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Question #540

Josh Atwell recently inherited a large sum of money and wants to invest a portion of the inheritance into a real

estate investment that provides a tax shelter. Atwell wants to take a limited management role in the real estate

investment, and avoid the expense of hiring professional project management. Also, Atwell requires that the real

estate investment generate high cash flows. Atwell hired Kellogg Investments to provide him potential real estate

investments. Kellogg created Exhibit 1 outlining alternative real estate investments, from which Atwell can make

his selection. Atwell's cost for any loan is 8%. The loan would be amortized over 20 years with annual payments.

His required rate of return is 11%.

After reviewing the potential real estate investments generated by Kellogg, Atwell decided against all of the

choices. Instead, Atwell requested a detailed report on the investment merits of an apartment complex. In Exhibit 2,

Kellogg details the operating income of a targeted apartment complex investment. Atwell will make an equity

contribution of $1,000,000. The loan-to-value ratio for the apartment complex investment would be 75%.

An adviser from Kellogg states that Atwell should purchase the apartment complex because the net present value of

the investment is positive. The adviser also states, however, that the investment's IRR is less than Atwell's required

rate of return. After reviewing the historical financial statements of the potential hotel investment, the advisor notes

its erratic net operating income. In fact, the hotel generated several years of growing cash flow followed by two

negative years and then a return back to a positive cash flow.

Based upon the information presented in Exhibit 2, the after-tax cash flow for year 2 is closest to:

A. $40,000.

B. $72,000.

C. $114,000.

Answer: B

Loan-to-value ratio is 75%, Atwell's equity contribution is $1M, so the total value is:

(Study Session 13, LOS 45.c)

Question #551

A client of Colby Nash, CFA, wants to add an alternative asset class to his portfolio. However, the client is

concerned that any investment in hedge funds may be far riskier and generate lower returns than is generally

expected. Nash believes the client's attitude toward hedge funds was influenced by negative press coverage

regarding fraud perpetrated by a few funds. Nash decided to conduct his own research on the risk/reward

characteristics of hedge funds. Nash generated a report (shown in Exhibit 1) comparing several hedge fund

strategies and a traditional investment benchmark; the S&P 500 index. Each hedge fund strategy is represented by

an individual fund, which is used to measure risk and return over a ten year period. Nash also created a correlation

matrix between hedge funds and the S&P 500 index, shown in Exhibit 2.

In addition to the statistics presented in the exhibits above, Nash created a hedge fund index to evaluate each fund's

performance. Nash recognized the fact that several shortcomings exist in creating an adequate hedge fund index. To

that end, Nash created an index in which all the hedge funds included in the index agreed to provide data that can

be verified by Nash. Nash also set up strict rules for inclusion and removal of hedge funds into and out of the

hedge fund index.

As a further improvement to his research, Nash created a positive risk-free rate benchmark to evaluate each hedge

fund. However, his review of academic research indicated thar the positive risk-free rate benchmark is only

appropriate for a limited number of hedge fund strategies. The current risk-free rate is 4%.

Nash conducted a personal interview with the portfolio manager of the Fixed Income Arbitrage hedge fund. The

portfolio manager disclosed that he exploited pricing inefficiencies between fixed income securities while hedging

exposure to interest rate risk. The portfolio manager utilizes a convergence trading strategy, which assumes that the

price difference between two similar assets will narrow in the future. The portfolio manager is willing to invest in

illiquid bonds if the opportunity presents itself. in reviewing the correlation matrix (Exhibit 2), Nash concluded that

the Fixed Income Arbitrage hedge fund would be an ideal addition to his client's current traditional investment

portfolio. Nash's rationale was that a low correlation between the hedge fund and the S&P 500 index will assure

that the fund's returns will be positive when the returns of the index are negative.

After reviewing Nash's research, the Director of Research at his firm inquired why he did not examine the value at

risk (VAR) measure for the various hedge fund strategies. Nash stated that VAR is an ineffective statistical

measure of risk when a hedge fund has high turnover or frequent changes in its strategy. In addition,

Nash stated his belief that when the only input is historical data, VAR does not provide a reliable estimate of future

risk.

Rather than comparing hedge funds against the S&P 500 index, Nash believes a hedge fund index may be more

appropriate. Which of the following is least likely to be a problem with the hedge fund index constructed by Nash?

A. Backfill bias.

B. Selection bias.

C. Autocorrelation.

Answer: B

Several problems exist with hedge fund index data. The problems include: hedge fund listing issues, exclusion of

certain hedge funds, data verification issues, turnover, survivor bias, backfill bias, estimation bias due to the closing

of funds to new investors, autocorrelation, and the short performance history of hedge funds. As discussed in the

problem, Nash recognized and addressed two issues: data verification and hedge fund selection. Therefore, these

issues would least likely be problems in this case. (Study Session 13, LOS 49.b)

Question #552

A client of Colby Nash, CFA, wants to add an alternative asset class to his portfolio. However, the client is

concerned that any investment in hedge funds may be far riskier and generate lower returns than is generally

expected. Nash believes the client's attitude toward hedge funds was influenced by negative press coverage

regarding fraud perpetrated by a few funds. Nash decided to conduct his own research on the risk/reward

characteristics of hedge funds. Nash generated a report (shown in Exhibit 1) comparing several hedge fund

strategies and a traditional investment benchmark; the S&P 500 index. Each hedge fund strategy is represented by

an individual fund, which is used to measure risk and return over a ten year period. Nash also created a correlation

matrix between hedge funds and the S&P 500 index, shown in Exhibit 2.

In addition to the statistics presented in the exhibits above, Nash created a hedge fund index to evaluate each fund's

performance. Nash recognized the fact that several shortcomings exist in creating an adequate hedge fund index. To

that end, Nash created an index in which all the hedge funds included in the index agreed to provide data that can

be verified by Nash. Nash also set up strict rules for inclusion and removal of hedge funds into and out of the

hedge fund index.

As a further improvement to his research, Nash created a positive risk-free rate benchmark to evaluate each hedge

fund. However, his review of academic research indicated thar the positive risk-free rate benchmark is only

appropriate for a limited number of hedge fund strategies. The current risk-free rate is 4%.

Nash conducted a personal interview with the portfolio manager of the Fixed Income Arbitrage hedge fund. The

portfolio manager disclosed that he exploited pricing inefficiencies between fixed income securities while hedging

exposure to interest rate risk. The portfolio manager utilizes a convergence trading strategy, which assumes that the

price difference between two similar assets will narrow in the future. The portfolio manager is willing to invest in

illiquid bonds if the opportunity presents itself. in reviewing the correlation matrix (Exhibit 2), Nash concluded that

the Fixed Income Arbitrage hedge fund would be an ideal addition to his client's current traditional investment

portfolio. Nash's rationale was that a low correlation between the hedge fund and the S&P 500 index will assure

that the fund's returns will be positive when the returns of the index are negative.

After reviewing Nash's research, the Director of Research at his firm inquired why he did not examine the value at

risk (VAR) measure for the various hedge fund strategies. Nash stated that VAR is an ineffective statistical

measure of risk when a hedge fund has high turnover or frequent changes in its strategy. In addition,

Nash stated his belief that when the only input is historical data, VAR does not provide a reliable estimate of future

risk.

Nash evaluated the hedge fund strategies using the positive risk-free rate benchmark. The positive risk-free rate

benchmark would be most appropriate for:

A. Long/Short Equity hedge funds.

B. Fixed Income Arbitrage hedge funds.

C. Equity Market Neutral hedge funds.

Answer: C

The positive risk-free rate benchmark can be justified by the fact that arbitrage strategies should be market neutral.

A market neutral fund should earn the risk-free rate. The Equity Market Neutral hedge fund employs a strategy that

is closest to a pure risk-free arbitrage. The investor expects the manager to use her skill to generate a return greater

than the risk-free rate. It should be understood that the Equity Market Neutral hedge fund manager must take on

some type of risk to generate excess returns. (Study Session 13, LOS 49-b)

Question #553

A client of Colby Nash, CFA, wants to add an alternative asset class to his portfolio. However, the client is

concerned that any investment in hedge funds may be far riskier and generate lower returns than is generally

expected. Nash believes the client's attitude toward hedge funds was influenced by negative press coverage

regarding fraud perpetrated by a few funds. Nash decided to conduct his own research on the risk/reward

characteristics of hedge funds. Nash generated a report (shown in Exhibit 1) comparing several hedge fund

strategies and a traditional investment benchmark; the S&P 500 index. Each hedge fund strategy is represented by

an individual fund, which is used to measure risk and return over a ten year period. Nash also created a correlation

matrix between hedge funds and the S&P 500 index, shown in Exhibit 2.

In addition to the statistics presented in the exhibits above, Nash created a hedge fund index to evaluate each fund's

performance. Nash recognized the fact that several shortcomings exist in creating an adequate hedge fund index. To

that end, Nash created an index in which all the hedge funds included in the index agreed to provide data that can

be verified by Nash. Nash also set up strict rules for inclusion and removal of hedge funds into and out of the

hedge fund index.

As a further improvement to his research, Nash created a positive risk-free rate benchmark to evaluate each hedge

fund. However, his review of academic research indicated thar the positive risk-free rate benchmark is only

appropriate for a limited number of hedge fund strategies. The current risk-free rate is 4%.

Nash conducted a personal interview with the portfolio manager of the Fixed Income Arbitrage hedge fund. The

portfolio manager disclosed that he exploited pricing inefficiencies between fixed income securities while hedging

exposure to interest rate risk. The portfolio manager utilizes a convergence trading strategy, which assumes that the

price difference between two similar assets will narrow in the future. The portfolio manager is willing to invest in

illiquid bonds if the opportunity presents itself. in reviewing the correlation matrix (Exhibit 2), Nash concluded that

the Fixed Income Arbitrage hedge fund would be an ideal addition to his client's current traditional investment

portfolio. Nash's rationale was that a low correlation between the hedge fund and the S&P 500 index will assure

that the fund's returns will be positive when the returns of the index are negative.

After reviewing Nash's research, the Director of Research at his firm inquired why he did not examine the value at

risk (VAR) measure for the various hedge fund strategies. Nash stated that VAR is an ineffective statistical

measure of risk when a hedge fund has high turnover or frequent changes in its strategy. In addition,

Nash stated his belief that when the only input is historical data, VAR does not provide a reliable estimate of future

risk.

Evaluate Nash's conversation with the Fixed Income Arbitrage hedge fund portfolio manager and Exhibit 2. Which

of following is least likely an investment risk of the hedge fund?

A. Leverage risk.

B. Credit spread risk.

C. Style drifts risk.

Answer: C

There is nothing in the case to suggest that style drifts are a problem. The correlation matrix indicates that the

portfolios returns are as expected relative to the other funds and the S&P 5U0 index. By definition the Fixed

Income Arbitrage hedge fund will generate a large part of its return by using leverage. This leverage can be as

much as 20 to 30 times the fund s capital base. The convergence trading strategy utilized by the Fixed Income

Arbitrage hedge fund takes advantage of credit spread anomalies. Thus, the risk of widening or narrowing credit

spreads must be monitored by the portfolio manager. The hedge fund invests in illiquid securities when the

opportunity presents itself. These investmentscan be difficult to price and can result in operational risks by

potentially inflating the valuation of these securities without any intent of fraud. (Study Session 13, LOS 50.a)

Question #554

Research associate Kate Sawyer is responsible for identifying the determinants of performance for her firm's

Progressive Fund (PF). All tests performed at

Sawyer's firm are examined at the 0.05 level of significance-Sawyer examines the following regressions using

monthly data observed for a 36 month period:

A colleague. Jack Lockhart, makes two recommendations to Sawyer:

Recommendation 1: My research indicates that inflation rate changes are highly correlated with the Wilshire 5000

stock index returns. Therefore, I recommend adding the inflation change variable to your regression.

Recommendation 2: My research indicates that the slope coefficients of your regression changed significantly after

the passage of Regulation Fair Disclosure, which took place in the middle of your 3-year sample period. Your

regression pools across two distinct sample periods. Therefore, I recommend correcting your current regression

equation (1) for model misspecification.

In her conversation with Lockhart, Sawyer explains that she is concerned that her regression equation (1) may

ignore other important determinants of performance for the Progressive Fund. Sawyer explains that she is aware

that the omission of important independent variables affects the quality of the parameter estimates of the regression.

She makes the following claims assuming the omitted variables arc correlated with the included variables:

Claim 1: The parameter estimates of equation (1) are unbiased.

Claim 2: The parameter estimates of equation (1) are inconsistent.

Regarding Claim 1 and Claim 2 made by Sawyer about the effects of omitted variables, indicate which claims are

correct.

A. Claim I only.

B. Claim 2 only.

C. Both Claim 1 and Claim 2.

Answer: B

Sawyer is incorrect with respect to Claim 1 and is correct with respect to Claim 2. If the omitted variables are

correlated with the included variables, then the omitted variable regression parameter estimates (i.e., from equation

(1)) will be biased and inconsistent. Desirable properties, on the other hand, are unbiasedness and consistency. An

estimator is unbiased if the expected value of the estimate equals the true population value. An estimator is

consistent if the estimate approaches the true population value as the sample size increases. The existence of

omitted variables (that are correlated with the included variables) destroys both of these desirable properties.

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