Equity Market-Neutral Strategies Quiz

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Questions and Answers

What is the primary objective of a pairs trading strategy in equity market-neutral investing?

To diversify investments across multiple volatile sectors for growth

To invest heavily in high beta stocks for increased returns

To maximize short-term profits from speculative trades

To create zero or very low beta exposure while achieving alpha through stock selection (correct)

Which of the following steps is NOT part of the typical process for executing a pairs trade?

Compile a list of possible trading pairs based on price trends

Select pairs based on the similarity of business activities

Review proprietary valuation models to identify mispricing

Predict future market movements using economic indicators (correct)

Why is moderate leverage typically employed in equity market-neutral strategies?

To improve liquidity in the portfolio for quick trades

To enhance returns while controlling risk, generally less than two times capital (correct)

To minimize transaction costs by investing larger amounts at once

To engage in high-risk ventures that promise substantial returns

When selecting trading pairs, what factor primarily influences the decision of which securities to pair?

The degree of similarity in business activities between the companies (D) Signup and view all the answers

Following the execution of a pairs trade, what is the next critical step an investment manager should undertake?

Enter the trade into a portfolio management system with target spread details (A) Signup and view all the answers

What is generally considered to be the expected source of return above the risk-free rate in an equity market-neutral strategy?

The manager's ability to generate alpha through effective stock selection (C) Signup and view all the answers

Which of the following best explains the concept of 'zero or low beta' in the context of pairs trading?

It signifies minimal sensitivity to broader market fluctuations (C) Signup and view all the answers

What is the value of the long position established in the S&P/TSX 60 futures contract during the trade initiation?

$180,140.00 (C) Signup and view all the answers

How many shares of RY were purchased during the trade initiation?

7,720 shares (D) Signup and view all the answers

What was the total profit achieved from the round-trip trade?

C$58,575 (A) Signup and view all the answers

What was the price spread at which the trade reversal occurred on March 1, 2019?

$28.30 (D) Signup and view all the answers

What was the annualized rate of return (RoR) on the initial investment of C$740,000?

23.75% (D) Signup and view all the answers

What calculation determines the number of shares Clara can convert from the bond?

The bond price divided by the conversion price (C) Signup and view all the answers

Which action did Clara take when initiating her trade on July 7, 2017?

She shorted TSLA stock and purchased a convertible TSLA bond. (A) Signup and view all the answers

When Clara reversed her trade on October 30, 2017, what amount did she sell the convertible TSLA bond for?

$1,094.81 (D) Signup and view all the answers

After Clara's trade reversal, how much did she spend on purchasing back TSLA stock?

$889.44 (A) Signup and view all the answers

What is the total profit Clara realized from her trades?

$14.65 (A) Signup and view all the answers

What is Clara's annualized rate of return (RoR) from the trade?

3.13% (B) Signup and view all the answers

Which of the following was NOT a simultaneous action taken by Clara during the trade reversal?

Purchasing additional shares of TSLA stock (B) Signup and view all the answers

How did Clara fund her purchase of the convertible TSLA bond during the initiation of her trade?

With the income from shorting TSLA stock (B) Signup and view all the answers

What mistake could a student make regarding the bond price in relation to shares converted?

Confusing stock price with conversion price (B) Signup and view all the answers

What primary skill enables bond portfolio managers to influence credit spread trades most effectively?

The ability to anticipate future interest rate movements (C) Signup and view all the answers

In credit risk analysis, what does the yield spread represent?

The variance between the yield of a risky bond and a sovereign bond (A) Signup and view all the answers

What happens to the profitability of a credit spread trade when overall market interest rates increase?

There is a negligible impact on profitability due to equal maturity durations (B) Signup and view all the answers

What is the preferred action taken by managers when the yield spread between a corporate bond and a government bond is considered wide?

Buy the corporate bond and short the government bond (C) Signup and view all the answers

What is the result of reversing a credit spread trade if the yield spread narrows after opening the position?

A capital gain due to advantageous pricing (A) Signup and view all the answers

What is meant by being 'underwater' in a credit spread trade?

Experiencing unrealized losses due to widening yield spreads (A) Signup and view all the answers

Which of the following accurately describes the correlation between credit risk and yield spread?

Increased credit risk usually results in higher yield spreads (B) Signup and view all the answers

Which bond is typically purchased in a credit spread arbitrage strategy when the credit bond is deemed 'cheap'?

A corporate bond that is undervalued (D) Signup and view all the answers

What relationship must bond portfolio managers maintain between the two bonds involved in a credit spread trade?

The bonds must have equal terms to maturity (D) Signup and view all the answers

What is the primary reason that merger arbitrage returns are largely uncorrelated to the overall stock market?

It focuses on specific transactions rather than market predictions. (A) Signup and view all the answers

In the example provided, what is the implied risk arbitrage hedge ratio when acquiring XYZ shares?

1 share of XYZ for 5 shares of ABC. (C) Signup and view all the answers

What characteristic defines a deal as dilutive for the acquiring firm?

A decrease in the acquiring firm's earnings per share. (C) Signup and view all the answers

What are high-yield bonds often referred to as?

Junk bonds. (C) Signup and view all the answers

Which of the following is NOT a common characteristic of high-yield bonds?

Lower risk profile than investment-grade securities. (C) Signup and view all the answers

How does a risk arbitrage fund typically seek to enhance its returns?

Using leverage. (C) Signup and view all the answers

What is the annualized return expected from the merger arbitrage scenario described?

8% (C) Signup and view all the answers

What might indicate that a merger will be considered accretive for the acquiring firm?

The targeted firm's earnings contribute positively post-merger. (B) Signup and view all the answers

What is the primary strategy of managers dealing with high-yield bonds?

To earn returns through interest income and potential capital appreciation. (A) Signup and view all the answers

What typical time frame does the risk arbitrage strategy in the example suggest for the transaction to completion?

6 months. (D) Signup and view all the answers

Study Notes

Alternative Investments: Strategies and Performance

Alternative investment strategies include relative value, event-driven, and directional strategies
Relative value strategies attempt to profit by exploiting inefficiencies or differences in the pricing of related stocks, bonds, or derivatives, and have low or no exposure to the market
Event-driven strategies seek to profit from unique corporate events such as mergers, acquisitions, stock splits, and buybacks, and have medium exposure to the market
Directional strategies bet on changes in market prices (equity, debt, currency, and commodities) and have high exposure to the market
Equity market-neutral strategies create long and short matched equity portfolios to generate returns unaffected by market direction
Convertible arbitrage strategy identifies and exploits mispricing between convertible bonds or preferred shares and underlying stock
Fixed-income arbitrage strategy leverages arbitrage opportunities in the pricing of related interest rate securities
Credit spread arbitrage exploits differences in the market yield to maturity of risky bonds and sovereign government bonds
Yield spread arbitrage trades on differences in the yield curve of bonds across different terms of maturity

Key Terms

Absolute risk: total variability or volatility of returns
Maximum drawdown: largest peak-to-trough decline in a given period, expressed as a percentage
Time to recovery: number of months required to recover peak-to-trough decline
Sharpe ratio: measures excess returns generated above the risk-free rate
Skew: tendency of a distribution to be tilted toward negative or positive returns
Kurtosis: measures a distribution's tendency to collect around the average or tail values

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Description

Test your knowledge on equity market-neutral investing and pairs trading strategies. This quiz covers the objectives and processes involved in executing these strategies, along with the use of leverage. Perfect for finance students and professionals looking to sharpen their understanding.