56. On a due diligence visit, the manager of an arbitrage fixed-income fund claims that his fund has very low risk. He tells you that the fund invests in mortgage-backed inverse floaters issued in the U.S. The current value of the long positions of the fund is roughly USD 100 million. Typically, the fund buys inverse floaters that are undervalued and hedges them so that the position is not sensitive to interest rate changes using the nearest maturity futures contract on the 10-year T-Note. The fund captures the difference between the inverse floater and the hedge portfolio when it puts on the position. You are told that the only risk arises because the fund might have to sell the hedged position. He calls this LTCM risk. Which of the following risks not discussed by the manager can affect significantly the return of the hedge fund?

I. Model risk because the prepayment model used by the fund might be wrong.

II. Default risk because the hedging strategy assumes that the inverse floaters have no default risk.

III. Liquidity risk because the hedge fund uses the nearest futures contract on the 10-year T-Note to hedge interest rate risk and trading price impact may not be possible in that contract in times of stress.

IV. Volatility risk because shocks to interest rate volatility will affect the inverse floaters but cannot typically be hedged with the 10-year T-Note contract.

A. Only risks I and IV are present.

B. Only risks I, III and IV are present.

C. Only risks I, II and IV are present.

D. Only risks I and III are present.

57. You are being interviewed for the position of CRO for a large fund-of-funds. You are asked to comment on the risk management approach of the CRO you would replace, James Smith, and who just left to start his own fund-of-funds. To evaluate the risk of a hedge fund that invests in U.S. equities over the coming month, Smith proceeded as follows. Using monthly data, he would regress, using ordinary least-squares, the return of the fund over its history on the return of the S& 500, the return of a portfolio long growth stocks and short value stocks, and the return of a portfolio long large firms and short small firms. He would then use an EWMA model to forecast volatilities and correlations for the risk factors. Using the exposures of the fund to the risk factors and the standard deviation of the residual of the regression, he would then forecast the volatility of the fund and use the parametric approach assuming normally distributed returns to estimate the one-month VaR of the fund. Which of the following statements are correct?

I. The well-known work of Fama and French tells us that Smith uses an appropriate risk model, so that the risk factors do not need to be changed. However, his approach makes the mistake of ignoring the fact that hedge fund returns are not normally distributed. The correct distribution of the residual should have higher kurtosis than the normal distribution.

II. The estimates of the exposures to the risk factors will often be biased since the returns of many hedge funds exhibit high serial correlation compared to the returns of mutual funds.

III. The model used by Smith will have low explanatory power because hedge funds change exposures to the risk factors he uses often, but the explanatory power could be improved by using additional asset based factors that have been developed in the literature.

IV. Since portfolio holdings for the typical hedge fund change so much, it is hopeless to hope to explain more than a trivial faction of the return of a typical hedge fund using a factor model.

A. Statements I and II are correct.

B. Only statement I is correct.

C. Statements II and III are the only correct statements.

D. Statement IV is the only correct statement.

58. For a portfolio of illiquid assets, hedge fund managers often have considerable discretion in portfolio valuation at the end of each month and may have incentives to smooth returns by marking values below actual in high return months and above actual in low return months. Which of the following is not a consequence of return smoothing over time?

A. Higher Sharpe ratio

B. Lower volatility

C. Higher serial correlation

D. Higher market beta

59. If interest rates rise, a bank with a positive maturity gap will experience:

A. A gain in equity capital.

B. A loss of equity capital.

C. Either a gain or a loss of equity capital.

D. No change in equity capital.

60. Diseconomies of scale imply that:

A. As the output of a financial institution increases, average costs of production decrease.

B. Small financial institutions are more cost efficient than large ones.

C. Small financial institutions do not prosper in a freely competitive environment.

D. Revenues derived from major technological investments fail to cover development costs providing a distinct advantage to smaller financial institutions.

56. On a due diligence visit, the manager of an arbitrage fixed-income fund claims that his fund has very low risk. He tells you that the fund invests in mortgage-backed inverse floaters issued in the ffice:smarttags" />U.S. The current value of the long positions of the fund is roughly USD 100 million. Typically, the fund buys inverse floaters that are undervalued and hedges them so that the position is not sensitive to interest rate changes using the nearest maturity futures contract on the 10-year T-Note. The fund captures the difference between the inverse floater and the hedge portfolio when it puts on the position. You are told that the only risk arises because the fund might have to sell the hedged position. He calls this LTCM risk. Which of the following risks not discussed by the manager can affect significantly the return of the hedge fund?

I. Model risk because the prepayment model used by the fund might be wrong.

II. Default risk because the hedging strategy assumes that the inverse floaters have no default risk.

III. Liquidity risk because the hedge fund uses the nearest futures contract on the 10-year T-Note to hedge interest rate risk and trading price impact may not be possible in that contract in times of stress.

IV. Volatility risk because shocks to interest rate volatility will affect the inverse floaters but cannot typically be hedged with the 10-year T-Note contract.

A. Only risks I and IV are present.

B. Only risks I, III and IV are present.

C. Only risks I, II and IV are present.

D. Only risks I and III are present.

Correct answer is A

There is no default risk on inverse floaters, so 2 is wrong. The risk that one might not be able to trade the nearest 10-year T-Note is trivial. The other risks are important. fficeffice" />

Reference: Risks of fixed-income arbitrage strategies are discusses in Hsieh and Fong and in Jaeger.

57. You are being interviewed for the position of CRO for a large fund-of-funds. You are asked to comment on the risk management approach of the CRO you would replace, James Smith, and who just left to start his own fund-of-funds. To evaluate the risk of a hedge fund that invests in U.S. equities over the coming month, Smith proceeded as follows. Using monthly data, he would regress, using ordinary least-squares, the return of the fund over its history on the return of the S& 500, the return of a portfolio long growth stocks and short value stocks, and the return of a portfolio long large firms and short small firms. He would then use an EWMA model to forecast volatilities and correlations for the risk factors. Using the exposures of the fund to the risk factors and the standard deviation of the residual of the regression, he would then forecast the volatility of the fund and use the parametric approach assuming normally distributed returns to estimate the one-month VaR of the fund. Which of the following statements are correct?

I. The well-known work of Fama and French tells us that Smith uses an appropriate risk model, so that the risk factors do not need to be changed. However, his approach makes the mistake of ignoring the fact that hedge fund returns are not normally distributed. The correct distribution of the residual should have higher kurtosis than the normal distribution.

II. The estimates of the exposures to the risk factors will often be biased since the returns of many hedge funds exhibit high serial correlation compared to the returns of mutual funds.

III. The model used by Smith will have low explanatory power because hedge funds change exposures to the risk factors he uses often, but the explanatory power could be improved by using additional asset based factors that have been developed in the literature.

IV. Since portfolio holdings for the typical hedge fund change so much, it is hopeless to hope to explain more than a trivial faction of the return of a typical hedge fund using a factor model.

A. Statements I and II are correct.

B. Only statement I is correct.

C. Statements II and III are the only correct statements.

D. Statement IV is the only correct statement.

Correct answer is C

A is the wrong answer because the risk model used is not one that captures the nonlinear exposures of hedge funds.

B is correct as smoothing of fund returns means that this month's return reflects only part of the impact of the risk factor returns of this month.

C is correct as asset-based factor models perform reasonably well when they use factors designed to capture the non-linear exposures of hedge funds.

D is not correct because C is correct.

Reference: All of this could be inferred from the introduction of Hsieh and Fund and from the Getmansky et al. paper.

58. For a portfolio of illiquid assets, hedge fund managers often have considerable discretion in portfolio valuation at the end of each month and may have incentives to smooth returns by marking values below actual in high return months and above actual in low return months. Which of the following is not a consequence of return smoothing over time?

A. Higher Sharpe ratio

B. Lower volatility

C. Higher serial correlation

D. Higher market beta

Correct answer is D

A is incorrect. Return smoothing yields a more consistent return over time which also implies lower volatility, which in turn implies a higher Sharpe ratio.

B is Incorrect. Return smoothing yields a more consistent return over time which also implies lower volatility.

C is incorrect. Return smoothing produces higher (positive) serial correlation.  Tracking serial correlation is one method of detecting return smoothing, which is important because it is often also a sign of fraud.

D is correct. Return smoothing yields a more consistent return over time with lower market beta.

Reference: Getmansky, Lo and Mei. Sifting through the Wreckage: Lessons from Recent Hedge-Fund Liquidations, pages 21-23.

59. If interest rates rise, a bank with a positive maturity gap will experience:

A. A gain in equity capital.

B. A loss of equity capital.

C. Either a gain or a loss of equity capital.

D. No change in equity capital.

Correct answer is B

A is incorrect. The Bank will experience a loss of equity capital. See explanation in B below.

B is correct. A loss of equity capital. If the maturity gap is positive, the assets have a longer weighted-average maturity than the liabilities. If rates rise, the value of the liabilities will fall by less than the value of the assets, and equity capital will decrease.

C is incorrect. The Bank will experience a loss of equity capital. See explanation in B above.

D is incorrect. The Bank will experience a loss of equity capital. See explanation in B above.

Reference: Saunders, Chapter 8.

60. Diseconomies of scale imply that:

A. As the output of a financial institution increases, average costs of production decrease.

B. Small financial institutions are more cost efficient than large ones.

C. Small financial institutions do not prosper in a freely competitive environment.

D. Revenues derived from major technological investments fail to cover development costs providing a distinct advantage to smaller financial institutions.

Correct answer is B

Diseconomies of scale imply that as the output of a financial institution increases, its average costs of production increase. In general larger institutions have an advantage over smaller institutions simply due to their size and potential efficiencies when trying to recoup the cost of large technology expenditures. In this case, if a smaller institution has an advantage, it is considered a diseconomy of scale.