Question #13
Reading: Reading 34 Hedge Fund Strategies
PDF File: Reading 34 Hedge Fund Strategies.pdf
Page: 4
Status: Incorrect
Correct Answer: B
Your Answer: C
Question
Because convertible securities are issued sporadically by smaller companies in small offering sizes with unrated debt, the value of the embedded option tends to trade at:
Answer Choices:
A. relatively low implied volatility levels compared with realized volatility for the underlying equity
B. a discount to the implied equity volatility of the underlying equity
C. a premium to implied volatility of the underlying equity. A hedge fund analyst working for a corporate pension fund uses a conditional linear factor risk model to identify the sources of return for the hedge fund Uno Investments (UNO). Through stepwise regression, the model identifies four independent factors: 1. Equity risk (SNP500) 2. Currency risk (USD)
Explanation
Negative issues for investors like small issue size, poor covenant protection, lack of
institutional familiarity with the issue and no-rated credits result in contraction in overall
valuation which represents itself as lower implied volatility compared with historic
observations. These factors contribute to the convertible option being undervalued.
(Module 34.2, LOS 34.d)
A hedge fund analyst working for a corporate pension fund uses a conditional linear factor
risk model to identify the sources of return for the hedge fund Uno Investments (UNO).
Through stepwise regression, the model identifies four independent factors:
1. Equity risk (SNP500)
2. Currency risk (USD)
3. Credit risk (CREDIT)
4. Volatility risk (VIX)
Using monthly returns for the last 10 years, the coefficient estimates from the model and
corresponding t-statistics are displayed in Exhibit 1: Conditional Linear Factor Model
Coefficients for UNO.
Exhibit 1: Conditional Linear Factor Model Coefficients for UNO
UNO
Coefficient
Estimate t-Statistic
Normal Times
USD
0.095
0.65
CREDIT
0.015
0.12
SNP500
0.678
7.42
VIX
–0.183
–2.67
Crisis Times (Incremental)
DUSD
0.327
1.49
DCREDIT
–0.251
–2.20
DSNP500
–0.189
–2.35
DVIX
+0.054
+2.88
UNO is an equity long/short fund with the following statement in its fund documents
regarding its strategy:
UNO is a sector-focused long/short manager that aims to identify attractive
alpha-generating opportunities on both the long and short side in the
biotechnology sector. The fund uses a two-pronged approach: a team of
research analysts work with the fund manager to identify the best bottom-up
investments in the biotechnology sector, while macro-focused analysts work
with the fund manager to apply overlay strategies using futures and options to
adjust the market exposure of the fund.
The analyst uses the model to assess global macro hedge fund managers in their investment
universe for superior market timing skills. They base their assessment on the signs and
statistical significance of the coefficients of the model.
The investment committee of the corporate pension fund has asked the investment
management team to review the rationale for including an allocation to hedge funds in the
pension portfolio.