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MBA 570x Homework 1 Due 10/3/2012 Individual works: 1. Chapter 11: 10 2. Chapter 12: 1, , !, ", # 3. Chapter 2 $%&'(: , !

1: Ch11/10
)h* do *ou think there is a +und o+ +und market +or hed,e +unds, -ut not +or mutual +unds.

/nswer: Investors 0an ine1pensivel* re0reate diversi+i0ation -* investin, in various mutual +unds. 'ost investors do not have the amount o+ 0apital needed to invest in multiple hed,e +unds to a0hieve diversi+i0ation. In addition, while mutual +unds are ver* transparent a-out their investment strate,ies $whi0h are relativel* strai,ht +orward( and there is an entire industr* dedi0ated to providin, investors with anal*sis o+ mutual +unds, hed,e +unds are mu0h more opa2ue a-out their investment a0tivities and their strate,ies are more esoteri0. /s a result, the 0ost/reward ratio +or a +und o+ hed,e +unds is mu0h hi,her than +or a +und o+ mutual +unds.

2. Chapter 12: 1
During the height of the financial crisis in late 2008, the yield curve flattened and the yield on the 30-year Treasury bond reached an all-time low of 2.52 . !s a hedge fund manager, su""ose you thin# the mar#et has overreacted and will eventually correct itself, leading to a stee"ening in the yield curve. $hat trades might you e%ecute in a long&short strategy to ta#e advantage of the situation'

!nswer( )hort the 30-year Treasury* long the +-year Treasury.

3. Chapter 12: )h* did 0onverti-le ar-itra,e strate,ies per+orm so poorl* in 2003.

In this trade, hed,e +unds ,o lon, the 0onverti-le, and short the underl*in, sto0k. )hen the temporar* short4-an was instituted in late 2003, traders 0ould no lon,er hed,e their position -* shortin, sto0k. /s the sto0k market +ell, 0onverti-le values dropped, and the ina-ilit* to mana,e short positions 0ompounded the loss.

. Chapter 12: !
!ssume you buy ,+,000 of a convertible bond at "ar, which was offered at a 2.5 discount to its theoretical value. The stoc# "rice on the day of "urchase is ,35 and carries a + dividend yield. The convertible bond has a - cou"on, a conversion "remium of 20 , and a delta of 5. . /nterest income from the short "osition is +.5 , and stoc# borrow cost is 0.25 . During a +-year holding "eriod, the stoc# moves three times. The "ercentage change in stoc# "rice, corres"onding convertible bond value, and new delta ratio, in se0uential order are as follows( 12 & ,+,032.+2 & .+ * 35 & ,+,0+2.++ & 58 * 1- & ,+,032.2+ & .0 . 4alculate the returns generated from this investment after one year, bro#en out by /ncome 5eneration, 6oneti7ing 8olatility, and 9urchasing an :ndervalued 4onvertible. /gnore transaction costs for the "ur"oses of this e%ercise.

A.

)"ot , 35.00 Dividend ;ield +.0 9ar , +,000.00 4ou"on -.00 4onversion 9remium 20 4onversion ?atio 23.80@5 Delta 5. /nterest /ncome +.5 4ost of >orrow 0.25 /nitial )hort 9osition , -....2

Income Generation 4ou"on /nterest /ncome from )hort )toc# Dividend >orrow 4ost Total ?eturn Monetizing Volatility t10 )toc# 9rice 4hange )toc# 9rice , 35.00 Delta 5. 4onvertible , +,000.00 >egin. )hort 8al. , -....2 8alue 1& Delta Aedge !dB. Cnding )hort 8al. 4onvert. 9rofit& <Doss= )hort 9rofit& <Doss= Eet 9rofit& <Doss= Total 9rofit& <Doss= ?eturn Purc a!ing an "n#er$alue# %on$erti&le 'otal (eturn t1+ 2 , 32.-5 .+ , +,032.+2 , -....2 , 32..2 , --.58 , 5-3.@2 32.+2 <32..2= -.-5 t12 -5 , 35.58 58 , +,0+2.++ , 5-3.@2 , <22.20= , <25.-+= , -@+.3+ -25.0+ 22.20 2.+@

, , , ,

-0.00 2.00 <-..2= <+.+2= 41.17 4.12%

t13 32.00 .0 , +,032.2+ , -@+.3+ , +@..5 , +2..2 , 528.58 , 20..0 <+@..5= 0.@5 7.59 0.76% 2.50% 7.)*%

!. Chapter 12: "


6EF ma#es a tender offer for 9?) at +.5 6EF shares "er 9?) share. 6EF was trading at ,-0 "er share "rior to announcement and fell to ,38 on announcement. 9?) was trading at ,-0 "er share "rior to announcement and is now trading at ,50. /f you are "ursuing a merger arbitrage strategy, what is the "osition you would set u" to create "otential investment value' $hat derivative transaction could you use to mitigate your ris#'

!( 5o long 9?) shares and short 6EF shares at an a""ro%imately 2 for 3 ratio, res"ectively. 9uts on 9?) may be "urchased to limit downside ris#.

5. Chapter 12: #
$hy do you thin# distressed&restructuring hedge fund strategies did so "oorly in 2008 <down 25 for the year='

!( The investment thesis for a distressed strategy is that the mar#et is unable to accurately value securities in distress. /n 2008, the mar#et went into a tails"in and credit dried u", which means a distressed com"any trying restructure its liabilities in an effort to restore valuation would have had a very difficult time. This would have further driven down the value of e%isting debt securities as it decreased the li#elihood of the com"any reemerging from distress. /n addition, credit s"reads widened significantly in late 2008, es"ecially for Bun# rated debt securities, which would have further de"ressed the value of hedge fundsG holdings. 2. 4ha"ter 2- <>H6=( >ased on current dividend yields and e%"ected ca"ital gains, the e%"ected rates of return on "ortfolios ! and > are +2 and +. , res"ectively. The beta of ! is 0.2, while that of > is +.-. The T-bill rate is currently 5 , whereas the e%"ected rate of return of the )I9 500 inde% is +3 . The standard deviation of "ortfolio ! is +2 annually, that of > is 3+ , and that of the )I9 500 inde% is +8 . a. /f you currently hold a mar#et-inde% "ortfolio, would you choose add either of these "ortfolio to your holdings' 4om"are their al"ha. ! is greater. b. /f instead you could invest only in T-bills and one of these "ortfolio which would you choose. 4om"aring )har"e ratios, ! is greater. 8. 4ha"ter 2- <>H6=( 5 4onsider the two <e%cess return= inde%-model regression results for stoc#s ! and >. the ris#-free rate over the "eriod was . , and the mar#etGs average return was +- . 9erformance is measured using an inde% model regression on e%cess returns. a. 4om"ute the statistics for each stoc# ! > !l"ha + 2 !""raisal ratio +&+0.3 2&+@.+ )har"e ratio <+0..-.=&2+.. <8.--.=&2-.@ Treynor measure <+0..-.=&+.2 <8.--.=&0.8 b. $hich stoc# is the best choice under the following circumstances' i. This is the only ris# asset to be held by the investor 3 !, based on )har"e ratio ii. The stoc# is to mi%ed with the rest of the investorGs "ortfolio, currently com"osed solely of holding in the mar#et inde% fund 3 >, based on al"ha. iii. This is one of many stoc#s that the investor is analy7ing to form an actively managed stoc# "ortfolio. 3 !, based on the Treynor measure.