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?

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

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

<p>Enter the trade into a portfolio management system with target spread details (A)</p> 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?

<p>The manager's ability to generate alpha through effective stock selection (C)</p> 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?

<p>It signifies minimal sensitivity to broader market fluctuations (C)</p> 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?

<p>$180,140.00 (C)</p> Signup and view all the answers

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

<p>7,720 shares (D)</p> Signup and view all the answers

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

<p>C$58,575 (A)</p> Signup and view all the answers

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

<p>$28.30 (D)</p> Signup and view all the answers

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

<p>23.75% (D)</p> Signup and view all the answers

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

<p>The bond price divided by the conversion price (C)</p> Signup and view all the answers

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

<p>She shorted TSLA stock and purchased a convertible TSLA bond. (A)</p> 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?

<p>$1,094.81 (D)</p> Signup and view all the answers

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

<p>$889.44 (A)</p> Signup and view all the answers

What is the total profit Clara realized from her trades?

<p>$14.65 (A)</p> Signup and view all the answers

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

<p>3.13% (B)</p> Signup and view all the answers

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

<p>Purchasing additional shares of TSLA stock (B)</p> Signup and view all the answers

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

<p>With the income from shorting TSLA stock (B)</p> Signup and view all the answers

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

<p>Confusing stock price with conversion price (B)</p> Signup and view all the answers

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

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

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

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

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

<p>There is a negligible impact on profitability due to equal maturity durations (B)</p> 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?

<p>Buy the corporate bond and short the government bond (C)</p> 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?

<p>A capital gain due to advantageous pricing (A)</p> Signup and view all the answers

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

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

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

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

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

<p>A corporate bond that is undervalued (D)</p> Signup and view all the answers

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

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

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

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

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

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

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

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

What are high-yield bonds often referred to as?

<p>Junk bonds. (C)</p> Signup and view all the answers

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

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

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

<p>Using leverage. (C)</p> Signup and view all the answers

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

<p>8% (C)</p> Signup and view all the answers

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

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

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

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

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

<p>6 months. (D)</p> Signup and view all the answers

Flashcards

Pairs Trading

An equity market-neutral strategy that identifies and trades pairs of related stocks with mispriced valuations.

Low Beta

A portfolio with minimal directional exposure to the overall market.

Market-Neutral Portfolio

A portfolio that hedges against several risks, such as industry, market, or sector risk.

Fundamental Valuation Models

Models used to determine the fair value of a company's stock.

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Trading Pairs

Two similar stocks (e.g., competitors) that are traded together.

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Price Spread

The difference between the market prices of two securities.

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Equity Market Neutral Strategy

An investment strategy where the portfolio's overall market exposure is very close to zero or zero.

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Convertible Bond

A bond that can be exchanged for a specified number of shares of the issuing company's common stock.

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Conversion Price

The price at which a convertible bond can be exchanged for shares of the underlying stock.

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Conversion Ratio

The number of shares of common stock that a convertible bond can be exchanged for.

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Shorting a Stock

Borrowing shares of stock and immediately selling them in the market, with the expectation of buying them back later at a lower price to return to the lender.

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Longing a Bond

Buying a bond with the expectation that its price will increase.

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Simultaneous Actions

Two or more actions happening at the same time.

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Realized Value

The actual financial gain or loss from a trade.

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Reversal

The process of undoing a previous trade by selling the asset that was bought and buying back the asset that was sold.

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RoR

Return on investment, calculated as the profit obtained from a trade divided by the initial investment.

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Credit Spread

The difference in yield between a risky bond and a similar-maturity government bond.

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Credit Spread Arbitrage

A strategy of profiting from differences in yield spreads between risky bonds and government bonds.

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What is the primary factor influencing bond prices?

Interest rates. When interest rates rise, bond prices fall, and vice versa.

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Yield to Maturity (YTM)

The total return an investor can expect to receive from holding a bond until maturity.

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How do portfolio managers use credit spreads in trading?

They buy “cheap” credit bonds with wider spreads and short similar-term government bonds.

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What happens when the yield spread widens?

The credit spread arbitrage trade experiences an unrealized capital loss. The credit bond becomes less valuable.

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What happens when the yield spread narrows?

The credit spread arbitrage trade results in a capital gain. The credit bond becomes more valuable.

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What is the goal of credit spread arbitrage?

To capitalize on market inefficiencies and profit from differences in yield spreads between similar bonds.

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Why is it important to match the maturities of the bonds in credit spread arbitrage?

To minimize the impact of overall interest rate changes on the trade's profitability.

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What is fundamental analysis in the context of credit spread arbitrage?

Analyzing the financial health and creditworthiness of the issuer of the risky bond.

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Trade Initiation

The initial action of entering a pairs trading strategy by simultaneously shorting one stock, purchasing another stock with the proceeds, and establishing a long position in a futures contract.

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Trade Reversal

The process of undoing a previous pairs trade by selling the purchased stock, buying back the shorted stock, and closing the futures contract.

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Price Spread Target

The specific price difference between two stocks that triggers the reversal of a pairs trade.

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Net Financial Result

The overall profit or loss made from a completed round-trip pairs trade, calculated by subtracting the total cost from the total proceeds.

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Annualized RoR

The annual equivalent return on investment, calculated by compounding the realized return over a year.

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Merger Arbitrage

A strategy that profits from the price difference between a target company's stock and the offer price in a merger or acquisition.

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Risk Arbitrage

A specific type of merger arbitrage that aims to profit from the uncertainty and risk associated with a merger deal.

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Hedge Ratio

The ratio of shares sold in the acquiring company (ABC) to shares bought in the target company (XYZ) to mitigate risk in merger arbitrage.

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Dilutive Merger

A merger where the acquiring company's earnings per share decrease after the merger due to a lower earnings contribution from the target company.

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Accretive Merger

A merger where the acquiring company's earnings per share increase after the merger due to a strong earnings contribution from the target company.

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High-Yield Bonds

Bonds issued by companies with lower credit ratings (BB or lower) that offer potentially higher returns but carry more risk.

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Credit Strategy

An investment strategy that focuses on investing in debt securities (bonds) with varying levels of credit risk.

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Capital Appreciation

An increase in the value of an investment over time, often through price appreciation or reinvestment of earnings.

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Traditional Investment Grade Credit

Bonds issued by companies with very good credit ratings (AAA) that are considered relatively safe and offer lower returns.

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Junk Bonds

Another name for high-yield bonds, reflecting their lower credit rating and higher risk compared to investment-grade bonds.

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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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Related Documents

CSC Volume 2 Section 3 Alternative Investments PDF

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.

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