CFM Hedge Fund Strategies & Operations 4 — Questions and Answers
Question 1: A statistical arbitrage fund identifies that the historical correlation between two tech stocks has broken down. The fund shorts the outperforming stock and buys the underperformer. This approach relies on the assumption of:
- Momentum persistence
- Mean reversion in the spread relationship (Correct answer)
- Factor premium capture
- Volatility clustering
Correct answer: Mean reversion in the spread relationship
Statistical arbitrage pairs trading is predicated on mean reversion — the belief that divergences in historically correlated securities will converge back toward their historical relationship.
Question 2: Regulation D (Reg D) in the US primarily allows hedge funds to:
- Operate with unlimited leverage without disclosure
- Raise capital from accredited investors without SEC registration (Correct answer)
- Advertise publicly to retail investors
- Avoid filing 13F reports
Correct answer: Raise capital from accredited investors without SEC registration
Reg D provides an exemption allowing hedge funds to raise capital from accredited investors via private placement without registering the securities offering with the SEC.
Question 3: A volatility arbitrage fund sells realized volatility through delta-hedged short options and buys implied volatility through variance swaps. The primary source of profit is:
- The volatility risk premium — implied volatility consistently exceeding realized volatility (Correct answer)
- Rising equity markets reducing option premiums
- Positive theta decay on long option positions
- Interest rate sensitivity of variance swaps
Correct answer: The volatility risk premium — implied volatility consistently exceeding realized volatility
Volatility arbitrage strategies exploit the persistent volatility risk premium, where implied volatility tends to be priced above subsequent realized volatility on average.
Question 4: Under the Dodd-Frank Act, which hedge funds are required to register with the SEC as investment advisers?
- All hedge funds regardless of AUM
- Funds with AUM over $150M managing private funds (Correct answer)
- Only funds with more than 2,000 investors
- Funds investing in publicly listed equities only
Correct answer: Funds with AUM over $150M managing private funds
Dodd-Frank eliminated the private adviser exemption, requiring advisers to private funds with over $150M in AUM to register with the SEC.
Question 5: A fund's 'drawdown' is defined as:
- The total return generated in a calendar year
- The peak-to-trough decline in fund NAV before a new high is reached (Correct answer)
- The amount of capital returned to investors during redemptions
- The difference between gross and net performance
Correct answer: The peak-to-trough decline in fund NAV before a new high is reached
Maximum drawdown measures the largest peak-to-trough loss in NAV before recovery, serving as a key risk metric for hedge funds.
Question 6: Which of the following is a key operational control in hedge fund administration to prevent NAV manipulation?
- Using the portfolio manager to value illiquid positions
- Independent fund administrator calculating NAV separately from the manager (Correct answer)
- Relying solely on prime broker statements for asset verification
- Allowing manager discretion on pricing hard-to-value assets
Correct answer: Independent fund administrator calculating NAV separately from the manager
Having an independent third-party administrator calculate NAV provides a critical check against the manager inflating asset values or manipulating reported returns.
Question 7: A convertible bond is trading at a conversion premium of 30%. If the underlying stock rises 20%, the convertible bond will most likely:
- Rise by exactly 20% matching the stock
- Rise by less than 20% due to the high premium reducing delta (Correct answer)
- Fall in value due to rising equity dilution risk
- Rise by more than 20% due to positive gamma
Correct answer: Rise by less than 20% due to the high premium reducing delta
A high conversion premium implies a low delta, so the convertible bond participates in less than 100% of the stock's upside, rising by less than 20%.
CFM Hedge Fund Strategies & Operations 4
A statistical arbitrage fund identifies that the historical correlation between two tech stocks has broken down.
The fund shorts the outperforming stock and buys the underperformer.
This approach relies on the assumption of: