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Book Exercises

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FOR

ExercisesforEfficientlyInefficient

Contents

Preface to the Exercises

PART I: ACTIVE INVESTMENT

1 Understanding Hedge Funds and Other Smart Money

2 Evaluating Trading Strategies: Performance Measures

3 Finding and Backtesting Strategies: Profiting in Efficiently Inefficient Markets

4 Portfolio Construction and Risk Management

5 Trading and Financing a Strategy: Market and Funding Liquidity

PART II: EQUITY STRATEGIES

6 Introduction to Equity Valuation and Investing

7 Discretionary Equity Investing

8 Dedicated Short Bias

9 Quantitative Equity Investing

PART III: ASSET ALLOCATION AND MACRO STRATEGIES

10 Introduction to Asset Allocation:The Returns to the Major Asset Classes

11 Global Macro Investing

12 Managed Futures: Trend-Following Investing

PART IV: ARBITRAGE STRATEGIES

13 Introduction to Arbitrage Pricing and Trading

14 Fixed-Income Arbitrage

15 Convertible Bond Arbitrage

16 Event-Driven Investments

LasseHejePedersen

ExercisesforEfficientlyInefficient

This compendium of exercises is meant to be used with the book on Efficiently Inefficient: How Smart

Money Invests and Market Prices Are Determined, by Lasse Heje Pedersen, Princeton University Press,

2015.Thecompendiumcontainsexercisesforeachchapterinthebook,excepttheintroductorychapters

(i.e.,chapters6,10,13).IamgratefulforfeedbackfromstudentsandcolleaguesatNewYorkUniversity

SternSchoolofBusinessandCopenhagenBusinessSchoolandespeciallytoNiklasKohlfortakingthelead

ondevelopingseveraloftheexercises(7.17.6,9.89.12,16.116.8).

Several of the exercises require additional material, which is distributed separately. For example, several

problems rely on data to be processed in a spreadsheet such as Excel, while other problems rely on

financialstatementssuchasmergeroffers.Professorswhousethebookcancontactmeforthismaterial.

LasseHejePedersen

ExercisesforEfficientlyInefficient

1.1.

Selectionvs.Timing.Explainthemeaningsofmarkettimingandsecurityselection,highlightingtheir

similaritiesanddifferences.

1.2. Biases.Youworkasananalystatadiscretionaryequityhedgefund.Youhavetheinvestmentthesis

that it pays to buy the best in breed, that is, stocks that are the industry leaders. You find the

companies that are currently the largest in each industry and track their performance the last 5

years.Thisportfoliosignificantlyoutperformsthemarketoverthetimeperiod.

Arethereanyissueswiththisanalysis?Shouldthehedgefundbuythisportfolioand,ifso,whatare

therisks?

1.3. Hedgefundsvs.mutualfunds.Considerapassivemutualfund,anactivemutualfund,andahedge

fund.Themutualfundsclaimtodeliverthefollowinggrossreturns:

passive fund before fees

active fund before fees

2.20%

stock index

stock index

Thepassivefundchargesanannualfeeof0.10%.Theactivemutualfundchargesafeeof1.20%and

seekstobeatthesamestockmarketindexbyabout1%peryearafterfees.Theactivemutualfund

hasabetaof1andhasatrackingerrorvolatilityof var

3.5%.

Thehedgefundusesthesamestrategyastheactivemutualfundtoidentifygoodandbadstocks,

but implements the strategy as a longshort hedge fund, applying 4 times leverage. The riskfree

interestrateis

1%andthefinancingspreadiszero(meaningthatborrowingandlendingrates

areequal).Therefore,thehedgefundsreturnbeforefeesis

hedge fund before fees

1%

stock index

a. Whatisthehedgefundsvolatility?

b. Whatisthehedgefundsbeta?

c. Whatisthehedgefundsalphabeforefees(basedonthemutualfundsalphaestimate)?

d. Suppose that an investor has $40 invested in the active fund and $60 in cash (measured in

thousands,say).Whatinvestmentsinthepassivefund,thehedgefund,andcash(i.e.,therisk

free asset) would yield the same market exposure, same alpha, same volatility, and same

exposure to ? As a result, what is the fair management fee for the hedge fund in the sense

thatitwouldmaketheinvestorindifferentbetweenthetwoallocations(assumethatthehedge

fundchargesazeroperformancefee)?

LasseHejePedersen

ExercisesforEfficientlyInefficient

e. Ifthehedgefundchargesamanagementfeeof2%,whatperformancefeemakestheexpected

feethesameasabove?Ignorehighwatermarksandignorethefactthatreturnscanbenegative,

but recall that performance fees are charged as a percentage of the (excess) return after

management fees. Specifically, assume the performance fee is a fraction of the hedge funds

outperformanceabovetheriskfreeinterestrate.

f. Comment on whether it is clear that hedge funds that charge 2and20 fees are expensive

relative to typical mutual funds. More broadly, what should determine fees for active

management?

1.4. StylesandStrategies

a. FillouttheanswersforeachHFstyleinthetablebelow.(Whilemostproblemsetquestionswill

testthatyoucanapplywhatyoulearnedinclass,someoftheinformationinthetablewasnot

coveredinclass.Theideaisthatyoushouldstartthinkingcarefullyabouteachstyle,discussingit

withyourclassmates,friendsintheindustry,andanswertothebestofyourknowledge.)

Longshort

equity

Short

biased

Quant

equity

Global

macro

Man.

futures

Fixed

income

arb

Convert

bond

arb

Event

driven

arb

Left tail (1=often positive return, but sometimes blows up, 5=positive skewness)

b. Explainthemainideabehindthethreeequitystrategiesandhowtheyaredifferent.Also,discuss

whythesestrategiesmightprofitoverthelongtermandwhytheymightnot.

LasseHejePedersen

ExercisesforEfficientlyInefficient

c. Discusshowglobalmacroinvestorsandmanagedfuturestraderstradeandthepotentialdrivers

oftheirreturns.Explainthedistinctionbetweentopdownvs.bottomupinvesting.

d. Discussthecommonideabehindarbitragestrategies.Whatarethepotentialrisksoftradingon

anapparentarbitrageopportunity?Whatarethedifferencesacrossthethreetypesofarbitrage

strategies?

LasseHejePedersen

ExercisesforEfficientlyInefficient

For each of the following exercises, consider the hedge fund index data provided and evaluate the

performance(abstractingherefromthepotentialbiasesinthedata).

2.1.

Performance measures. For each hedge fund style, calculate and interpret the following

performancemeasures

a. Annualizedarithmeticaveragereturn

b. Annualizedgeometricaveragereturn

c. Annualizedvolatility

d. AnnualizedSharperatio

e. Marketbeta

f. Annualizedalphatothemarket

g. AnnualizedInformationratio

h. Maximumdrawdown

i. Skewness

j. Excesskurtosis

2.2. Cumulativereturnanddrawdown.MakethefollowingplotsforGlobalMacroHedgeFundindex

a. Thecumulativereturn

b. Thedrawdown

2.3. Factormodels.ForEquityLong/Short,runtworegressions:(i)aunivariateregressionofthehedge

fundindexsexcessreturnonmarketexcessreturn;and(ii)amultivariateregressiononthemarket,

size,value,andmomentumfactors.

a. Interprettheloadingsonthedifferentfactors.Whatdowelearnoftheinvestmentstyle?

b. Compare the multivariate alpha with the alpha from the univariate market regression. Discuss

thedifferenceininterpretationbetweentheunivariatevs.multivariatealphas.

2.4. Illiquidityandstaleprices.ForConvertibleBondArbitrage,compare:

a. Thebetainamonthlyunivariateregressiononthemarket

b. The beta in a univariate regression on the market using 3month returns. (The regression

coefficientscanstillbeestimatedbyrunningtheregressionmonthly,i.e.,withoverlappingdata,

but,inthiscase,tstatisticsneedtobeadjustedifyouweretoconsiderthese)

c. Thesumofbetasinamonthlyregressiononthemarket,the1monthlaggedmarket,andthe2

monthlaggedmarket

LasseHejePedersen

ExercisesforEfficientlyInefficient

Inefficient Markets

Examplesofbacktestsoftradingstrategiesarecontainedinmanyoftheexercisesinthechapterstocome

(e.g., 9.19.12, 11.111.7, 12.112.4, 16.1116.13). Hence, exercises with techniques for backtests are not

includedhere,butinsteadweconsidersomeconceptualexercises.

3.1.

3.2.

3.3.

Information collection. Discuss how active investors can be compensated for their information

collection.Giveexamplesofhowyoucouldtrytocollectinformationaboutspecificfirmsandhow

youcouldtradeonthis.

Adverse selection and IPOs. Some initial public offerings (IPOs) are oversubscribed, meaning that

more investors want to be allocated shares than what is for sale. Other IPOs are undersubscribed,

meaningthatthefirmanditsunderwriterstruggletoselltheshares.

InwhichcasedoyouexpectthatthereturnaftertheIPOisthehighest?

Suppose that you bid for an allocation for IPO shares without knowing whether the offering is

oversubscribedorundersubscribed.Inwhichcaseareyoumorelikelytobeallocatedthenumber

ofsharesthatyouaskforandhowdoesthisaffectyourexpectedreturn?

HistoricallyfirstdayIPOreturnshavebeenpositiveonaverage,i.e.,aninvestorwhoputanequal

amount in all IPOs and sold at close on the first trading day made abnormal profits. Does this

implyabnormalprofitsfromparticipatinginIPOs?

Marketandfundingliquidity.Supposethatyouareconsideringbuyingahome,whichyouexpectto

liveinforabout5years,and,giventhemobileworkforceintheregion,youalsoexpectfuturebuyers

ofthepropertytomoverelativelyfrequently.Youfindahouseandanapartmentwhichareequally

attractive and consider which one to buy. (The house and apartment are equally attractive in the

sense,forinstance,thatsomethingsimilarcouldberentedatthesamerates.)

a. Marketliquidity.Supposethatthehouseismuchmoreexpensivetotradeintermsoffeestothe

realestateagent,alongerexpectedwaitingtimewhenthepropertyisonthemarket(andyou

may already have moved), and other costs. What would you pay more for, the house or the

apartment?Explainyouranswer.

b. Funding liquidity. Suppose that the house and apartment are equally easy and costly to trade

(have equal market liquidity), but the bank will give you (and future potential buyers) a larger

loanfortheapartment.Wouldthatleadyoutobewillingtopaymorefortheapartmentthan

thehouse?WhatwouldModiglianiMillersayandwhy?Whymightyouranswerbedifferent?

c. Liquidityspiralsandliquidityrisk.

If the house can be expected to be more difficult to trade than the apartment, which

propertydoyouthinkthebankwillbemorewillingtoprovidealargeloanfor?

LasseHejePedersen

ExercisesforEfficientlyInefficient

3.4.

Iftheapartmentismoreeasytoborrowagainst,whichpropertydoyouthinkwillbemore

easytosell?

Ifsuddenlytherearemanymorepropertiesforsaleinthisareathanavailablebuyers,how

could the market and funding liquidity evolve? Might the market for houses evolve

differentlythanthemarketforapartments?

Howdoesthisliquidityriskaffectthepriceyouwanttopayforthehousevs.theapartment?

Howdoestheanswerchangeifyouexpecttoliveinthepropertyfor40years?

Demandpressure.Supposethatasignificantfractionofthepopulationofinvestorsneedstobuya

security, say a stock ABC, for reasons unrelated to the stocks fundamentals (its expected future

earningsanddividends).Forinstance,supposethatanimportantstockmarketindexsuddenlygivesa

largeweighttostockABC.

a. Whatwillhappentothestockpriceinaperfectlyefficientmarket?

b. Whatislikelytohappentothestockpriceinamarketwithlimitedarbitrage?

c. In an efficiently inefficient market, where the stock price moves (as discussed in 3.4), what is

likely to happen to the price of another stock that is highly correlated to stock ABC (but not

directlyaffectedbythedemandpressure)?

LasseHejePedersen

ExercisesforEfficientlyInefficient

Thefollowingexercisesarebasedonthehedgefundindexdataprovided.Theunderlyingdataisthesame

asthatusedintheexercisesforChapter2andtheseexercisescomplementeachother.

4.1.

4.2.

Portfoliooptimization.Supposethatyouwererunningafundofhedgefundsin2003andneededto

allocateyourcapitalbetweenthevarioushedgefundstyles.(Alternatively,youcouldbe runninga

multistrategy hedge fund and allocating capital across the various trading groups or running a

pension fund allocating capital to various hedge funds.) Compute the excess return of each of the

hedgefundindices.

a. Define portfolio weights above each column for each of the first 9 hedge fund styles (not

includingtheoverallindexcalledDJCSHedgeFundUSD)andchoosetheseportfolioweightsto

be equal (i.e., 1/9). Compute the excess return of the corresponding portfolio (as the

SUMPRODUCT of portfolio weights and excess returns of hedge funds). Finally, compute the

Sharperatioovertheearlysample19942003(thatyouwouldhavebeenawareofin2003),the

late sample 20042012 (the period over which your returns would be realized), and the full

sample.

b. Computeanotherweightedaverageofthese9hedgefundstyles,wheretheweightsarechosen

tomaximizetheSharperatioovertheearlysample(e.g.,usethesolverinExcel).Whatisthe

SRofthisportfoliooverthelatesample?Howdoestheanswercomparetoa.?Discusstheissues

withportfoliooptimizationandwhatyoumightdoaboutit.

Riskmanagementanddrawdowncontrol.

a. For each hedge fund style and each month, compute the annualized volatility as the realized

standardofexcessreturnsoverthepast12months.Forthefirstyear1993,usethevaluefrom

January 1994 (which is cheating, but it does not matter here). Plot the volatility over time for

fixedincomearbitrage.

b. Foreachhedgefundstyle,computethereturnoftheriskmanagedstrategy.Specifically,choose

aninvestmentxsuchthat

x3tMADDDDt

wheretisthecurrentannualizedvolatility,MADD=30%isthemaximumacceptabledrawdown,

andDDtisthecurrentdrawdownoftheriskmanagedstrategy.Specifically,if3tMADDDDt

thenyouarenotindrawdowncontrolmodeandyoucontinuewithafullinvestmentofx=1.

Otherwise,youenterdrawdowncontrolmodelissetx=(MADDDDt)/(3t).

LasseHejePedersen

10

ExercisesforEfficientlyInefficient

Inoneplot,showthedrawdownsofemergingmarketshedgefundswithandwithoutdrawdown

control.Inanotherplot,showthecumulativereturnofthesetwostrategies.

c. ComputetheSR,averagereturn,andmaximumdrawdownforthestrategy withoutdrawdown

control(asintheexercisesforChapter2,wherexisalways1)andthecorrespondingnumbers

fortheriskmanagedstrategies.Commentonthedifferences.

LasseHejePedersen

11

ExercisesforEfficientlyInefficient

Liquidity

Thefollowingsectionscontainexercisesrelatedtohowtradingisfunded(e.g.,8.1,15.4,16.13)andhow

transactioncostsaffecttheperformanceoftradingstrategies(e.g.,11.4).Thefollowingquestionsregarding

trade execution should be answered independently of each other and relate to the following limit order

book:

<Bids

Asks>

Topofthelimitorderbook

5.1.

5.2.

5.3.

5.4.

Shares

1900

1700

1200

400

300

1000

1100

1400

1500

2200

Price

34.56

34.54

34.53

34.52

34.51

34.49

34.48

34.47

34.46

34.45

Bidaskspread.Whatisthepostedbidaskspreadincentsandbasispointsofthemidprice?Ifyou

buy 100 shares with a market order and immediately (i.e., before any new orders arrive or any

existingordersarecancelled)sellthemwithamarketorder,thenwhatisyourP&L?

Limit order. A limit order to buy 150 shares at $34.50 arrives in the market. What happens? I.e.,

which transactions occur and what is the resulting bidask spread in cents? (In the rest of the

exercise,assumethatthisorderissubsequentlycancelled.)

Walking the book. A limit buy order for 2000 shares at $34.53 arrives. Document all transactions,

computethevolumeweightedaverageexecutionpriceofthetransaction,anddeterminethebidask

spreadafterthetransaction(s).

Marketimpactcurve.Computetheaverageexecutionpriceformarketorderstobuy,respectively,

10,1000,2000,3000,and4000shares.Plotthemarketimpactcurve,thatis,theexecutionpriceasa

functionofthesizeoftheorder.Discusstherelativeimportanceofthebidaskspreadvs.theslope

ofthemarketimpactcurveforsmallandlargetraders.Also,discusswhatmarketliquidityriskmeans

intermsofwhatcanhappentothelimitorderbookinthefuture.

LasseHejePedersen

12

ExercisesforEfficientlyInefficient

Assume that you are portfolio manager of a market neutral discretionary equity hedge fund with EUR 1

billioninNAV.YourmandateistomaximizethereturnmeasuredinEURwithavolatilityofatmost15%

annually.Youarepermittedtotakelongandshortpositionsinequities,equityindices,andcurrenciesas

wellasfuturesandderivativesonthese.Find16companiesthatyouconsidertakingpositionsin,oragree

inclassonashortlistofcompaniestobestudied.

Youcanfindalotofinformationoncompaniesontheinternet,e.g.,onthefirmshomepages,Wikipedia,

andinvestorsitessuchasfinance.yahoo.comandwww.4traders.com.

Valuationratios.Foreachofthesecompaniesfindorcalculatemarketcap(marketvalue),P/E,B/M,

anddividendyieldusingthemostrecentdataavailable.Findthedividendyieldforeachofthepast

fiveyears.

7.1

7.2

7.3

7.4

7.5

7.6

Expected nearterm dividends. For each company give your point estimate and 90% confidence

intervalforthedividendforthenextthreeyears.

Valuationmethods.Whichmethodsareparticularsuitableforcalculatingthefundamentalvalueof

eachofthecompanies?Arethereanymethodswhichareparticularunsuitableordifficulttoapply?

Arethereanyspecificissues,e.g.risksorupsidepotentials,whichshouldbetakenintoconsideration

inthevaluationofeachcompany.Thinkaboutandusetheterminologyofthecoursee.g.valuetrap,

sustainablegrowth,managementquality,triggers,activistinvestment,etc.

Expectedreturn.Whichreturndoyouexpectfromeachofthecompaniesoverthenext12months

and 36 months? Give point estimates and your 90% confidence intervals. Which return would you

requirefromaninvestmentineachofthecompanies?

Positions.Whichposition,intermsofEURinvested,wouldyoutakeineachofthecompanies.Why?

(Rememberthatyourhedgefundalsohaslongandshortpositionsinotherglobalequities.)

Portfolio construction. Assume you have decided to take a nonzero position in each of the

companies.Arethereanyotherpositionsyouwouldconsidertotaketohedgeunwantedrisksorto

complywithyourmandate?

LasseHejePedersen

13

ExercisesforEfficientlyInefficient

8.1.

Short selling and capital. Suppose that you are the manager of a dedicated short bias hedge fund

with an NAV of $100M. You sell short 10 stocks, with a short position of $20M for each of them.

Specifically, you borrow the shares through your broker and sell the shares. You must pass the

shortsellproceedsascashcollateralaswellasa20%additionalmarginrequirement.Thepositions

arehedgedbybuying8stocksof$20Meach.Yourbrokeralsofinancesthelongpositionsandalso

requiresa20%marginonthose.

a. Whatisthecurrentminimummarginrequirement?Correspondingly,whatisthecurrentlevelof

freecash?Whatisthecurrentbalancesheetforthehedgefund?

b. If the margin requirement for long and short positions changed to 30%, would the current

positionsremainsustainable?Ifnot,howmuchwouldtheyneedtobescaledback?

c. Supposethatmarginrequirementsremainat20%andoverthenextyear.Further,theoverall

stock market performs strongly, yielding a return of around 25% for major stock indices. The

shortpositionsincreaseinvalueby10%andthelongpositionsby25%.Theriskfreereturnis

4%,includingonyourbrokerageaccountandyourmarginloans(nofinancingspread).

WhatistheNAVattheendoftheyear?

What is the percentage return of the hedge fund (ignoring transaction costs and other

costs)?

Didthehedgefundperformwell?Specifically,howwhatwasthehedgefundsalphawith

respecttothemarket(assumingthatallstockshaveabetaof1)?

d. Supposeinsteadthatthestocksthatyoushortsellareonspecialsuchthattheshortproceeds

earnareturnof0%insteadof4%.(Theadditional20%margincashforshortpositionsearnthe

normalriskfreerate.)Underthisscenario,whatisthereturnovertheyear?

LasseHejePedersen

14

ExercisesforEfficientlyInefficient

8.2.

Shortsellingandvaluation.Twoinvestors,AandB,tradethestockTWTR.Eachinvestormaximizes

his expected future wealth subject to a penalty for risk (as discussed in Chapter 5). Investor As

optimalpositionmeasuredinamountsofmoney isgivenby

istheexpected

such that

excess return. The absolute risk aversion is decreasing in the investors wealth

1/

.Further,thecurrentdividendyieldandriskfreeratearezerosoinvestorAsexpected

,where

excessreturnisgivenby

year.Finally,

var

(

0ishisexpectationofthevalueofasharenext

.ThesameexpressionsholdforinvestorBwithtwoexceptions.

and, second, his expectation is that the stock will be worthless next year

1 and his position is

1 . The

supplyofsharesisgivenby .

a. Explainwhyequilibriumischaracterizedbytheconditionthat

andshowthattheequilibriumpricewithoutshortsaleconstraintsis(whereweassumethroughout

thatthenumeratorispositive).

b. IsinvestorAlongorshort?WhataboutinvestorB?

c. What is the equilibrium price if no investor is allowed to sell short? How does the answer

comparetotheequilibriumwithoutshortsaleconstraintsinquestiona.?

d. SupposethattheinvestorBfaceisallowedtosellshort,butthesizeofanyshortposition

0

islimitedbythefollowingmarginrequirement:

and a

parameter

0.Assumethatthismarginrequirementisbindingandsolvefortheequilibrium

price.Howdoesthepricedependonthemarginparameter ?

e. Howdoestheequilibriumpricewithmarginrequirementsind.dependontheinvestorswealth

and

?Specifically,whathappenstothepriceifoptimistsgetwealthierandpessimistsget

increasesand

decreases)?

poorer(

LasseHejePedersen

15

ExercisesfforEfficientlyyInefficient

f. Shortsqueezeeandliquidityspiral.Suupposethat agentstakepositionsassind.Immediatelyafterr

heirtrades(b

butbeforeanytimepassses),themarrginrequirem

mentunexpeectedlyincreases.

th

eprice?

Holdingageentswealthfixed,howddoestheincrreasedmarginrequiremeentaffectthe

Howdoesthepricechangeaffectthheagentswealthgiventtheirinitialppositions?

nwealthaffeecttheprice??

Howdoesthechangein

dityspiral

Discusstheconceptsofshortsqueeezeandliquid

ouneednotsolveforthe

enewequilibbriumprice.))

(Yo

price

m

margin

wealtth

LassseHejePed

dersen

16

6

ExercisesforEfficientlyInefficient

In problems 9.19.7, you backtest an equity strategy called industry momentum. The idea is to buy

industriesontherise,andshortdecliningindustries.TheaccompanyingExcelspreadsheethasreturnson

30industryportfolios,theriskfreereturn,andthemarketreturn.1YoucandotheproblemsetusingExcel

oranyotherprogramofyourchoice.

9.1

Startingin1927/07,foreachindustryandeachmonth,computethe(arithmetic)averagereturnover

theprevious12monthforthatindustry(notincludingthemonthitself).Thenforeachmonth,rank

the industries based on their past average return (hint: Excel has a function called

RANK(cell,range,1)).Computeeachindustrysaveragerank(1=lowestpastaveragereturn,etc.).

Whichindustryhasthelowestaveragerankandwhichhasthehighest?

Whatistheaveragerankoftheselowestandhighestindustries?

PlotoftherankofAutosindustryovertime.

Arethetopindustriesstableormovingaroundalot?I.e.,isindustrymomentumalongtermbet

on a few industries or a very dynamic strategy? Do you expect high or low turnover from this

strategy?

Winner portfolio. Let the winner industries be the 15 industries with the highest past 12month

returns. For each month after 1927/07, compute the average return of the winner industries. I.e.,

compute the return on a portfolio of winner industries. (Hint: There are many ways of doing it. In

Excel,aneasywayistousethefunctionIFinsidethefunctionAVERAGE:`=AVERAGE(IF(rankrange

>=16,returnrange,)),butthenyoumusthitcontrolshiftentertoexecute(thisiscalledanarray

formula).Anotherwayistodothisintwosteps:(1)Foreachindustry,reportthereturnifitisatop

industryandablankotherwise,IF(rank>=16,return,).(2)Taketheaverageofthesenumbers.)

Whatistheaveragemonthlyreturnonthiswinnerportfolioinexcessoftheriskfreereturn

Whatisthestandarddeviationofitsmonthlyexcessreturns?

WhatisitsmonthlySharperatio?

WhatisitsannualizedSharperatio?

9.2

9.3

Loser portfolio. Compute the return of a portfolio of loser industries, the 15 industries with the

worstpastreturns.

Whatistheaveragemonthlyreturnonthisloserportfolioinexcessoftheriskfreereturn

Whatisthestandarddeviationofitsmonthlyexcessreturns?

WhatisitsmonthlySharperatio?

WhatisitsannualizedSharperatio?

WhatistheannualizedSharperatiooftheoverallmarketindex?

9.4

Longshortindmom.Computethereturnofaportfolioofthatgoeslong$1ofwinnerindustriesand

short$1ofloserindustrieseachmonth.Thisisalreadyanexcessreturn.(Tounderstandthis,note

LasseHejePedersen

17

ExercisesforEfficientlyInefficient

thatifyoufirstcomputethewinnersandlosersexcessreturnsoverRfandthensubtractonefrom

theother,thentheriskfreerateswill cancel.) Regressthismonthlyindmomexcessreturnonthe

excessreturnofthemarket.(InExcel,youcanusethefunctionLINEST.)

9.5

9.6

9.7

WhatisitsannualizedSharperatio?

Whatisthemarketbetaandthetstatisticofthemarketbeta?

Whatisthemonthlyalphaandthetstatisticofthealpha?

Whatistheannualizedalpha(12timesmonthlyalpha)?

Commentonthesenumbers

Cumulativereturn.Computethecumulativereturnof(a)thewinnerportfolio,(b)theloserportfolio,

(c)thelong/shortindmomportfolio,and(d)themarket.(Remembertousetotalreturns,notexcess

returns, i.e., add the risk free return to the returns that are excess returns.) Plot these cumulative

returnsonalogscale.

Indmomloss.Industrymomentumhadabiglossin3consecutivemonthsin2009.Whichmonths?

Howdidthemarketdothosemonths?Whatdoyouthinkhappened?

Extraquestion(notrequired).SupposeyoubuythetopNwinnerindustriesandshortselltheworst

N loser industries, where N is some number. Above we consider the top/bottom half, so we had

N=15,butthestrategymightworkbetterforasmallerN.AsmallerNconcentratestheportfoliois

more extreme winners/losers, which might perform better, at the expense of less diversification.

WhathasbeenthebestNhistorically?

LasseHejePedersen

18

ExercisesforEfficientlyInefficient

Inproblems9.89.12,youhavetoexplorethepotentialprofitsontradingtwinstocks.Theaccompanying

Excelsheetcontainthestockpriceandthereturnindexatcloseof16stocks,correspondingtotwoshare

classesforthefollowingeightcompanies:A.P.MllerMrsk(Denmark),Industrivrden,Investor,Svenska

Handelsbanken and Volvo (Sweden), Volkswagen (Germany), Hyundai Motors (Korea) and Store Enso

(Finland).Allthesesharespaydividendsandyoucanassumethattwostocksinthesamepairpaythesame

dividend2onthesameday.

Stockpriceshavebeenadjustedforsplits,butnotfordividendsandothercorporateactions,whereasyou

canthinkofthereturnindexasastockpriceadjustedfordividendsandothercorporateactions(i.e.with

reinvesteddividendsetc.).

9.8 Pair correlation. First calculate the daily returns for each stock. Then calculate the correlation

betweendailyreturnsforthestocksintheeachpair.Makeabarplotofthecorrelations.

9.9 Pair comovement. Adjust all the return indices to 100 on the September 8, 2004. Plot the return

indicesforstocksinthesamepairtogetherandassesswhetheryouthinktheremaybeanarbitrage

strategy.Doyouseeanyunusualorsurprisingpatterns?

9.10 Spreads.Calculateandplottherelativespreadbetweenthestockpricesinthesamepair(i.e.,one

pricedividedbytheotherminus1)andassesswhetheryouthinktheremaybeanarbitragestrategy.

Doyouseeanyunusualorsurprisingpatterns?

9.11 Pairstradingbasedonabsoluteprices.Implementthefollowingstrategy:Atcloseonthelastdayof

each year, take a selffinancing position in each pair where you go long the stock with the lowest

priceandshorttheonewiththehighestprice.Theinitialvalueofeachlongpositionshouldbe$1

and,similarly,theinitialvalueofeachshortpositionshouldbe$1.Holdthepositionforayearand

rebalanceagainatcloseonthelastdayoftheyear.

a. Whymightthisstrategybeprofitable?Hint:Whathappensifthesharepriceisunchangedfrom

rebalancingtorebalancing?

b. Calculatetheyearlyexcessreturnperpair,theSR,andtestwhethertheyearlyexcessreturns

are statistically significant from zero (under the assumption that returns are independent and

normallydistributed).

c. Sameasquestionbforaportfolioconsistingofalleightpairs,equallyweighted.

d. Whichcostswouldyouincurifyouweretoimplementthisstrategyinpractice?

9.12 Pairstradingbasedonunusualpricespreads:meanreversion.Considerthefollowingalternative

strategy:Putonatradewheneverthespread(relativepricedifference)betweenthestocksinapair

isunusualrelativetotherecenthistoricalvalueofthisspread.Specifically,atsuchtimes,golong

$1ofthestockthatiscurrentlycheap(relativetowhatitusuallyis)andshortsell$1ofthestock

whichiscurrentlyexpensive.Eachday,eitherrebalancebackto$1longand$1shortor,whenthe

For Volkswagen and Hyundai Motors there is a small difference in dividends but we can safely ignore this in this

problem set.

LasseHejePedersen

19

ExercisesforEfficientlyInefficient

spread again is usual, close the position. The strategy can be implemented in many ways, for

instance,youcandothefollowingforeachpaironeachday:

Calculatetherelativepricespread

shareclassesondayt.

Calculate the rolling 20day average spread,

volatility,

,where

and

arethepricesofeachofthe

/20, and the 20day spread

/19.

Calculatethezscoreofthespread,

Openapositionwhentheabsolutevalueofthezscoreexceeds2,goinglongthestockthatis

usuallycheapandshorttheotherone(i.e.,signthepositionsbasedonthesignofthezscore).

Closethepositionwhenthesignofthezscorereverses.

Calculatethedailyreturn(zeroondayswherenopositionisopen).

Calculate the daily return of a strategy that equal weights all the pairs (including pairs that

havenopositionon).

a. Whymightthisstrategybeprofitable?

b. Assumeyoucanobserveclosingpricesandtradeonthesepricessameday,i.e.if exceeds2

ondayt,apositionisopenedatcloseondaytandprofitsarerecordedfromdayt+1.Plotthe

cumulatedprofitsfromthestrategyforeachpairandfortheequalweightedportfolio.Whatis

theannualizedSRoftheportfolio?

c. Alternatively,assumingthatyouhavetowaitonedayfromyouobserveclosepricesuntilyou

trade.Nowplotthecumulatedprofitsfromthestrategyforeachpairandtheportfolio.Whatis

theannualizedSRoftheportfolio?Whichismorerealisticandimplementable,borc?

LasseHejePedersen

20

ExercisesforEfficientlyInefficient

FX carry trading

Inproblems11.111.7,youbacktestthecurrencycarrytradeusingthedataprovidedintheaccompanying

Excelspreadsheet.YoucandotheproblemsetusingExceloranyotherprogramofyourchoice.

11.1 Investment currencies and funding currencies. For each month of the sample, rank the countries

based on their interest rate (hint: Excel has a function called RANK(cell,range,1)). Compute each

countrysaveragerank(1=lowestinterestrate,etc.).

Whichcountryhasthelowestaveragerank,i.e.,mostoftenfundingcurrencywiththelowest

interestrate?

Whichcountryisthesecondtomostoftenfundingcurrency(secondlowestaveragerank)?

Whichcountryismostofteninvestmentcurrency,i.e.highestaveragerank?

Whichcountryissecondtomostofteninvestmentcurrency?

PlotheretherankoftheUSovertime.

11.2 Carrypositions.Createpositionsforeachcurrency,either$1(long),$1(short),or0(flat).Dothisby

going short the three currencies with the lowest interest rate, and long the three with the highest

interestrate.(Hint:youcanusetheExcelfunctionIFtwice,oneinsidetheother:=IF(cell<=3,1

,IF(cell>=7,1,0)).

WhatistheaveragepositioninNewZealand?

11.3 Carrytradereturn.Computetheexcessreturnoneachposition,andaddtheseuptogettheexcess

returnoftheentireportfolioinanymonth.Makesuretogetthetimingright.(Hint:useSKEWand

KURT,andannualizeasinnotes.)

Whatistheannualizedaverageexcessreturnoftheportfolio?

Whatistheannualizedstandarddeviation?

WhatistheannualizedSR?

Whatistheskewnessofmonthlyreturns?

Whatisthe(excess)kurtosisofmonthlyreturn?

Commentonthesenumbers

11.4 Transactioncosts.Foreachcurrency,computethetradeeachmonth,thatis,thechangeinposition.

(Position this month, minus last month.) Assuming that the transaction costs are proportional as

giveninthesheet,computethetransactioncostsforeachcurrency.Addupthetransactioncoststo

getthetotaltransactioncosts.Subtracttotaltransactioncostsfromtheportfoliosexcessreturnto

getthereturnnetoftradingcosts.

Whatistheannualizedaveragenetreturnoftheportfolio?

WhatistheannualizednetSR?

LasseHejePedersen

21

ExercisesforEfficientlyInefficient

Whyistheeffectoftransactioncostssomodestinthiscase?Doyouthinkthatthisistypicalof

all trading strategies? Under which circumstances might a global macro trader incur larger

transactioncostsinconnectionwiththecurrencycarrytrade?

11.5 High water mark. Compute the portfolios total return including the US risk free rate, but net of

transactioncosts(i.e.addtheannualUSinterestratedividedby12totheportfoliosreturn).Next,

compute the cumulative return, assuming you start with $1, and then keep reinvesting all

profits/losses. Further, compute the high water mark as the maximum cumulative return from the

firstdatetothecurrentdate.(Hint:ExcelhasafunctioncalledMAX).Makeaplotwithboththe

cumulativereturnandthehighwatermark.

11.6 Drawdown.Computeandplotthedrawdown,DDt=(HWMtPt)/HWMt,wherePisthecumulative

returnandHWMisthehighwatermark.

11.7 Timingthecarrytrade.Suggestawayofdynamicallytimingthecarrytrade(thatis,increasingand

decreasingthepositionsizesovertime)thatmightimprovetheperformanceofthestrategyand/or

reducethedrawdowns.

LasseHejePedersen

22

ExercisesforEfficientlyInefficient

Inproblems12.112.4,youbacktestthetimeseriesmomentumstrategiesusingthedataprovidedinthe

accompanyingExcelspreadsheet.

12.1 Direction of the estimated trend. For each instrument, estimate the direction of the trend as the

signofthepast12monthreturns(+1ifthepastreturnispositive,1otherwise).Whatistheaverage

over time of these trend direction indicators for each instrument? Interpret these numbers and

discusswhetherthestrategyismarketneutralatanypointintimeandonaverage.

12.2 Timeseriesmomentum:constantnotional.Foreachinstrument,considerthestrategyofgoinglong

$1wheneverthetrendisestimatedtobepositiveandotherwisegoshort$1.

a. WhatistheaverageSRofeachofthesestrategies?

b. Considertheequalweightedportfolioofthesestrategies.WhatistheSRofthisportfolio?

c. What is the correlation between each individual strategy and the equalweighted average?

Whatarethemaximumandminimumcorrelations?

d. Arethereanyproblemsofrealismswithusingtheendofmonthreturntocomputethetrading

signal and the next months return (from endofmonth to endofmonth) to compute the

strategy return (as is common in academic research papers)? What would be a more realistic

approach?(Theeffectisnotlargeinthiscase,andwecontinuewiththesameapproachinthe

restoftheexercise.)

12.3 Timeseriesmomentum:riskbalanced.Foreachinstrument,firstestimatetheexantevolatilityas

thestandarddeviationoverthepast2years.Thenconsiderthestrategyofgoinglong$xwhenever

the trend is estimated to be positive and otherwise go short $x, where x is chosen such that the

positionsvolatilityis40%basedontheexanteassetvolatilities.

a. What is the average SR of each of these strategies? How does the answer compare to that in

12.2.a.?

b. Considertheequalweightedportfolioofthesestrategies.WhatistheSRofthisportfolio?How

doestheanswercomparetothatin12.2.b.?

c. What is the correlation between each individual strategy and the equalweighted average?

Whatarethemaximumandminimumcorrelations?

d. Comment on the ideas of being risk balanced a) over time and b) across securities.

LasseHejePedersen

23

ExercisesforEfficientlyInefficient

12.4 Returnduring60/40drawdowns.Computethereturnonthe60/40stock/bondportfoliothatsome

view as a benchmark for pension funds (although the only benchmark that can be used for all

investorsinthemarketcapitalizationweightedaverageofallsecurities).

a. Compute the drawdowns of the 60/40 portfolio and identify the time periods of the 3 largest

drawdownsfromthebeginningofthedrawdowntothepeakofthedrawdown.Whatarethe

returnsofthe60/40portfolioandtheriskbalancedtimeseriesmomentumportfolioovereach

ofthesetimeperiods?

b. Identify the recovery time periods corresponding to these drawdowns, namely the time

periodsfromthepeakofthedrawdowntotheendofthedrawdown.Whatarethereturnsof

the 60/40 portfolio and the riskbalanced time series momentum portfolio over each of these

timeperiods?

c. Whatisthereturnoverthefullcycle,fromthebeginningofthedrawdowntotheendofeach

drawdown?

LasseHejePedersen

24

ExercisesforEfficientlyInefficient

Toanswerproblems14.114.7,considerthefollowingbonds,eachwithafacevalueof$100:

Typeofbond

Zerocoupon

Zerocoupon

Zerocoupon

Annualpaycoupon

Maturity

Coupon

Price

YTM

1

2

3

2

0

0

0

5%

96.32

P_zero

89.11

P_coupon

3.82%

4.60%

Y

14.1 Priceandyield.Whatisthepriceofthe2yearzerocouponbond,P_zero?Whatistheyieldto

maturityofthe3yearzerocouponbond?

14.2 Noarbitragepricing.Whichpricewouldbeconsistentwithnoarbitragefortheannualpaycoupon

bond(i.e.,abondthatpays$5afteroneyearand$105aftertwoyears)?

14.3 Fixedincomearbitrage.Supposethatthecouponbondtradesatapriceof$101.00.

a. Whatarbitragetradewouldyoudo?

b. Suppose that you hold this arbitrage position until maturity in two years. What will be your

profitindollars?Whatistheannualreturnasapercentageofthevalueofthelongsideofthe

position? If the margin requirement is 10% for all long and short positions, what is the initial

marginrequirementindollars?Whatistheannualreturnasapercentageofthisinitialmargin

requirement?

c. Supposethat,afteroneyear,theyieldtomaturityonallbondsis5%.Whatistheprofitorloss

in dollars at this time? What is the annual return as a percentage of the initial margin

requirement?

d. Supposethattheyieldtomaturityonallbondsbecomes5%already1monthafteryouputon

thetrade.Whatistheprofitorlossindollarsatthistime?Whatistheannualreturnasa

percentageoftheinitialmarginrequirement?

14.4 Forwardratesanddirectionalfixedincometrading.

a. Whatistheforwardratefromtime1totime2impliedbytheabovezerocouponbondprices?

b. Supposethatyoubelievethatthe1yearinterestratewillbe4%inoneyearfromnow(based

on your views on central bank policy). What trade would you consider as a result of the

differencebetweenyourviewandtheforwardrate?

14.5 Yieldcurve.Plotthezerocouponyieldcurve,thatis,theyieldsonzerocouponbondsasafunction

oftheirtimetomaturity.Includetheovernightinterestrateof3.7%.

LasseHejePedersen

25

ExercisesforEfficientlyInefficient

14.6 Duration. Compute the duration and modified duration of each of the four bonds. If each bonds

yieldtomaturityimmediatelyincreasesby1percentagepoint,approximatelyhowmanydollarswill

eachpricedecline?

14.7 Yield curve trading. What is average of the yields of the 1year and 3year zerocoupon bonds?

Supposethatyouviewthe2yearinterestrateasabnormallyhighrelativetothisaverage.Yourview

that the 2year rate is too high is supported by information that several pension funds and banks

have been forced to sell large positions of 2year bonds, pushing down the price, hopefully only

temporarily.

a. Structure a longshort trade between 1, 2, and 3year zero coupon bonds which reflects this

view while being relatively immune to changes in the level of yield curve (i.e., the modified

durationoflongsideisequaltothatoftheshortside)andrelativelyimmunetochangesinthe

slopeofyieldcurve.Specifically,golongone2yearbondanddecideonyoupositionsin1year

and 3year bonds. Hint: as discussed in the book, you can try having a dollar duration in each

wingbondthatisequaltohalfthedollardurationofthebodybond.I.e.,withpositions(the

numberofbonds) denotedby ,prices byP, modifieddurationby ,andbondsindicated by

1and and givenby

theirmaturity(1,2,or3),wehave

0.5

b. Level change up. What is your profit or loss if the yields of the three zerocoupon bonds

immediatelychangeto4.82%,4.87%,and4.92%?

c. Level change down. What is your profit or loss if the yields of the three zerocoupon bonds

immediatelychangeto2.82%,2.87%,and2.92%?

d. Slope change up. What is your profit or loss if the yields of the three zerocoupon bonds

immediatelychangeto2%,3%,and4%?

e. Slope change down. What is your profit or loss if the yields of the three zerocoupon bonds

immediatelychangeto4%,3%,and2%?

f. Biggerkink.Whatisyourprofitorlossiftheyieldsofthethreezerocouponbondsimmediately

changeto3.82%,5%,and3.92%?

LasseHejePedersen

26

ExercisesfforEfficientlyyInefficient

d Arbitrag

ge

Consideracconvertibleb

bondwith1yeartomatturity.Thebo

ondhasafaccevalueof$$100andpayysanannuall

couponof$$5.Theconvertiblebondhasnocallaandputfeaturesandfaccesnoriskoffdefault.The

econversion

n

priceis1000,correspond

dingtoacon

nversionratiioof1(i.e., youcancon

nvert1conveertiblebond

dto1stock)..

The risk freee return is 2% per periiod (i.e., perr half year). The currentt stock pricee is $100 pe

er share and

d

evolvesinaabinomialtreeewithtwoperiodsper yearwith10

0%upmovessand5%doownmoves:

t=0

t

t=

t=1

110

0

100

1

95

5

121

104.5

1

104.5

1

90.25

9

15.1 Theoreticalvalue

eoftheconvvertiblebondd:

a. W

Whenshouldtheconvertiblebondbeeconverted??

Whatistheth

heoreticalva

alueofthecoonvertiblebo

ondateachstateinthettree?

b. W

me 0, a hedgge fund buyys a convertible for the price compuuted in 1 an

nd optimallyy

hedgestheposition.

a. Su

pstoanewvvalueSimmeediatelyattime0.From

m

upposethat thestockpricesunexpeectedlyjump

th

henon,the stockpricea

againevolveesinabinom

mialtreewith

htwoperioddsperyearw

with10%up

p

m

movesand5%

%downmovves.Whatistthehedgefu

undsP&Lattime0forS =90,95,100

0,105,110?

b. Su

upposethat thestockpricejumped downtoS=90andthatthehedgefuundreadjusstsitshedgee

att this price level. Then

n the stock

k price jump

ps back up 100. All thhis happens completelyy

unexpectedlyyattime0,and,fromtheenon,thestockmovesin

nthebinom ialtree.Wha

atistheP&LL

e?

frromthejumpupinprice

LassseHejePed

dersen

27

7

ExercisesforEfficientlyInefficient

c. Supposeinsteadthatthestockpriceremains100,butthatthevolatilitychangesimmediatelyat

time0.Specifically,supposethatthejumpsizeschangetoup=20%anddown=10%.Whatisthe

P&Lofthehedgefund?WhatistheP&Lifthejumpsizeschangetoup=5%anddown=3%?

theconvertiblebonddiffersfromitstheoreticalvalue.Attime0,theconverthasapriceof101.A

hedgefundbuysaconvertiblebondandhedgesit(inthesamewayasiftheconvertwaspricedat

thetheoreticalvalue).Attimet=,thestockpricefallsto95andtheconvertpricefallsto96.

a. Howcheapisthebondrelativetoitstheoreticalvalue?

b. WhatistheP&Lindollarsofthehedgedconvertposition?Inpercentageoftheconvertsinitial

price?Howistheanswerrelatedtotheconvertscheapness?

c. Ifthehedgefundcanholditspositionuntiltime1,whatwillbeitsP&Lfromtimetotime1?

15.4 Marginrequirements.Afterthehedgefundhasmarkedtomarketitstimelosswhentheconvert

drops to 96, it has a net asset value of $100M. The hedge fund owns 4M convertible bonds. The

hedge funds prime broker states that the margin requirement for each convertible bond and its

hedgeis30%oftheconvertvalue.

a. Does the hedge fund have sufficient capital to meet the margin requirement for its current

position?

b. Whatisthemaximumpositionthatthehedgefundcantake?

LasseHejePedersen

28

ExercisesforEfficientlyInefficient

In this problem set, we study Volkswagens takeover of the Swedish heavy truck and bus manufacturer

Scania,atransactionvaluedatalmostSEK60billionSEK(EUR6.5billion).Thetransactionwascompleted,

but this was not a certain outcome during most of the process. You can find a lot of information on the

process on the internet, but you are encouraged to solve the questions with the information provided

before you seek further information. You are provided with five press releases, please read them as

instructedbelow.

16.1 Mergerpremium.ReadthepressreleaseVolkswagenannouncesacashoffer.Whatwastheprice

beforetheannouncementforAandBsharesandwhatistheofferedprice.Discussthedifference,

themergerpremium,andcomparethisconcepttothedealspread.

16.2 Merger event risk. Volkswagens offer to purchase all outstanding Scania shares comes with six

conditions.

a. For each of these conditions give your subjective estimate of the probability of the condition

beingmetorwaived.Whatistheprobabilityofthetransactionbeingcompleted?

b. Ifyouworkedforaneventdriveninvestmentmanagerandhadmoretimeandresources,what

kindofinformationorresearchdoyouthinkismostvaluableinthistypeofmerger?

16.3 Marketimplied market risk. Scania closed at a price of SEK 194.5 per share on February 24, 2014

(thefirsttradingdayaftertheofferwasannounced).Whatdoesthispricesayabouttheimpliedrisk

neutral probability of the transaction going through? You will need to make some assumptions.

Statetheseexplicitly.

16.4 Mergersandshareclasses.Scaniahastwoshareclasses,AandB.Immediatelybeforetheoffer,the

Asharetradedatadiscountof3SEK,perhapsbecauseitwaslessliquidthantheBshare.Whatdo

youthinkthediscountwasatcloseonFebruary24?Arguewhyyouranswerisconsistentwiththe

answersgiventothequestionsabove.

16.5 Mergers and options. Consider options written on Scania B shares with expiry on September 19,

2014andstrikepriceSEK150.Assumethat,onFebruary21,calloptionstradedforSEK12andput

optionstradedforSEK13.Approximatelyatwhich pricesdoyouthinktheseoptionstradedatthe

close on February 24? Do you think the BlackScholes formula would have been appropriate to

calculatethepriceoftheseoptionsatcloseonFebruary24?Why?

LasseHejePedersen

29

ExercisesforEfficientlyInefficient

16.6 Mergernews.

Recommendationindependentcommittee. How do you think the recommendation of the

independentcommitteeaffectedthepriceofScaniastock?Whatdoyouthinkthevalueofthe

Scaniastockshouldhavebeenaftertherecommendationwasannounced?

b. Assume, in this question only, that the announcement of the independent committees

recommendationwasgreetedwithnoreactioninthestockmarket.Whatwouldthissayabout

thetypeofinformationthatwaspricedintothevalueofScaniastockbeforetheannouncement?

c. Initialoutcomeoftenderoffer.ReadthepressreleaseVolkswagenannouncesoutcome.How

doyouthinkthisannouncementaffectedtheScaniastockprice?Whatdoyouthinkthevalueof

theScandiastockshouldhavebeenatcloseonApril30?

16.7 Mergeroutcome.ReadthepressreleaseVolkswagendeclaresunconditional.Whatdoyouthink

thevalueoftheScandiastockshouldhavebeenatcloseonMay13?

16.8 Negativedealspread.Insomecases,thepriceofthetakeovertargetexceedstheofferpriceafter

theofferisannounced.Whataresomepossiblereasonsforsuchanegativedealspread?

LasseHejePedersen

30

ExercisesforEfficientlyInefficient

Trading on CarveOuts

Read Harvard Business School Case 9202024 on Strategic Capital Management, LLC (A) and answer the

followingquestions.

16.9 Understandingcarveouttrading.

a. SupposethatElenawantedtobuyeitherCreativeComputersorUbid.Whatarethearguments

for/againstbuyingCreativeComputers?Argumentsfor/againstbuyingUbid?

b. HowmanyUbidshareswereheldbyCreativeComputersintotal?

c. Ifyouowned1shareofCreativeComputers,howmanysharesofUbiddidyoueffectivelyown?

d. Istherealongshortstrategythatsheshouldconsider?

e. Choose a single trade that you would recommend Elena to pursue and specify how she should

size the position. I.e., how many dollars should be invested in this opportunity? Answer this

questionbeforeyoureadthefollowingquestions.

16.10 Balancesheet.CreateamarketvaluebalancesheetforCreativeComputers.

16.11 Longshort stub trade. Suppose Elena goes long 1 share of Creative Computers and short 0.7159

Ubidsharesandthattheriskfreeinterestrateiszero.

a. Returnonconvergence.AfterthemarketclosedonJune7,1999CreativeComputersdistributed

allitsUbidsharestoitsshareholdersonaproratabasis.Thiswas6monthsafterthepartialIPO,

as planned. At this time, Creative Computers stock price was $32.625 per share and Ubid was

tradingat$34pershare.Whatisthereturnonherstrategyindollars?Whatisthereturnasa

percentageoftheinitiallongposition?Whatistheannualizedreturn?

b. Initialequity.AssumethatStrategicCapitalManagementinitiallyposts50%marginforbothlong

andshortpositions.WhatistheinitialmarginequityonDec.9,1998foreachsharethatSCMis

long?I.e.0.50times(the dollarvalueoflong1CCshareplusdollarvalueofshort0.7159Ubid

shares).

c. Marginequity.AssumingthatStrategicCapitalManagementdoesnotaddorwithdrawfromthe

marginaccount,whatwasthemarginequityonDec.18,21,22,23giventhefollowingevolution

ofthestockprices?

LasseHejePedersen

31

ExercisesforEfficientlyInefficient

9-Dec-98

18-Dec-98

21-Dec-98

22-Dec-98

23-Dec-98

CC share price

$22.750

$28.875

$35.375

$46.922

$59.688

$35.688

$53.125

$84.125

$134.500

$188.000

d. Marginrequirements.Assumingthattheminimummaintenancemarginrequirementswere25%

forlongpositionsand30%forshortpositions,whatwastheminimumrequiredmarginequityon

Dec.18,21,22,23?Isthemarginequitysufficienttocoverthesemarginrequirementsoristhere

amarginshortfallonthesedates?(Continuetodothisanalysisfor1shareofCC.)

e. Margincalls.Giventhesizeofthepositionthatyouchoseinquestion16.9.e.,howmanyshares

wouldyouhavebought?(I.e.ifyouinvested$5M,itwouldbe5M/22.75.)Couldyousustainthe

margincallonDec.23?

LasseHejePedersen

32

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