Assignment 2 for MGT 647 Hedge Funds

By Zhiwu Chen

1.One of the popular equity strategies employed by hedge funds is called pairs trading.

  1. Explain how this strategy works and state key assumptions on which it is based.
  2. What measure would you use to select securities for pairs trading? Show how you would compute this measure.
  3. Now that the stocks have been selected, describe in detail how you would execute the trading strategy.
  4. What risks do you see in implementing this strategy? What steps can you take to mitigate these risks?

2.What does empirical evidence suggest about survivorship rates of new hedge funds over the short and medium term? Be specific.

  1. Describe the main challenges faced by new hedge funds that may have contributed to this low survival rate.
  2. Is there anything in the structure of hedge fund compensation that may have increased the closing rate of hedge funds? Provide a numerical example to illustrate your point.

3.Hedge funds have traditionally focused on delivering high absolute returns independent of market conditions. However, many hedge funds today have positive market betas. Explain why hedge funds tend to exhibitsome market-directional biases. What categories of funds have the highest betas? Near-zero betas? Negative betas?

4.If you are tasked with selecting a hedge fund for investment purposes, what factors would play a key role in your analysis? Why?

  1. What caveats and biases do you want to keep in mind in using the past track record for fund selection?
  2. What does empirical evidence suggest about persistence in fund performance?

5.In “What is the intrinsic value of the Dow?” Lee, Myers and Swaminathan (1997) studies the performance of a residual-income stock valuation model, which has been well received in the investment management circle. After reading this paper, please answer the following questions:

  1. Which way of applying this model gives the best investment performance? That is, do you want to combine it with other factors to yield the best performance? What factors? How should you combine it with these other factors? Explain why such a combined strategy will work the best?
  2. List at least two market scenarios in which the above combined strategy will not work. Discuss the risk of such a strategy.