43 Questions
What is the primary strategy of relative value arbitrage in hedge funds?
Differences in performance of 2 securities from a homogeneous universe
Hedge funds are known for their long-term investment strategies.
False
What percentage of stock market transactions have been related to hedge fund activity?
1/3
Convertible bond arbitrage involves buying a convertible bond and selling ______________________ if conversion seems likely.
shares
Match the following hedge fund strategies with their descriptions:
Event Driven Investment = Takeover bids and index composition changes Relative Value Arbitrage = Differences in performance of 2 securities from a homogeneous universe Pure Short Sellers = Invest in overvalued stocks
What is one of the claimed advantages of mutual funds?
Time saver
Actively managed funds have low fees.
False
What is the main difference between actively managed funds and passively managed funds?
Actively managed funds employ professional managers to pick stocks, while passively managed funds track a market index.
Exchange-traded funds (ETFs) are a popular cheap alternative to _______________________.
mutual funds
What is an example of an alternative investment?
Hedge fund
Leverage always yields a positive return.
False
Match the following types of mutual funds with their characteristics:
Open-ended funds = Unlimited number of shares can be issued Closed-ended funds = Fixed number of shares outstanding Capitalization funds = Invest in stocks and bonds Monetary funds = Invest in low-risk, short-term instruments
What is the main risk associated with using leverage in investments?
The risk of amplified losses if the investment does not perform as expected.
What is the primary goal of a hedge fund?
To seek absolute return
Hedge funds are tightly regulated and have limitations on the use of derivatives
False
What is the main characteristic of an equity hedge fund?
Extensive use of leverage and focus on stocks
Short selling involves borrowing an asset, selling it _______________________, and buying it back at some future time
spot
Match the following hedge fund strategies with their characteristics:
Equity Hedge Funds = Focus on stocks and use leverage Global Asset Managers = Invest in a wide universe of asset classes
What is a characteristic of alternative investments, such as hedge funds?
They are less regulated
What type of insurance products are increasingly being offered by life insurers?
All of the above
Policies can be written against the general account of an insurance company.
True
What type of insurance provides coverage for medical treatment?
Health insurance
What type of depository institutions are mutually owned by the depositors?
Savings and loan associations (S&Ls)
Cooperative banks are necessarily profit maximizing.
False
A _______________________ is a type of insurance product that is purely investment-oriented.
Guaranteed investment contract (GIC)
Match the following types of insurance with their descriptions:
Health insurance = Provides coverage for medical treatment Property and casualty insurance = Covers losses due to fire, flood, theft, etc. Liability insurance = Covers litigation and third-party claims Umbrella insurance = Provides pure liability coverage over and above standard policies
What is the primary way Islamic banks get around the prohibition on paying or receiving interest?
Buying the property outright and renting it to the mortgage holder, or reselling the property to the customer at a fixed mark-up price.
What type of model involves a strategic alliance between a bank and an insurance company?
Bancassurance model
The differences between thrifts and banks are negligible after the creation of ______________________ accounts.
negotiable order of withdrawal (NOW)
Mutual funds are a type of non-depository institution.
True
What is the primary characteristic of a credit union?
Common bond of occupation or neighbourhood
Leverage always yields a positive return.
False
What is the primary goal of a mutual fund?
To provide a return on investment to its shareholders
Match the following types of depository institutions with their characteristics:
Savings banks = Mutually owned by depositors Credit unions = Common bond of occupation or neighbourhood Cooperative banks = Low-cost loans to members Thrifts = Historically could not accept deposits transferable by check
What is the name of the German who founded the concept of cooperative banks?
Wilhelm Friedrich Raiffeisen
What are the main liabilities of commercial banks?
Deposits and other sources of funding
Depository institutions encompass only commercial banks and thrifts
False
What is the main goal of commercial banks?
Generate spread income (i.e., an interest margin)
Banks engage in _______________ banking, which involves providing financial services to individuals
retail
Match the following banking services with their descriptions
Individual banking = Financial services to individuals Institutional banking = Loans to governments, non-financial corporates, and other financial corporates Global banking = Corporate financing, capital market products, and forex products
What is a common way for banks to fund their operations?
All of the above
Deposits are a primary source of funding for banks
True
Banks can borrow from the central bank at the _______________ rate
discount
Study Notes
Hedge Funds
- Hedge funds are actively managed funds that seek absolute returns, targeting high net worth individuals and institutional investors.
- They are less regulated, with no limitations on the use of derivatives, and often use short selling.
- Hedge funds are characterized by their investment policy.
Strategies
- Relative value arbitrage: exploiting differences in performance of two securities from a homogeneous universe.
- Examples: rating downgrades to speculative grade, convertible bond arbitrage.
- Event-driven investment:
- Takeover bids: buy the victim, sell the bidder.
- Index composition changes: long in new entrants, short in the 'fallen angels'.
- Buy distressed debt.
- Pure short sellers: invest in overvalued stocks.
Importance
- Hedge funds account for 1/3 of stock market transactions.
- 30% of large banks' fee income is driven by hedge fund activity.
- However, things can go wrong, e.g., the Long Term Capital Management example (1998).
Preliminary Concepts
Short Selling
- Borrow an asset, sell it spot, and buy it back at a future time.
- Bearish strategy.
- Important considerations: coupons and dividends, voting rights, and restrictions.
Mutual Funds
- Claimed advantages: professional management, access to closed markets, time-saving, tax advantages, and diversification.
- Taxonomy:
- Actively managed funds: stock pickers, higher fees.
- Passively managed funds: index trackers, low fees.
- Types:
- Retail investors vs institutional investors.
- Contractual vs statutory funds, open-ended vs closed-end funds.
- Harmonized funds (European passport) vs non-harmonized funds.
- Capitalization funds, distribution funds, monetary funds, bond funds, equity funds, balanced funds, capital guaranteed funds, etc.
Exchange Traded Funds (ETFs)
- A popular, cheap alternative to mutual funds.
Leverage
- Buying 100K of a share using 20K of own capital and 80K of borrowed money.
- Example: 20% increase in share price yields a 90% return, but a 20% decrease yields a -110% return.
Depository Institutions
- Depository institutions include commercial banks, thrifts, savings and loan associations, savings banks, and credit unions.
Commercial Banks
- Business model: main liabilities are deposits and other sources of funding, main assets are loans and investments, and the main goal is to generate spread income (interest margin).
- Business lines include individual banking (consumer lending, residential mortgages, credit cards, investment services), institutional banking (loans to governments, non-financial corporates), and global banking (corporate financing, capital market products).
Bank Funding
- Deposits: demand deposits (checking accounts), savings deposits, and time deposits (certificates of deposit, CDs).
- Borrowing in the interbank market (federal funds market in the US).
- Borrowing at the central bank's discount window at the discount rate.
- Other non-deposit borrowing (money market, bond market).
- Equity.
Savings Institutions
- Thrifts (non-bank depository institutions) historically could not accept deposits transferable by check.
- Savings and loan associations (S&Ls) are mutually owned by depositors through stock ownership.
- Savings banks and credit unions (depositors have a common bond of occupation or neighborhood).
Cooperative Banks
- Owned by members.
- Not necessarily profit-maximizing (e.g., low-cost loans to members).
Islamic Banks
- Since paying or receiving interest is not allowed, bankers use creative methods, such as:
- Buying property outright and renting it to the mortgage holder.
- Reselling the property to the customer at a fixed mark-up price and being paid in monthly installments.
Non-Depository Institutions
Insurance Types
- Life insurers offer products that are purely investment-oriented, such as:
- Guaranteed investment contracts (GICs) are zero bonds issued by life insurance companies.
- Annuities are mutual funds in an insurance wrapper.
- Policies can be written against the general account (participating policy) or special accounts (non-participating policy).
- Non-life insurance includes health, property and casualty, liability, umbrella, disability, and long-term care insurance.
Bancassurance Model
- Strategic alliance between banks and insurance companies.
- Full integration of banking and insurance services.
This quiz covers hedge funds and their strategies, including relative value arbitrage and convertible bond arbitrage. Learn about the differences in performance of securities and how hedge funds take advantage of them.
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