Hedge Funds and Mergers Quiz

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Questions and Answers

Which strategy focuses specifically on predicting the outcomes of corporate mergers?

Convertible arbitrage

Distressed securities

Dedicated short

Merger arbitrage (correct)

What typical fee structure is associated with a fund of funds?

1 + 15%

2 + 20%

1 + 10% (correct)

2 + 15%

What is a common limitation for hedge funds that have low betas?

They may not outperform the market in bullish conditions. (correct)

They must only report their performances to regulators.

They cannot borrow securities for short positions.

They can only invest in equivalent markets.

Which aspect is a responsibility of prime brokers regarding hedge funds?

They handle hedge fund trades and assess leverage needs. Signup and view all the answers

Which factor can bias the performance statistics of hedge funds upward?

Only successful funds reporting their returns. Signup and view all the answers

What is the primary risk associated with moral hazard in insurance?

Policyholders take more risks due to coverage Signup and view all the answers

How do life insurance contracts typically behave over time?

They remain the same over the life of the contract Signup and view all the answers

What is the main factor affecting the cost of health insurance?

Health care cost inflation Signup and view all the answers

In a defined contribution pension plan, what happens to the contributions made by employees?

They are kept separate and invested individually Signup and view all the answers

Which statement is true regarding the liabilities of a simplified balance sheet for property-casualty insurance?

Policy reserves are typically higher than for life insurance Signup and view all the answers

What impacts the actuarial estimates for a defined benefit pension plan?

Market interest rates and equity prices Signup and view all the answers

What is a characteristic of adverse selection in insurance?

Insurance companies attract a higher proportion of bad risks Signup and view all the answers

Which regulatory framework primarily governs insurance in the United States and Canada?

Provincial and state level regulations Signup and view all the answers

What is the cumulative percentage of shares filled for order D?

66.7% Signup and view all the answers

Which option describes a potential conflict of interest for a bank?

Investment bank sells securities to benefit its own brokerage. Signup and view all the answers

What was a significant effect of the Riegel-Neal Interstate Banking and Branching Efficiency Act?

It allowed interstate banking services and branching. Signup and view all the answers

What percentage of the total order was filled for shares under order H?

100% Signup and view all the answers

Which asset category does NOT appear in the simplified banking balance sheet?

Accounts Receivable Signup and view all the answers

Which act was introduced in the U.S. to regulate bank holding companies?

Bank Holding Companies Act Signup and view all the answers

In the simplified banking balance sheet, what is the total amount of liabilities and shareholders' equity?

100 million Signup and view all the answers

What is the payment price for shares allocated to bidders in order D?

$29.00 Signup and view all the answers

What major change do lenders need to implement under IFRS 9 regarding credit losses?

Estimate expected credit losses and subtract them from the amount owed. Signup and view all the answers

What is the main advantage of the Originate-to-Distribute Model for banks?

It frees up funds and capital to create more loans. Signup and view all the answers

Which type of life insurance allows for investment choices regarding surplus?

Variable life insurance Signup and view all the answers

What is a crucial consideration when valuing expected cash flow for a whole life policy?

Future mortality projections. Signup and view all the answers

What defines the minimum premium in life insurance pricing?

The present value of cash inflows equals the present value of cash outflows. Signup and view all the answers

How is an annuity contract commonly initiated?

With a one-time lump sum payment. Signup and view all the answers

What is a characteristic of mortality tables used by insurance companies?

They are essential for determining actuarial pricing. Signup and view all the answers

Which of the following best describes the cash flow expectation of a whole life policy over time?

It initially incurs losses and becomes profitable over time. Signup and view all the answers

What primary role does the Originate-to-Distribute Model play in a bank's operations?

It enhances liquidity and supports loan origination. Signup and view all the answers

What advantage might policyholders gain from life insurance contracts regarding surplus investment?

Tax deferral benefits for the policyholder or their beneficiaries. Signup and view all the answers

What is the primary concern of property insurance?

Loss or damage to property Signup and view all the answers

What is a characteristic of catastrophe (CAT) bonds?

Claims are paid from both interest and principal if certain thresholds are met. Signup and view all the answers

What is indicated by a loss ratio of 75% in non-life insurance?

The company pays out 75% of its premiums in claims. Signup and view all the answers

What is the effect of a combined ratio of 106% after dividends?

The insurer is operating at a loss. Signup and view all the answers

Which of the following is a factor that could lead to premium changes in insurance?

Changes in life expectancy calculations Signup and view all the answers

What does a combined ratio of 105% without dividends imply?

The insurance company is losing money on operations. Signup and view all the answers

Longevity derivatives are primarily used by which entities?

Life insurance companies and pension funds Signup and view all the answers

What is the significance of a payout profile in non-life insurance?

It indicates the amount and timing of claims that must be paid. Signup and view all the answers

What is the relationship between risk and expected return in investments?

Higher risk is associated with higher expected returns. Signup and view all the answers

Which of the following investments is likely to have the highest expected return?

Stocks with a range of possible returns Signup and view all the answers

What role does standard deviation play in evaluating investments?

It characterizes the risk associated with the return of an investment. Signup and view all the answers

In a two-asset portfolio, what are R1 and R2 in terms of expected return?

Returns of the individual assets in the portfolio. Signup and view all the answers

What distinguishes systematic risk from non-systematic risk?

Systematic risk affects the entire market, while non-systematic risk affects individual assets. Signup and view all the answers

What is the purpose of the Capital Asset Pricing Model (CAPM)?

To determine the expected return of an asset based on systematic risk. Signup and view all the answers

How is expected return calculated for an investment with multiple possible outcomes?

Through a probability-weighted calculation based on possible returns. Signup and view all the answers

What does the Efficient Frontier represent in investment theory?

The optimal portfolio that maximizes expected return for a given level of risk. Signup and view all the answers

Study Notes

Risk-Return Trade-offs

There's a trade-off between risk and expected return.
Higher risk typically leads to higher expected return, but there's no "free lunch."
Investors require higher returns to compensate for taking on higher risk in investments like stocks compared to risk-free Treasury bills.

Quantifying Risk

Investments can be characterized by their expected return and standard deviation of return.
Examples include equity investments with a 10% expected return and 18.97 standard deviation of return.
Standard deviation measures return per annum (R).
Expected return (E(R)) and standard deviation are calculated using formulas involving probabilities and returns.

Quantifying Risk - 2 Asset Portfolio

Combining two risky investments (R₁, W₁, R₂, W₂) gives an expected portfolio return (μp) calculated as (W₁μ₁ + W₂μ₂).
Standard deviation of the portfolio (σp) is calculated using a formula involving variances and correlations of the individual investments.

The Efficient Frontier of Risky Investments

Figure 1.3 (page 6) is a visual representation of the efficient frontier.
The efficient frontier shows the relationship between expected return and standard deviation of return for various investments.
The frontier illustrates the best risk-return trade-offs for a range of possible investment portfolios.

The Efficient Frontier of All Investments

The formula for expected portfolio return is presented (E(R_p) = RF +.). Risk-free rate is designated by RF.
Figure 1.4 (page 7) is a visual representation of the efficient frontier showing the best mix of investments.

Systematic vs Nonsystematic Risk.

Using historical data and regression analysis, the relationship between investment returns and market portfolio returns is determined (R =).
Systematic risk is non-diversifiable (market risk), while nonsystematic is diversifiable.

Capital Asset Pricing Model

If there is no systematic risk, the return is equal to the risk-free return (R = RF).
If there is systematic risk, the return is equal to market portfolio return (R = RM).
Capital asset pricing model (CAPM) formula for determining expected return (E(R)) : E(R) = RF + Equity Risk Premium.

Assumptions

Investors care only about expected return and standard deviation of the portfolio return (requires a normal distribution of the underlying return).
Investments have independent returns connected through correlations with the market portfolio.
Investors focus on returns over a set period, which is constant for all investors.
Investors can borrow and lend at the risk-free rate.
Tax rates don't influence investment decisions, and all investors have identical estimates of expected return, standard deviation, and correlations.

Alpha

Alpha is the excess return earned by a portfolio that surpasses the return predicted by the CAPM.
Alpha is calculated as excess return (Rp - RF +)
The weighted average alpha of all investors must equal zero,

Arbitrage Pricing Theory

The theory extends CAPM by acknowledging that returns depend on various factors, such as domestic interest rates and inflation.
A portfolio can be structured to eliminate dependence on these factors.
Investment return is linearly related to these factors after a portfolio is structured.

Risk vs Return for Companies

Companies must manage risk in the best interests of shareholders.
Should companies evaluate projects based solely on systematic risk (as shareholders care only about systematic risk)?
In practice, companies consider total risk (systematic + unsystematic).
Earnings stability and company survival are crucial for companies.
Regulators focus on total risk for financial institutions (FIs).

Bankruptcy Costs

Bankruptcy costs include lost sales, loss of key employees, and significant legal and accounting costs.
Arguments about bankruptcy costs suggest that managers are concerned with total risk for shareholders, since projects with high total risk are rejected.

Risk Management by FIs

Two main approaches to risk management for financial institutions (FIs): Risk decomposition and risk aggregation.
Risk decomposition involves breaking down risks and handling them separately.
Risk aggregation involves diversification of business/operations to reduce unsystematic risk.

Credit Ratings

Credit ratings measure the credit quality of a debt instrument. They must be lower than the issuer's creditworthiness itself.
Agencies like S&P, Moody's, and Fitch assign ratings.
Ratings indicate credit quality from AAA (highest) to C (lowest), categorized as investment-grade and non-investment-grade.

Chapter 2: Banks

This provides an overview of the nature of banking activity.

Nature of Banking

Commercial banks take deposits and give loans, whether wholesale or retail.
Money center banks work in the wholesale market, often funding loans by borrowing.
Investment banking involves raising debt/equity for companies, advising on mergers and acquisitions (M&A) and restructurings, as well as initial public offerings (IPOs).

Sample Dutch Auction

A sample Dutch auction demonstrates how shares are allocated based on bids and prices.

Potential Conflicts of Interest

Conflicts of interest can arise in banking relationships (e.g., recommendation of securities for sale, sharing of client information).
Banks may also pass information from one investor to another or recommend an investment to please company management.
Investment banks may sell securities to give a loan to a commercial bank to improve their liquidity.

History of Bank Regulation in US

Key legislation impacting US banks includes the McFadden Act (1927, 1933), Douglas Amendment (1956), Bank Holding Companies Act (1970), and Riegel-Neal Interstate Banking and Branching Efficiency Act (1994).

Simplified Banking Balance Sheet

Assets and liabilities of a simplified balance sheet for a bank are presented.
Total assets and total liabilities (including shareholder's equity) should be equal in a properly functioning balance sheet.

Simplified Income Statement

Key income statement line items (net interest income, provision for loan losses, non-interest income, non-interest expense) are shown.
Operating income and taxes are included in profits or loss figures.

Role of Regulation/External Oversight

Regulators impose minimum capital requirements for banks in various tiers (Tier 1, Tier 2, Tier 3 capital).
Equity is an example of Tier 1 capital, subordinated long-term debt is an example of Tier 2 capital.
The appropriate capital level impacts return on equity (RoE) and the bank's ability to handle losses.

Deposit Insurance

Many countries implement deposit insurance programs to protect depositors against losses.
CDIC and FDIC are examples of such programs.
Deposit insurance levels vary by country.

Accounting

Accounting practices in banking can differ significantly between banking books and trading books.
Newer accounting standards (IFRS 9, FASB update) require lenders to estimate expected credit losses, deducting them from amounts owed on loans.

Originate-to-Distribute Model

This was a common method of mortgage origination in 2000-2007.
Banks originated loans and then packaged them into mortgage-backed securities that were sold to investors.
Credit standards for loans stayed important despite the process.

Chapter 3: Insurance Companies & Pension Plans

This covers different types of insurance and pension plans.

Life Insurance

Different types of life insurance (term life, whole life, variable life, universal life, endowment life, group life) are discussed.
Cash flow expectations for insurers are presented visually.
Early-year investment strategies and annuity contracts are covered.

Mortality Tables & Actuarial Pricing

Mortality tables are used for actuarial pricing, estimating the likelihood of death at various ages.
Minimum premiums are close to the present value (PV) of inflows and outflows of financial risks, illustrating the basis for actuarial premiums.
Data from US Mortality Tables (2019) shows mortality probabilities and life expectancies at different ages for males and females.

Longevity Derivatives

Companies use derivatives to manage longevity risk.
The value of life insurance, pension, or bond contracts depends on the number of people who remain in the population.

Non-Life (Property-Casualty) Insurance

Non-life insurance covers property and legal liability risks.
Issues such as payout profile (amount and timing of payouts) are analyzed in this segment.
Biggest risks for insurers in this area are highlighted.

CAT Bonds

Catastrophe bonds are an alternative to reinsurance.
They are issued by a subsidiary of an insurance company, and pay higher than normal interest rates.
They utilize principal payments to handle extreme claims.

Ratios for Non-Life Insurance

Key ratios for non-life insurance such as loss ratio, expense ratio, combined ratio, dividends paid, and combined ratio after dividends, and investment income.
The ratios reflect different business performance components.

When do Premiums Change?

Life insurance premiums typically remain the same throughout the policy's term.
Property-casualty premiums change with contract renewals as risks are reassessed.
Health insurance premiums are tied to health care costs.

Moral Hazard and Adverse Selection

Moral hazard arises when an insurance policy incentivizes riskier behavior.
Adverse selection occurs when insurers attract the riskier clients because they can't readily distinguish good from bad risks.

Simplified Balance Sheet: Life Insurance

A balance sheet for a life insurance company showing assets (like investments) and liabilities (policy reserves) is presented to illustrate the financial position of insurers.

Simplified Balance Sheet: P&C Insurance

A balance sheet for property-casualty insurance companies is presented to illustrate how assets, liabilities, and equity are organized.

Regulation

Insurance regulation in both US and Canada (mostly at the state/provincial level) and in Europe (mostly at the EU level) is highlighted.

Pension Plans

Defined benefit and defined contribution plans (types of retirement plans) and their principles are discussed.
Plan viability, employer and employee contributions, and required contribution amounts are also covered.

Chapter 4: Fund Managers

Fund managers and the types of funds are under this topic.

Open-End vs Closed-End Mutual Funds

Open-ended mutual funds are characterized by variable share counts that fluctuate with investor activity..
Net Asset Value (NAV) is the key metric for these funds.
There's a distinction between open-end and closed-end funds that are traded on securities exchanges—closed-end fund shares' value relates to the market value of their underlying assets and sometimes differ from the net asset value (NAV).

Exchange-Traded Funds (ETFs)

ETFs are designed to track an index, acting as a trading vehicle for an index's underlying components.
Shares are traded on an exchange like company shares.
There are features to manage ETFs versus open and closed-end mutual funds.

ETFs vs Open- and Closed-End Mutual Funds

Key features of ETFs, like trading at any time of day and not having to sell holdings to cover redemptions, are discussed.
The share price of ETFs closely follows NAV.

Performance of Mutual Funds

Jensen (1969) demonstrated that mutual fund average alpha is close to zero before accounting for investment expenses.
Data is presented illustrating that mutual funds may not outperform the market over time consistently.

Mutual Fund Scandals

Late trading, market timing, front running, and directed brokerage are presented as examples of mutual fund scandals.

Hedge Funds (Alternative Investments)

Hedge funds are alternative investments that are not subject to mutual fund restrictions (e.g., daily NAV calculation, redeemability).
Characteristics include typical fee structure, lock-up period, and manager incentives.

Other Notable Points

Fund of funds are portfolios of hedge funds, typically with fees between 1% and 10% depending on what the fund buys.
Prime brokers handle trades and determine loan and collateral requirements for hedge funds, and they play a critical role in managing and supporting hedge funds.

Hedge Fund Returns

Historical hedge fund returns, in relation to the S&P 500, are presented illustrating the performance of various funds over time.
A statistic bias is described as a potential upward bias from hedge funds in performance statistics, in situations where only some funds report performance for a given lookback period.

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Test your knowledge on hedge funds and corporate mergers with this quiz. Explore strategies related to predicting merger outcomes, fee structures of funds of funds, and responsibilities of prime brokers. Challenge yourself with questions on performance statistics and fund limitations.