Multiple Choice Questions
1. Which of the following are characteristics of a hedge fund?
I. Pooling of assets
II. Strict regulatory oversight by the SEC
III. Investing in equities, debt instruments, and derivative instruments
IV. Professional management of assets
A. I and II only
B. II and III only
C. III and IV only
D. I, III, and IV only
Answer: D. I, III, and IV only
2. A __________ is a private investment pool open only to wealthy or institutional investors
that is exempt from SEC regulation and can therefore pursue more speculative policies than
mutual funds.
A. commingled pool
B. unit trust
C. hedge fund
D. money market fund
Answer: C. hedge fund
3. Hedge funds are typically set up as _______________.
A. limited liability partnerships
B. corporations
C. REITs
D. mutual funds
Answer: A. limited liability partnerships
4. A(n) _______________ hedge fund attempts to profit from situations such as mergers,
acquisitions, restructuring, bankruptcy, or reorganization.
A. multistrategy
B. managed futures
C. dedicated short bias
D. event-driven
Answer: D. event-driven
5. ______ are private partnerships of a small number of wealthy investors, are often subject to
lock-up periods, and are allowed to pursue a wide range of investment activities.
A. Hedge funds
B. Closed-end funds
C. REITs
D. Mutual funds
Answer: A. Hedge funds
6. Which of the following typically employ(s) significant amounts of leverage?
I. Hedge funds
II. Equity mutual funds
III. Money market funds
IV. Income mutual funds
A. I only
B. I and II only
C. III and IV only
D. I, II, and III only
Answer: A. I only
7. As of 2012, hedge funds had approximately _____ under management.
A. $.5 trillion
B. $1.6 trillion
C. $2 trillion
D. $3.2 trillion
Answer: C. $2 trillion
8. A restriction under which investors cannot withdraw their funds for as long as several
months or years is called __________.
A. transparency
B. a lock-up period
C. a back-end load
D. convertible arbitrage
Answer: B. a lock-up period
9. Hedge fund managers are compensated by ___________________.
A. deducting management fees from fund assets and receiving incentive bonuses for beating
index benchmarks
B. deducting a percentage of any gains in asset value
C. selling shares in the trust at a premium to the cost of acquiring the underlying assets
D. charging portfolio turnover fees
Answer: A. deducting management fees from fund assets and receiving incentive bonuses for
beating index benchmarks
10. Management fees for hedge funds typically range between _____ and _____.
A. .5%; 1.5%
B. 1%; 2%
C. 2%; 5%
D. 5%; 8%
Answer: B. 1%; 2%
11. Hedge funds can invest in various investment options that are not generally available to
mutual funds. These include:
I. Futures and options
II. Merger arbitrage
III. Currency contracts
IV. Companies undergoing Chapter 11 restructuring and reorganization
A. I only
B. I and II only
C. I, II, and III only
D. I, II, III, and IV
Answer: D. I, II, III, and IV
12. A typical traditional initial investment in a hedge fund generally is in the range between
_____ and _____.
A. $1,000; $5,000
B. $5,000; $25,000
C. $25,000; $250,000
D. $250,000; $1,000,000
Answer: D. $250,000; $1,000,000
13. The difference between market-neutral and long-short hedges is that market-neutral hedge
funds _________.
A. establish long and short positions on both sides of the market to eliminate risk and to
benefit from security asset mispricing whereas long-short hedges establish positions only on
one side of the market
B. allocate money to several other funds while long-short funds do not
C. invest in relatively stable proportions of stocks and bonds while the proportions may vary
dramatically for long-short funds
D. invest only in equities and bonds while long-short funds use only derivatives
Answer: A. establish long and short positions on both sides of the market to eliminate risk and
to benefit from security asset mispricing whereas long-short hedges establish positions only
on one side of the market
14. Convertible arbitrage hedge funds _________.
A. attempt to profit from mispriced interest-sensitive securities
B. hold long positions in convertible bonds and offsetting short positions in stocks
C. establish long and short positions in global capital markets
D. use derivative products to hedge their short positions in convertible bonds
Answer: B. hold long positions in convertible bonds and offsetting short positions in stocks
15. Assuming positive basis and negligible borrowing cost, which of the following
transactions could yield positive arbitrage profits if pursued by a hedge fund?
A. Buy gold in the spot market, and sell the futures contract.
B. Buy the futures contract, and sell the gold spot and invest the money earned.
C. Buy gold spot with borrowed money, and buy the futures contract.
D. Buy the futures contract, and buy the gold spot using borrowed money.
Answer: A. Buy gold in the spot market, and sell the futures contract.
16. An example of a neutral pure play is _______.
A. pairs trading
B. statistical arbitrage
C. convergence arbitrage
D. directional strategy
Answer: C. convergence arbitrage
17. You believe that the spread between the September S&P 500 future and the S&P 500
Index is too large and will soon correct. To take advantage of this mispricing, a hedge fund
should ______________.
A. buy all the stocks in the S&P 500 and write put options on the S&P 500 Index
B. sell all the stocks in the S&P 500 and buy call options on the S&P 500 Index
C. sell S&P 500 Index futures and buy all the stocks in the S&P 500
D. sell short all the stocks in the S&P 500 and buy S&P 500 Index futures
Answer: C. sell S&P 500 Index futures and buy all the stocks in the S&P 500
18. You believe that the spread between the September S&P 500 future and the S&P 500
Index is too large and will soon correct. This is an example of ______________.
A. pairs trading
B. convergence play
C. statistical arbitrage
D. a long-short equity hedge
Answer: B. convergence play
19. A 1-year oil futures contract is selling for $74.50. Spot oil prices are $68, and the 1-year
risk-free rate is 3.25%.
The 1-year oil futures price should be equal to __________.
A. $68
B. $70.21
C. $71.25
D. $74.88
Answer: B. $70.21
Parity F0 = S0(1 + rf - d)T = $68(1 + .0325 - .0)1 = $70.21
20. A 1-year oil futures contract is selling for $74.50. Spot oil prices are $68, and the 1-year
risk-free rate is 3.25%.
The arbitrage profit implied by these prices is _____________.
A. $6.50
B. $5.44
C. $4.29
D. $3.25
Answer: C. $4.29
Arbitrage profit 74.50 - 70.21 = $4.29
21. A 1-year oil futures contract is selling for $74.50. Spot oil prices are $68, and the 1-year
risk-free rate is 3.25%.
Based on the above data, which of the following sets of transactions will yield positive
riskless arbitrage profits?
A. Buy oil in the spot market with borrowed money, and sell the futures contract.
B. Buy the futures contract, and sell the oil spot and invest the money earned.
C. Buy the oil spot with borrowed money, and buy the futures contract.
D. Buy the futures contract, and buy the oil spot using borrowed money.
Answer: A. Buy oil in the spot market with borrowed money, and sell the futures contract.
22. Assume that you have invested $500,000 to purchase shares in a hedge fund reporting
$800 million in assets, $100 million in liabilities, and 70 million shares outstanding. Your
initial lockout period is 3 years.
How many shares did you purchase?
A. 13,333
B. 25,000
C. 50,000
D. 66,000
Answer: C. 50,000
23. Assume that you have invested $500,000 to purchase shares in a hedge fund reporting
$800 million in assets, $100 million in liabilities, and 70 million shares outstanding. Your
initial lockout period is 3 years.
If the share price after 3 years increases to $15.28, what is the value of your investment?
A. $553,600
B. $625,000
C. $733,800
D. $764,000
Answer: D. $764,000
(50,000)($15.28) = $764,000
24. Assume that you have invested $500,000 to purchase shares in a hedge fund reporting
$800 million in assets, $100 million in liabilities, and 70 million shares outstanding. Your
initial lockout period is 3 years.
What is your annualized return over the 3-year holding period?
A. 14.45%
B. 15.18%
C. 16%
D. 17.73%
Answer: B. 15.18%
25. Which of the following are not managed investment companies?
A. Hedge funds
B. Unit investment trusts
C. Closed-end funds
D. Open-end funds
Answer: B. Unit investment trusts
26. You manage a $15 million hedge fund portfolio with beta = 1.2 and alpha = 2% per
quarter. Assume the risk-free rate is 2% per quarter and the current value of the S&P 500
Index is 1,200. You want to exploit the positive alpha, but you are afraid that the stock market
may fall and you want to hedge your portfolio by selling 3-month S&P 500 future contracts.
The S&P contract multiplier is $250.
How many S&P 500 contracts do you need to sell to hedge your portfolio?
A. 25
B. 35
C. 50
D. 60
Answer: D. 60
27. You manage a $15 million hedge fund portfolio with beta = 1.2 and alpha = 2% per
quarter. Assume the risk-free rate is 2% per quarter and the current value of the S&P 500
Index is 1,200. You want to exploit the positive alpha, but you are afraid that the stock market
may fall and you want to hedge your portfolio by selling 3-month S&P 500 future contracts.
The S&P contract multiplier is $250.
When you hedge your stock portfolio with futures contracts, the value of your portfolio beta is
__________.
A. 0
B. 1
C. 1.2
D. The answer cannot be determined from the information given.
Answer: A. 0
28. You manage a $15 million hedge fund portfolio with beta = 1.2 and alpha = 2% per
quarter. Assume the risk-free rate is 2% per quarter and the current value of the S&P 500
Index is 1,200. You want to exploit the positive alpha, but you are afraid that the stock market
may fall and you want to hedge your portfolio by selling 3-month S&P 500 future contracts.
The S&P contract multiplier is $250.
What is the expected quarterly return on the hedged portfolio?
A. 0%
B. 2%
C. 3%
D. 4%
Answer: D. 4%
E(rp) = E[rf + β(rM - rf) + e + α] = rf+ α = 2% + 2% = 4%
29. You manage a $15 million hedge fund portfolio with beta = 1.2 and alpha = 2% per
quarter. Assume the risk-free rate is 2% per quarter and the current value of the S&P 500
Index is 1,200. You want to exploit the positive alpha, but you are afraid that the stock market
may fall and you want to hedge your portfolio by selling 3-month S&P 500 future contracts.
The S&P contract multiplier is $250.
How much is the portfolio expected to be worth 3 months from now?
A. $15,000,000
B. $15,450,000
C. $15,600,000
D. $16,000,000
Answer: C. $15,600,000
S1 = S0(1 + rp) = $15,000,000(1.04) = $15,600,000
30. You manage a $15 million hedge fund portfolio with beta = 1.2 and alpha = 2% per
quarter. Assume the risk-free rate is 2% per quarter and the current value of the S&P 500
Index is 1,200. You want to exploit the positive alpha, but you are afraid that the stock market
may fall and you want to hedge your portfolio by selling 3-month S&P 500 future contracts.
The S&P contract multiplier is $250.
Hedging this portfolio by selling S&P 500 futures contracts is an example of ___________.
A. statistical arbitrage
B. pure play
C. a short equity hedge
D. fixed-income arbitrage
Answer: B. pure play
31. Hedge funds that change strategies and types of securities invested and also vary the
proportions of assets invested in particular market sectors according to the fund manager's
outlook are called ____________________.
A. asset allocation funds
B. multistrategy funds
C. event-driven funds
D. market-neutral funds
Answer: B. multistrategy funds
32. When a short-selling hedge fund advertises in a prospectus that it is a 120/20 fund, this
means that the fund may sell short up to ______ for every $100 in net assets and increase the
long position to __________ of net assets.
A. $120; $20
B. $20; $120
C. $20; $20
D. $120; $120
Answer: B. $20; $120
33. The collapse of the Long Term Capital Management hedge fund in 1998 was a case of an
extremely unlikely statistical event called ________.
A. statistical arbitrage
B. an unhedged play
C. a tail event
D. a liquidity trap
Answer: C. a tail event
34. Which of the following investment styles could be the best description of the Long Term
Capital Management market-neutral strategies?
A. Convergence arbitrage
B. Statistical arbitrage
C. Pairs trading
D. Convertible arbitrage
Answer: A. Convergence arbitrage
35. Consider a hedge fund with $250 million in assets at the start of the year. If the gross
return on assets is 18% and the total expense ratio is 2.5% of the year-end value, what is the
rate of return on the fund?
A. 15.05%
B. 15.5%
C. 17.25%
D. 18%
Answer: A. 15.05%
36. Consider a hedge fund with $200 million at the start of the year. The benchmark S&P 500
Index was up 16.5% during the same period. The gross return on assets is 21%, and the
expense ratio is 2%. For each 1% above the benchmark return, the fund managers receive a
.1% incentive bonus.
What was the management cost for the year?
A. $4,877,000
B. $4,900,000
C. $5,929,000
D. $6,446,000
Answer: C. $5,929,000
$200,000,000(1.21) = $242,000,000
21% - 16.5% = 4.5%; 2% + 4.5%(.1) = 2.45%
.0245(242,000,000) = $5,929,000
37. Consider a hedge fund with $200 million at the start of the year. The benchmark S&P 500
Index was up 16.5% during the same period. The gross return on assets is 21%, and the
expense ratio is 2%. For each 1% above the benchmark return, the fund managers receive a
.1% incentive bonus.
What was the annual return on this fund?
A. 16.5%
B. 18.04%
C. 18.55%
D. 21%
Answer: B. 18.04%
38. Consider a hedge fund with $400 million in assets, $60 million in debt, and 16 million
shares at the start of the year and with $500 million in assets, $40 million in debt, and 20
million shares at the end of the year. During the year, investors have received an income
dividend of $.75 per share. Assuming that the total expense ratio is 2.75%, what is the rate of
return on the fund?
A. 6.45%
B. 8.52%
C. 8.95%
D. 9.46%
Answer: B. 8.52%
39. Market-neutral hedge funds may experience considerable volatility. The source of volatile
returns is the use of _________.
A. pure play
B. leverage
C. directional bests
D. net short positions
Answer: B. leverage
40. A hedge fund has $150 million in assets at the beginning of the year and 10 million shares
outstanding throughout the year. Throughout the year assets grow at 12%. The fund charges a
3% management fee on the assets. The fee is imposed on year-end asset values. What is the
end-of-year NAV for the fund?
A. $15
B. $15.60
C. $16.30
D. $17.55
Answer: C. $16.30
41. You pay $216,000 to the Capital Hedge Fund, which has a price of $18 per share at the
beginning of the year. The fund deducted a front-end commission of 4%. The securities in the
fund increased in value by 15% during the year. The fund's expense ratio is 2% and is
deducted from year-end asset values. What is your rate of return on the fund if you sell your
shares at the end of the year?
A. 5.35%
B. 7.23%
C. 8.19%
D. 10%
Answer: C. 8.19%
42. A hedge fund owns a $15 million bond portfolio with a modified duration of 11 years and
needs to hedge risk, but T-bond futures are available only with a modified duration of the
deliverable instrument of 10 years. The futures are priced at $105,000. The proper hedge ratio
to use is ______.
A. 143
B. 157
C. 196
D. 218
Answer: B. 157
43. Unlike market-neutral hedge funds, which have betas near ________, directional long
funds exhibit highly _______ betas.
A. zero; positive
B. positive; negative
C. positive; zero
D. negative; positive
Answer: A. zero; positive
44. Portfolio A has a beta of .2 and an expected return of 14%. Portfolio B has a beta of .5 and
an expected return of 16%. The risk-free rate of return is 10%. If you manage a long-short
equity fund and want to take advantage of an arbitrage opportunity, you should take a short
position in portfolio ______ and a long position in portfolio __________.
A. A; A
B. A; B
C. B; A
D. B; B
Answer: C. B; A
45. According to a model that was estimated using monthly excess returns from January 2005
through November 2011, average returns of equity hedge funds are __________ the S&P 500
Index.
A. equal to
B. considerably higher than
C. slightly lower than
D. slightly higher than
Answer: B. considerably higher than
46. Research by Aragon (2007) indicates that lock-up restrictions tend to hold ____________
portfolios.
A. less liquid
B. more liquid
C. event-driven
D. shorter-maturity
Answer: A. less liquid
47. Higher returns of equity hedge funds as compared to the S&P 500 Index reflect positive
compensation for __________ risk.
A. market
B. liquidity
C. systematic
D. interest rate
Answer: B. liquidity
48. Portfolio A has a beta of 1.3 and an expected return of 21%. Portfolio B has a beta of .7
and an expected return of 17%. The risk-free rate of return is 9%. If a hedge fund manager
wants to take advantage of an arbitrage opportunity, she should take a short position in
portfolio __________ and a long position in portfolio __________.
A. A; A
B. A; B
C. B; A
D. B; B
Answer: B. A; B
49. In a 2011 study, Agarwal, Daniel, and Naik documented that hedge funds tend to report
average returns in ____________ that are __________ than their average returns in other
months.
A. September; lower
B. January; higher
C. January; lower
D. December; higher
Answer: D. December; higher
50. To attract new clients, hedge funds often include past returns of funds only if they were
successful. This is called __________.
A. long-short bias
B. survivorship bias
C. backfill bias
D. incentive bias
Answer: C. backfill bias
51. Some argue that abnormally high returns of hedge funds are tainted by __________,
which arises when unsuccessful funds cease operations, leaving only successful ones.
A. reporting bias
B. survivorship bias
C. backfill bias
D. incentive bias
Answer: B. survivorship bias
52. Malkiel and Saha (2005) estimate that the survivorship bias for hedge funds equals 4.4%,
which is __________ the survivorship bias for mutual funds.
A. about the same as
B. much lower than
C. much higher than
D. only slightly lower than
Answer: C. much higher than
53. Hedge fund managers receive incentive bonuses when they increase portfolio assets
beyond a stipulated benchmark but lose nothing when they fail to perform. This is equivalent
to __________.
A. writing a call option
B. receiving a free call option
C. writing a put option
D. receiving a free put option
Answer: B. receiving a free call option
54. A typical hedge fund incentive bonus is usually equal to ________ of investment profits
beyond a predetermined benchmark index.
A. 5%
B. 10%
C. 20%
D. 25%
Answer: C. 20%
55. The fastest-growing category of hedge funds is feeder funds. These funds invest in
________.
A. other hedge funds
B. convertible securities and preferred stock
C. equities and bonds
D. managed futures and options
Answer: A. other hedge funds
56. A high water mark is a limiting factor of hedge fund manager compensation. This means
that managers can't charge incentive fees ________.
A. when a fund stays flat
B. when a fund falls and does not recover to its previous high value
C. when a fund falls by 10% or more
D. none of these options. (Managers can always charge incentive fees.)
Answer: B. when a fund falls and does not recover to its previous high value
57. If the risk-free interest rate is rf and equals the fund's benchmark, the portfolio's net asset
value is S0, and the hedge fund manager incentive fee is 20% of profit beyond that, the
incentive fee is equivalent to receiving ______ call(s) with exercise price ________.
A. .2; S0
B. 1; S0(1 + rf)
C. 1.2; S0
D. .2; S0(1 + rf)
Answer: D. .2; S0(1 + rf)
58. Assume the risk-free interest rate is 10% and is equal to the fund's benchmark, the
portfolio's net asset value is $100, and the fund's standard deviation is 20%. Also assume a
time horizon of 1 year.
What is the exercise price on the incentive fee?
A. $100
B. $105
C. $110
D. $115
Answer: C. $110
Strike price = S0(1 + rf) = 100(1 + .1) = $110
59. Assume the risk-free interest rate is 10% and is equal to the fund's benchmark, the
portfolio's net asset value is $100, and the fund's standard deviation is 20%. Also assume a
time horizon of 1 year.
What is the Black-Scholes value of the call option on the management incentive fee?
A. $6.67
B. $8.18
C. $9.74
D. $10.22
Answer: B. $8.18
d2 = d1 - .2(1).5 = .1234 - .2 = -.766; N(d2) = .4697
Call value = S0N(d1) - Xe-rTN(d2) = (100)(.5495) - (110)e-(.1)(.4697) = $8.18
60. Assume the risk-free interest rate is 10% and is equal to the fund's benchmark, the
portfolio's net asset value is $100, and the fund's standard deviation is 20%. Also assume a
time horizon of 1 year.
Assuming a 2% management fee and a 20% incentive bonus, what is the expected
management compensation per share if the fund's net asset value exceeds the stated
benchmark?
A. $4.24
B. $4
C. $3.84
D. $2.20
Answer: C. $3.84
d2 = d1 - .2(1).5 = .1234 - .2 = -.766; N(d2) = .4697
Call value = S0N(d1) - Xe-rTN(d2) = (100)(.5495) - (110)e-(.1)(.4697) = $8.18
Expected incentive fee is 2% of year-end NAV + 20% of the value of $110 call option =
.02(110) + .2(8.18) = $3.84
Test Bank for Essentials of Investments
Zvi Bodie, Alex Kane, Alan Marcus
9780078034695, 9789389957877, 9781264140251, 9781260316148, 9780073382401, 9780078034695, 9781260013924, 9780077835422
