SECTION A

Multiple Choice

This section is worth SIXTY (60) marks, THREE (3) marks for every question.

IMPORTANT:

You should write the question number and your chosen response in your exam

answer booklet. You must only select ONE (1) answer for each question. Multiple answers will not be marked.

Each question is worth THREE (3) marks. Marks are not deducted for incorrect answers.

1.  The following is true of a long/short hedge fund strategy:

A.  It can be based on either fundamental, technical or statistical analysis

B.  Managers of this strategy often have to trim long positions and add to short positions after a downward move in the market

C.  Managers of this strategy seek to minimize the portfolio’s gross exposure D.  It is a strategy that seeks to maintain a beta close to zero

2.  In an equity market neutral strategy:

A. The manager goes long on high beta names, and goes short on low beta names

B. The manager aims to construct a portfolio with a beta-adjusted net exposure of zero.

C. The manager is only interested in high alpha names

D. The strategy eliminates geographic or sector risk

3.  A dedicated short bias strategy:

A.  Has a Sharpe ratio that is considered average

B.  Has about as many positive return months as negative return months

C.  Has modest monthly returns but an attractive risk-adjusted performance

D.  Features higher volatility in monthly returns as compared to other strategies

4.  Companies Cool Health and Nature Juice announce the acquisition of

Nature Juice by Cool Health before the market opens. Cool Health will pay  three (3) of its own shares for every two (2) shares of Nature Juice. On that day, Nature Juice’s shares trade up to $72.5 and Cool Health’s shares

decline to $49 from the previous day’s closes. A risk or merger arbitrageur should then:

A.  Long Cool Health and short Nature Juice in equal share numbers

B.  Short Cool Health and long Nature Juice in equal share numbers

C.  Short 1.5 shares of Cool Health for every long share of Nature Juice D.  Long 1.5 shares of Cool Health for every short share of Nature Juice

5.  A trade consists of a long delta-hedged call option. The following is true about this trade:

A. The trade requires rebalancing to maintain the delta hedge

B. The two legs of the trade are: short N shares and long delta times N options, divided by 100

C. The trade’s P&L is never negative

D. The delta hedge of the trade mitigates the time decay of the trade

6.  All the following are tenets of the Dow Theory, except one – identify which one:

A.  Day-to-day market fluctuations are indications of the waves around the primary trend

B.  Market trends have three phases and are confirmed by volume C. The stock market discounts all news

D.  Stock market averages must confirm each other

7.  All the following are types of poison pill defence strategy, except one - identify which one:

A.  Preferred stock plan

B.  Flip-over rights plan

C.  Pac-Man plan

D.  Back-end rights plan

8.  A breakeven inflation trade:

A.  Is a trade entered when the trader expects inflation to rise

B.  Is a trade entered when the trader expects inflation to fall

C.  Is an example of an intra-curve arbitrage trade

D.  Is a bet on the trader’s view on the market’s expectation of inflation

9.  A yield curve butterfly trade:

A.  Is entered when the manager believes a yield curve is going to steepen or flatten

B.  Is applicable to a situation where a part of the yield curve is not smooth

C.  Involves going long one bond and shorting another of a different maturity issued by the same sovereign issuer

D.  Is an example of an inter-curve arbitrage trade

10.A long position in a TED spread trade:

A.  Is attractive when credit conditions are improving

B.  Is normally profitable when swap rates are falling

C.  Is a bet on widening spread between the 3-month T-bill rate and the 3-month LIBOR

D.  Is a bet on narrowing spread between the 3-month T-bill rate and the 3-month LIBOR

11.Contrary indicators include all the following except:

A.  Put call equity ratio

B.  Fear index (VIX)

C.  Short interest ratio

D.  Index support and resistance levels

12.All the following is true of the convexity of a convertible bond except:

A.  It is higher for an in-the-money than for a balanced bond

B.  It is positive for an at-the-money bond

C.  It is negative when the price of the bond has fallen below the bond floor D. When positive, it makes the delta hedge profitable (buy low, sell high)

13.You buy one call option struck at $45, short two call options struck at $50, and buy one call option struck at $55. All options are on the same stock

that is currently traded at $50 and have the same maturity. This trade, known as a long butterfly, is:

A.  Bullish, i.e. benefits from the stock price rising

B.  Bearish, i.e. benefits from the stock price falling

C. A bet on low volatility, i.e. that the stock won’t move much

D. A bet on high volatility, i.e. that the stock will move a great deal

14.Forced conversion of a convertible bond occurs when:

A. The convertible bond is systematically redeemed for shares at maturity

B. The issuer tries to pre-empt the investors’ attempt at exercising the put option

C. The issuer calls the bond, forcing investors to convert rather than have the bond called away

D. The convertible bond has no call protection feature

15.Capital structure arbitrage does not entail:

A. The use of leverage

B. The use of bank debt

C.  Going long a bond and short the issuer’s credit default swap

D. Taking advantage of price disparities or misalignments between two securities of the same issuer

16.There are different ways for a hedge fund manager to trade volatility (as opposed to directional moves). Those do not include:

A. Shorting options on the VIX futures

B.  Buying an at-the-money call on the S&P 500 and simultaneously shorting an at-the-money put option on that index

C. Shorting a straddle, and rebalancing to keep the position delta-neutral    D.  Going long a strangle and rebalancing to keep the position delta-neutral

17.In relation to the distressed securities strategy:

A. The J-curve aspect implies that a manager should only deploy capital at the trough of the credit cycle

B.  In a liquidation bankruptcy, shareholders are wiped out but bondholders get paid in full

C. Active non-control investors are considered insiders

D.  Debtor-in-possession investing is considered safe because if consists of buying existing senior debt

18.Activist hedge fund managers aim to create value through different strategies. Those do not include:

A.  Debt restructuring

B.  Disposal of non-core assets

C. Spin-off of business units

D.  Distribution of cash flow to shareholders through share buybacks or a special dividend

19.The following is true of global macro hedge fund managers, except:

A. They may be discretionary or systematic

B. They may use a top down or a bottom up approach

C. They anticipate trends rather than follow them

D. Their trades may include relative value trades

20.Specials risks related to the ADR/GDR arbitrage strategy include all the following, except:

A.  Currency risk, as the ADR/GDR is likely denominated in a currency that is different from that of the foreign company

B. Trading time and trading zones (especially when they do not overlap)

C.  Liquidity as ADRs and GDRs are often illiquid

D. That each ADR/GDR share may represent more than one share of the foreign company

SECTION B

This section consists of TWO (2) compulsory questions. Candidates should attempt ALL parts of the question.  This section is worth ONE HUNDRED AND FORTY

(140) marks.

QUESTION 1 [Total 70 marks] This question is compulsory.

Scenario/context

As a portfolio manager at Highrock Capital, you manage two equity-focused funds: a newly created long/short fund and another risk arbitrage fund

Parts I and II below are independent of each other, although each part relates to the two hedge funds managed by Highrock Capital referred to immediately above.

Part I [Total 45 marks]

This part relates to the long/short fund.

You are looking to build a long/short portfolio using two stocks, A and B. Information about the two stocks is provided in the table immediately below:

*200dma = 200 day moving average

You have $5,000,000 cash in your portfolio. You decide to go long 40,000 shares of A and short 15,000 shares of B. The two positions are unrelated, and at any time,

you can stay in one position while exiting the other.

Tasks

1.  [Total 20 marks]

Required

a)  Calculate the i) net, ii) gross and iii) beta-adjusted exposure of your newly constructed portfolio. Show your detailed workings. [8 marks]

b)  Calculate the initial margin requirement to initiate the two positions. Show your detailed workings. [6 marks]

c)  If you decide to enter stops on each of the two positions at its respective

200dma, calculate the percentage of the portfolio that the largest theoretical dollar loss value represents. Show your detailed workings. [6 marks]

2.  [Total 10 marks]

You decide that your profit target corresponds to a price of $60 for stock A and a price of $80 for stock B.

Required

a)  Describe the order you would enter to have the market take you out at these target prices. [4 marks]

b)  If you are lucky to get out of both positions at these prices, ignoring

commissions, and assuming no other trades, what would the balance of your portfolio be after your exit? Show your detailed workings. [6 marks]

TURN-OVER

3.  [Total 15 marks]

In relation to using stock options in portfolio position management, and assuming both stocks A and B are optionable:

Required

a)  Describe how you can accomplish your objectives in Task 2, Part b) immediately above using stock options. Justify your answer. [10 marks]

b)  Suppose you identify two additional stocks C and D, both optionable. Stock C  is a potential short if it rises to a certain level, and Stock D is a potential long if it falls to a certain level. Briefly explain how you may use options to initiate

your short (in Stock C) and long position (in Stock D). Justify your answer. [5 marks]

Part II [Total 25 marks]

This part relates to the risk arbitrage fund.

Tasks

4.  [Total 10 marks]

You are currently flat (no positions) and have $200 million cash in your portfolio.  You want to take a position in a cash M&A deal that was just announced where   company Micro Lattice is being bought by Flannery Semi for a cash value of $52 a share. The shares of Micro Lattice have already rallied to $50.

Required

a)  Clearly describe the trade you would enter as a risk arbitrageur and explain why the share price of Micro Lattice is lower than $52 post-announcement. [5 marks]

b)  If you believe the odds of the deal closing are 90%, and that if the deal does not go through, the shares of Micro Lattice would fall back to $45, calculate

Benjamin Graham’s Indicated Annual Return on the deal if the holding period is expected to be nine months. Show your detailed workings. [5 marks]

5.  [Total 15 marks]

A stock swap merger deal is announced whereby Fairbanks, Inc., the buyer, will swap one of its shares for each two (2) shares of Tamarind Seed, the target.

After the announcement, the share price of Fairbanks, Inc. settles at $128 and Tamarind Seed stock closes at $62.50.

Required

a)  Clearly describe the trade you would enter as a risk arbitrageur. [5 marks]

b)  Suppose a while after you entered the position in Part a) immediately above, and because the stock price of Fairbanks, Inc. had been falling, a collar is

added to the stock swap, so that the deal terms are modified as depicted in

the figure below. Describe the steps you would need to take given your trade  in Part a) immediately above, after the announcement and over the remaining life of the trade. [10 marks]

QUESTION 2 [Total 70 marks] This question is compulsory.

Scenario/context

You are a portfolio manager at Altimus Partners, where you manage a multi-strategy fund. Within this fund, you capitalize on convertible bond arbitrage and on fixed

income arbitrage ideas, among others.

Parts I and II below are independent of each other, although each part relates to the multi-strategy fund managed by Altimus Partners referred to immediately above.

Part I [Total 40 marks]

This part relates to convertible bond arbitrage.

Software maker Work Now Corp is looking to raise money, and their investment bankers offered them two alternatives:

Alternative A: To issue a 3-year regular bond at par ($100), that pays an annual coupon of 5%

Alternative B: To issue a 3-year convertible bond at par ($100), that pays an

annual coupon of 2%, convertible into eight (8) shares of the common

The share price of Work Now Corp is currently $10.

Tasks

1.  [Total 4 marks]

Required

If the 3-year treasury rate is 2%, calculate the issuer’s nominal credit spread. Show your detailed workings. [4 marks]

2.  [Total 12 marks]

Required

Calculate i) the value and ii) the modified duration of the straight bond embedded in the convertible bond (Alternative B). Show your detailed workings. [12 marks]

3.  [Total 8 marks]

Required

Calculate the value and the strike of the option (per share) that is embedded in the convertible bond. Show your detailed workings. [8 marks]

4.  [Total 8 marks]

Required

Calculate i) the investment premium and ii) the premium to parity of the convertible bond. Show your detailed workings. [8 marks]

5.  [Total 4 marks]

Required

If you wish to establish a delta-neutral, gamma-rich trade using this convertible

bond, identify the legs of the trade you would need to enter, assuming non-equity risks are not hedged. [4 marks]

6.  [Total 4 marks]

Required

If you wish to hedge interest rate risk using a zero-coupon treasury note, clearly define the trade and make sure you specify the maturity of the zero-coupon

treasury. You need not specify the number of treasury notes used in the trade. [4 marks]

Part II [Total 30 marks]

This part relates to fixed income arbitrage.

Your analysts bring forth the following three (3) situations:

Situation A: Upon examination of the recent issues of 30-year US treasuries, you identify the following two 30-year bonds:

•    Bond A issued January 15, 2022, paying a coupon of 2.25%, yielding 2.35 %

•    Bond B issued March 15, 2022 (most recent issue), paying a coupon of 2.375%, yielding 2.40%

Potential opportunity: issuance-driven arbitrage.

Situation B: The balance sheet of Pyke Foods, a gluten-free food company, reveals the following outstanding debt:

•   Straight debt paying 5.25% coupon, maturing on November 15, 2032, yielding 4.125%

•   Callable bonds paying 4.25% coupon, maturing on November 15, 2032, yielding 4.00%

•   Convertible debt, paying 4.50% coupon, maturing on November 15, 2032, yielding 4.125%

Potential opportunity: capital structure arbitrage.

Situation C: The capital structures of two corporate issuers, Packard Coffee, a B-

rated owner of global coffee houses and Hammer Electronics, a BB-rated electronics retailer, the following two issues were identified:

•   Packard Coffee has a five-year US dollar-denominated straight debt yielding 3.56%

•   Hammer Electronics has a five-year US dollar denominated convertible debt yielding 3.42%

Potential opportunity: long/short credit trade.