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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 stated that correlation analysis indicated that the Fixed Income Arbitrage hedge fund should be added to his client's traditional investment portfolio and Nash outlines his rationale for not including VAR in his analysis of hedge funds. Which of his statements is correct?
The conclusion drawn from correlation analysis is not correct. Although the Fixed Income Arbitrage hedge fund has a low 0.01 correlation with the S&P 500 index, this does not guarantee that the fund's returns will be positive when the returns of the index are negative. In fact, a study by Hsieh and Fung (2002) found that there exists a contagion effect, which suggests that there is high correlation between credit spreads and the S&P 500 index. In fact, their research concluded that most fixed income arbitrage hedge funds have a cyclical exposure to risk factors. The research concluded that a 10% decline in the S&P 500 index corresponded with a 1.5% decline in most fixed income arbitrage hedge funds. The statement about VAR is correct. VAR is an ineffective statistical measure of risk when a hedge fund has high turnover or frequent changes in its strategy. If VAR solely utilizes historical data as inputs, it does not provide a reliable estimate of future risk. (Study Session 13. LOS 50.a,b)
Maria Harris is a CFA Level 3 candidate and portfolio manager for Islandwide Hedge Fund. Harris is commonly involved in complex trading strategies on behalf of Islandwide and maintains a significant relationship with Quadrangle Brokers, which provides portfolio analysis tools to Harris. Recent market volatility has led Islandwide to incur record-high trading volume and commissions with Quadrangle for the quarter. In appreciation of Islandwide's business, Quadrangle offers Harris an all-expenses-paid week of golf at Pebble Beach for her and her husband. Harris discloses the offer to her supervisor and compliance officer and, based on their approval, accepts the trip.
Harris has lunch that day with C. K. Swamy, CFA, her old college roommate and future sister-in-law. While Harris is sitting in the restaurant waiting for Swamy to arrive, Harris overhears a conversation between the president and chief financial officer (CFO) of Progressive Industries. The president informs the CFO that Progressive's board of directors has just approved dropping the company's cash dividend, despite its record of paying dividends for the past 46 quarters. The company plans to announce this information in about a week. Harris owns Progressive's common stock and immediately calls her broker to sell her shares in anticipation of a price decline.
Swamy recently joined Dillon Associates, an investment advisory firm. Swamy plans to continue serving on the board of directors of Landmark Enterprises, a private company owned by her brother-in-law, for which she receives $2,000 annually. Swamy also serves as an unpaid advisor to the local symphony on investing their large endowment and receives four season tickets to the symphony performances.
After lunch, Alice Adams, a client, offers Harris a 1 -week cruise as a reward for the great performance of her account over the previous quarter. Bert Baker, also a client, has offered Harris two airplane tickets to Hawaii if his account beats its benchmark by more than 2% over the following year.
Juliann Clark, a CFA candidate, is an analyst at Dillon Associates and a colleague of Swamy's. Clark participates in a conference call for several analysts in which the chief executive officer at Dex says his company's board of directors has just accepted a tender offer from Monolith Chemicals to buy Dex at a 40% premium over the market price. Clark contacts a friend and relates the information about Dex and Monolith. The friend promptly contacts her broker and buys 2,000 shares of Dex's stock.
Ed Michaels, CFA, is director of trading at Quadrangle Brokers. Michaels has recently implemented a buy program for a client. This buy program has driven up the price of a small-cap stock, in which Islandwide owns shares, by approximately 5% because the orders were large in relation to the average daily trading volume of the stock. Michaels' firm is about to bring shares of an OTC firm to market in an
IPO. Michaels has publicly announced that, as a market maker in the shares, his trading desk will create additional liquidity in the stock over its first 90 days of trading by committing to minimum bids and offers of 5,000 shares and to a maximum spread of one-eighth.
Carl Park, CFA, is a retail broker with Quadrangle and has been allocated 5,000 shares of an oversubscribed IPO. One of his clients has been complaining about the execution price of a trade Park made for her last month, but Park knows from researching it that the trade received the best possible execution. In order to calm the client down. Park increases her allocation of shares in the IPO above what it would be if he allocated them to all suitable client accounts based on account size. He allocates a pro rata portion of the remaining shares to a trust account held at his firm for which his brother-in-law is the primary beneficiary.
Has either Harris or Clark violated Standard 11(A) Integrity of Capital Markets: Material Nonpublic Information?
Standard 11(A) Integrity of Capital Markets: Material Nonpublic Information prohibits members who possess material nonpublic information to act on or cause others to act on that information. Information disclosed to a select group of analysts is not made 'public' by that fact. (Study Session 1, LOS 2.a)
Mary Carr is 62 years old, in good health, and will retire in four years from her position as the CEO and chairman of the board of a large professional services firm, Appleton Professional Services, which is located in the midwestern United States. Carr has approached Tim Houlis, her financial planner, for help in preparing an investment policy statement and accompanying asset allocation. Jack Timmons is Houlis' assistant.
In a lunch meeting with Houlis and Timmons, Carr reveals that she is thinking of moving this year to be closer to Appleton's largest client. She is concerned about developing an investment plan now given that she will no longer have contact with Houlis if she does move. Houlis reassures her that this is not a problem. He states that a properly constructed investment policy statement can be readily implemented by her new financial advisor. Timmons states that the investment policy statement is a long-term document that should be changed only if the outlook for equities versus bonds and other assets changes.
Carr's parents were successful business people who owned a series of small firms. Their success, however, did not come without challenges. Twice they had to liquidate businesses in which they were the primary shareholders. As a child, Carr became accustomed to the uncertainties of the entrepreneurial world. When she graduated from college, her parents provided her with the funds to purchase Appleton Professional Services. Appleton was a small firm at that point, but Can-has grown it into one of the larger firms in its industry, even though the professional services industry is cyclical and is susceptible to economic recessions. Appleton went public eight years ago and Carr retained a majority shareholder position when it did. Over time she has sold some of the stock but still has a controlling position in the firm.
Despite the business difficulties Carr's parents experienced, they were able to amass a sizeable fortune in their later years. Including her inheritance and holdings in Appleton stock, Carr has a portfolio with a current value of $6,000,000, most of which is invested in Appleton and other domestic and international equities. Carr has instructed Houlis and Timmons to grow her portfolio over time, focusing on capital appreciation and achieving long-term return goals. She would like to leave her children a sizeable inheritance.
Carr is single with two children. Her oldest child, Mark, is 25 years old and financially independent. Her youngest son, John, is a junior in college at a prestigious liberal arts college in New England. The tuition payment for his last year of college of approximately $40,000 is due at the end of this year. She has no mortgage on her house. Carr is an avid bird watcher and gifts $50,000 a year to a local environmental group. She is concerned with the destruction of bird habitat, so she does not want to invest in highly-polluting industries or firms that are involved in real estate development.
When she retires, Carr will receive a lump-sum, after-tax distribution of approximately $500,000 from her firm. She will also begin collecting an annual pension payment equal to her current salary. The pension payment is indexed to inflation. She will be covered under Appleton's health insurance plan in retirement. Carr spends $ 170,000 a year on vacations and living expenses, which is about equal to her current salary at Appleton.
Houlis estimates that Carr is taxed at an effective marginal rate of 30% on capital gains and income. Houlis estimates an inflation rate of 3% for the rest of Carr's life expectancy, which he projects at 20 years or more, given her good health.
With regard to generating adequate liquidity for Carr's portfolio, Timmons states that she need not invest entirely in income-generating assets. Instead, Carr can generate income from stock dividends, bond coupons, and the sale of assets. By being willing to generate income through the sale of assets, Carr would be able to broaden the types of securities available to her for investment. Timmons states that the problem with most assets that produce income (e.g., dividend paying stocks) is that their expected return is usually lower. He states that the advantage of his approach is that Carr could pursue higher return assets, such as small company stocks.
Timmons' approach to generating liquidity can be best characterized as a:
Under a total return approach, the investor can generate income through the sale of assets, bond coupons, and stock dividends. This allows the investor to generate liquidity using non-income producing assets that may have higher returns. (Study Session 18, LOS 68.c)
Stanley Bostwick, CFA, is a business services industry analyst with Mortonworld Financial. Currently, his attention is focused on the 2008 financial statements of Global Oilfield Supply, particularly the footnote disclosures related to the company's employee benefit plans. Bostwick would like to adjust the financial statements to reflect the actual economic status of the pension plans and analyze the effect on the reported results of changes in assumptions the company used to estimate the projected benefit obligation (PBO) and net pension cost. But first, Bostwick must familiarize himself with the differences in the accounting for defined contribution and defined benefit pension plans.
Global Oilfield's financial statements are prepared in accordance with International Financial Reporting Standards (IFRS). Excerpts from the company's annual report are shown in the following exhibits.
What was the most likely cause of the actuarial gain reported in the reconciliation of the projected benefit obligation for the year ended 2008?
At rhe end of 2008, Global Oilfield reporred a net pension asset of 7,222 in accordance with IFRS. Under SFAS No. 158, Global Oilfields funded status of 2,524 should be reported on the balance sheet. Thus, it is necessary to reduce the net pension asset by 4,698 (7,222 as reported - 2,524 funded status). In order for the accounting equation to balance, it is also necessary to reduce equity by 4,698. (Study Session 6, LOS22.d)
Charles Mabry manages a portfolio of equity investments heavily concentrated in the biotech industry. He just returned from an annual meeting among leading biotech analysts in San Francisco. Mabry and other industry experts agree that the latest industry volatility is a result of questionable product safety testing methodologies. While no firms in the industry have escaped the public attention brought on by the questionable safety testing, one company in particular is expected to receive further attention---Biological Instruments Corporation (BIC), one of several long biotech positions in Mabry's portfolio. Several regulatory agencies as well as public interest groups have heavily criticized the rigor of BIC's product safety testing.
In an effort to manage the risk associated with BIC, Mabry has decided to allocate a portion of his portfolio to options on BIC's common stock. After surveying the derivatives market, Mabry has identified the following European options on BIC common stock:
Mabry wants to hedge the large BIC equity position in his portfolio, which closed yesterday (June 1) at $42 per share. Since Mabry is relatively inexperienced with utilizing derivatives in his portfolios, Mabry enlists the help of an analyst from another firm, James Grimell.
Mabry and Grimell arrange a meeting in Boston where Mabry discusses his expectations regarding the future returns of BIC's equity. Mabry expects BIC equity to make a recovery from the intense market scrutiny but wants to provide his portfolio with a hedge in case BIC has a negative surprise. Grimell makes the following suggestion:
"If you want to avoid selling the BIC position and are willing to earn only the risk-free rate of return, you should sell calls and buy puts on BIC stock with the same market premium. Alternatively, you could buy put options to manage the risk of your portfolio. I recommend waiting until the vega on the options rises, making them less attractive and cheaper to purchase."
If the gamma of Put E is equal to 0.081, which of the following correctly interprets the option's gamma?
An option's gamma measures the change in the delta for a change in the price of the underlying asset. The gamma of an option is highest when an option is at-the-money since the probability of moving in or out of the money is high. Put E is close to being at-the-money and because it has a gamma of greater than zero, the sensitivity of Put Es price to changes in BlC's stock price (i.e., the delta) is likely to change. The higher the gamma, the greater the change in delta given a change in stock price. (Study Session 17, LOS 60. f)
