Chap020 - Chapter 20 - Hedge Funds CHAPTER 20 HEDGE FUNDS...

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Chapter 20 - Hedge Funds CHAPTER 20 HEDGE FUNDS 1. No, a market-neutral hedge fund would not be a good candidate for an investor’s entire retirement portfolio because such a fund is not a diversified portfolio. The term ‘market-neutral’ refers to a portfolio position with respect to a specified market inefficiency. However, there could be a role for a market-neutral hedge fund in the investor’s overall portfolio; the market-neutral hedge fund can be thought of as an approach for the investor to add alpha to a more passive investment position such as an index mutual fund. 2. # of contracts = 1,200,000,000 / (250 x 800) x .6 = 3,600 contracts 3. At the end of two years, the fund value must reach at least 104% of its base value. Since the value of the fund at the end of the first year is 92% of its base value, the fund must earn 13% during the second year. This is merely the IRR of a 92 investment over one year with a FV of 104. 4. The incentive fee of a hedge fund is part of the hedge fund compensation structure; the incentive fee is typically equal to 20% of the hedge fund’s profits beyond a particular benchmark rate of return. Therefore, the incentive fee resembles the payoff to a call option, which is more valuable when volatility is higher. Consequently, the hedge fund portfolio manager is motivated to take on high-risk assets in the portfolio, thereby increasing volatility and the value of the incentive fee. 5. There are a number of factors that make it harder to assess the performance of a hedge fund portfolio manager than a typical mutual fund manager. Some of these factors are: Hedge funds tend to invest in more illiquid assets so that an apparent alpha may be in fact simply compensation for illiquidity. Hedge funds’ valuation of less liquid assets is questionable. Survivorship bias and backfill bias result in hedge fund databases that report performance only for more successful hedge funds. Hedge funds typically have unstable risk characteristics making performance evaluation that depends on a consistent risk profile problematic. Tail events skew the distribution of hedge fund outcomes, making it difficult to obtain a representative sample of returns over relatively short periods of time. 20-1
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Chapter 20 - Hedge Funds 6. No, statistical arbitrage is not true arbitrage because it does not involve establishing risk-free positions based on security mispricing. Statistical arbitrage is essentially a portfolio of risky bets. The hedge fund takes a large number of small positions based on apparent small, temporary market inefficiencies, relying on the probability that the expected return for the totality of these bets is positive. 7.
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This note was uploaded on 04/22/2010 for the course BUS BUS 136 taught by Professor Sukwonthomaskim during the Spring '10 term at UC Riverside.

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Chap020 - Chapter 20 - Hedge Funds CHAPTER 20 HEDGE FUNDS...

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