Question #31 - Reading 34 Hedge Fund Strategies

Reading: Reading 34 Hedge Fund Strategies

PDF File: Reading 34 Hedge Fund Strategies.pdf

Page: 13

Status: Incorrect

Correct Answer: A

Your Answer: B

Shared Context

of 49 Hedge Fund Z follows a short volatility strategy, while Hedge Fund Y makes insurance investments. Which of the following is most accurate concerning the funds? A) Z has a natural hedge against market declines. B) Z’s strategy is neither positively nor negatively correlated with the market. C) Y’s investments will be largely uncorrelated with market movements. Christine Kelly is chief investment officer of Pontoon Asset Management (PAM), a large multi- strategy hedge fund. She is meeting with all the management teams at PAM to understand their recent performance and current market positioning. Kelly first meets with Nicola Shore, head of the equity long/short team. Shore describes a recent pairs trade executed in two retailers: Homestore (HOM) and Sarks (SAR). Shore explains that the team took a long position in HOM and a beta-neutral short position in SAR with the expectation that HOM will execute a better business model, with respect to the migration from physical to online retailing. Kelly notes that HOM has a stock market beta of 1.1 and a stock price of USD 40, and SAR has a stock market beta of 0.55 and a stock price of USD 80. Kelly next meets with Luca Cohen, head of the merger arbitrage team. Cohen states that due to increasing competition and a reduction in opportunities in their traditional hard-catalyst investment universe, the team has begun executing more soft-catalyst trades. Kelly asks Cohen how this is likely to affect the risk and return of the investments in the future. Kelly asks about recent trades executed by the team and Cohen presents details regarding the details of a hard catalyst trade executed in relation to a merger between Bigco (BIG) and Small, Inc. (SMA), displayed in Exhibit 1: Details on Merger Arbitrage Trade in BIG and SMA: Exhibit 1: Details on Merger Arbitrage Trade in BIG and SMA Deal Terms 0.5 shares of BIG for 1 share in SMA BIG share price (pre-) deal announcement USD 54 BIG share price (post-) deal announcement USD 52 SMA share price (pre-) deal announcement USD 23 SMA share price (post-) deal announcement USD 25 Market value of position in SMA USD 10,000,000 Finally, Kelly meets with Alan Rode, head of the distressed securities team at PAM. Kelly has the least knowledge regarding distressed strategies out of all of the hedge fund strategies and asks Rode to describe recent trades undertaken by the fund. Rode presents to Kelly a capital structure arbitrage trade in a large retail department store company.

Question

In order to establish a beta-neutral pairs trade, relative to the number of shares bought in the long position in HOM, Shore should short sell:

Answer Choices:

A. the same number of shares in SAR

B. double the number of shares in SAR

C. half the number of shares in SAR

Explanation

Shore should short sell the same number of shares in SAR as the number of shares held in the long HOM position to establish a beta-neutral trade. Because SAR has a beta equal to half the beta of HOM, on a beta-risk basis alone, the pairs trade will need twice as many shares in SAR as HOM. However, because the share price of SAR is twice the price of shares in HOM, on a market value basis only half the number of shares in SAR are needed with respect to the number of shares of HOM. Therefore, creating a beta-neutral position will involve holding the same number of shares short in SAR as the number of shares bought in the long HOM position.

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