - hurdle rate)]} Define optimal contracting Optimal contracting between investors and hedge fund managers attempts to align the interests of both parties to the extent that the interest can be aligned cost-effectively, with marginal benefits that exceed marginal costs Define perverse incentive A perverse incentive is an incentive that motivates the receiver of the incentive to work in opposition to the interests of the provider of the incentive Define the incentive fee option value The incentive fee option value is the risk-adjusted present value of the incentive fees to a manager that have been adjusted for its optionality. The incentive fee option value is often expressed using the Black-Scholes option pricing model which generates the price of an option using five inputs Define the at-the-money incentive fee approximation The at-the-money incentive fee approximation expresses the value of a managerial incentive fee as the product of 40%, the fund's NAV, the incentive fee percentage, and the volatility of the assets (standard deviation) iver the option's life Based on option analysis, how the incentive fee can affect hedge fund manager's behavior? 1) Hedge fund managers can increase the value of their incentive fee call options by increasing the volatility. The greater the volatility the greater the upside potential, while losses are limited 2) When the call option is far-out-of-the-money, manager may decide to take substantial portion of risk or try to close the fund and open another one Who is the pure asset gatherer? Pure asset gatherer is a manager focued primarily on increasing the AUM of the fund, he's likely to take very little risk in a portfolio to become a closet indexer What are the 2 typical behavior activities performed by hedge fund managers? 1) Managers may take fewer risks after a period of high returns and take more risks after a period of negative returns 2) Managers may modify the time series returns to enhance risk-adjusted performance or to improve the number of profitable months Define lock-in effect Lock-in effect refers to the pressure exerted on managers to avoid further risks once high profitability and high incentive fee have been achieved List 5 groups of hedge funds CAIA classification strategies 1) Macro and managed futures funds 2) Event-driven hedge funds 3) Relative value hedge funds 4) Equity hedge funds 5) Funds of hedge funds What is an example of a perverse incentive caused by incentive fees? If a fund experiances negative returns within reporting period, the fund's managers may view the fund as likely to close, in which case the managers may have a strong inentive to take excessive risks in an attempt to recap losses and stay in the business. If the NAV drops substantially below its HWM managers may have incentive to take high risk How does the annuity view of hedge fund fees differ from the option view of hedge fund fees? The annuity view of hedge fund fees represents the prospective stream of cash flows from fees available to a hedge fund manager through the long term. The option view of incentive fees uses option theory to demonstrate the ability of managers to increase the present value of their fees by increasing the volatility of the fund's assets What is the primary difference between a fund of funds and a multistrategy fund? In a multistrategy fund, there is a single layer of fees, and the submanagers are part o the same organization. The underlying components of the fund of funds are themselves hedge funds with independently organized managers and with a second layer of hedge fund fees to compensate the manager for activities relating to portfolio construction monitoring and oversight Define hedge fund program Hedge fund program refers to the processes and procedures for the construction, monitoring and maintenance of a portfolio of hedge funds List 4 groups of hedge funds strategies based on systematic risk criteria 1) Equity strategies 2) Event-driven strategies 3) Absolute return strategies 4) Diversified strategies Define equity strategies hedge funds Short bias funds average a strong negative beta to global equity markets, essentially holding all stocks in a short sale position. These funds are a great risk reducer, serving to substantially reduce losses in a time of bear markets, usually those funds offer lowest return Define event-driven and relative value strategies Returns of hedge funds in the event-driven and relative value categories have historically experienced the lowest standard deviation, but also had the largest value of skewness and excess kurtosis. Define short volatility exposure Short volatility exposure is any risk exposure that causes losses when underlying asset return volatilities increases Define off-balance-sheet risk Off-balance-sheet risk is not explicitly reflected in the statement of financial positions. The balance sheet of a typical merger arbitrage hedge fund manager would have offsetting long and short equity positions reflecting the purchase of the target company's stock and the sale of the acquiring company's stock When do convergent strategies generate profit? Convergent strategies profit when relative value spreads move tighter, meaning that two securities move toward relative values that are perceived to be more appropriate. This tends to be associated with calm markets rather than turbulent markets What are an absolute return products Absolute return products are investments in which returns are designed to be consistently positive rather than being linked to or assessed against broad market performances. The term comes from the skill-based nature of the industry Define a relative return product Relative return product in an investment with returns that are substantially driven by broad market returns and that should therefore be evaluated on the basis of how the investment's return compares with broad market returns