CFM Hedge Fund Strategies & Operations 2 — Questions and Answers
Question 1: A global macro hedge fund manager believes the European Central Bank will cut rates aggressively over the next six months. Which position best expresses this view?
- Long EUR/USD
- Long Bund futures (Correct answer)
- Short German equities
- Long European credit spreads
Correct answer: Long Bund futures
Long Bund futures profits as German bond prices rise when the ECB cuts rates, directly expressing a rate-decline thesis.
Question 2: In a merger arbitrage strategy, the spread between the target's current price and the deal price primarily compensates the investor for:
- Liquidity risk
- Currency risk
- Deal break risk (Correct answer)
- Regulatory risk only
Correct answer: Deal break risk
The merger arbitrage spread represents compensation for deal break risk — the probability that the transaction fails to close.
Question 3: A convertible bond arbitrage fund buys a convertible bond and shorts the underlying equity. The primary risk this trade is designed to exploit is:
- Credit spread widening
- Convertible bond mispricing relative to its theoretical value (Correct answer)
- Rising interest rates
- Dividend cut risk
Correct answer: Convertible bond mispricing relative to its theoretical value
Convertible arbitrage seeks to profit when convertible bonds trade at a discount to their theoretical fair value derived from embedded optionality and credit components.
Question 4: Which operational risk is most unique to hedge funds relative to traditional long-only managers?
- Portfolio concentration
- Manager turnover
- Prime broker counterparty risk (Correct answer)
- Benchmark tracking error
Correct answer: Prime broker counterparty risk
Hedge funds use prime brokers for leverage, securities lending, and custody, creating material counterparty exposure not typical in long-only management.
Question 5: A fund employing a fixed income relative value strategy buys 10-year Treasuries and shorts 30-year Treasuries. This position profits if:
- The yield curve steepens
- The yield curve flattens (Correct answer)
- Overall rates rise sharply
- Credit spreads widen
Correct answer: The yield curve flattens
Buying the 10-year and shorting the 30-year profits when the yield curve flattens, as the spread between long and short yields narrows.
Question 6: A hedge fund's 'side pocket' mechanism is primarily used to:
- Segregate illiquid or hard-to-value investments from the main portfolio (Correct answer)
- Lock in investor capital for a minimum period
- Separate fee calculations for different investor classes
- Ring-fence positions with regulatory restrictions
Correct answer: Segregate illiquid or hard-to-value investments from the main portfolio
Side pockets isolate illiquid or Level 3 assets so they don't affect redemptions or NAV calculations for the liquid portion of the fund.
Question 7: In the context of hedge fund prime brokerage, 'rehypothecation' refers to:
- The prime broker's right to use client assets posted as collateral for its own financing purposes (Correct answer)
- A fund's ability to re-pledge the same asset as collateral to multiple lenders
- The process of revaluing illiquid assets using a hypothetical market price
- Transferring margin obligations between counterparties
Correct answer: The prime broker's right to use client assets posted as collateral for its own financing purposes
Rehypothecation allows a prime broker to use a hedge fund's pledged collateral for its own financing needs, which reduces borrowing costs but creates counterparty risk for the fund.
CFM Hedge Fund Strategies & Operations 2
A global macro hedge fund manager believes the European Central Bank will cut rates aggressively over the next six months.
Which position best expresses this view?