P2.T8.27. More arbitrage strategies (Stowell)

Discussion in 'Today's Daily Questions' started by Suzanne Evans, Apr 19, 2012.

  1. Suzanne Evans

    Suzanne Evans Administrator

    AIMs: Explain the mechanics involved in event-driven arbitrage, including their upside benefits and downside risks. Describe a numerical example of: A merger arbitrage; Pairs trading; Distressed investing; A global macro strategy

    Questions:

    27.1. Each of Stowell's hedge fund strategy illustrations includes a brief section on "Mitigating Risk Position Partway Through:" trades that might mitigate exposure if the strategy's thesis starts to unravel midstream. For which of the following hedge fund strategies is this partway mitigation probably the MOST difficult or expensive (or least easily achieved)?

    a. Merger Arbitrage
    b. Distressed Securities
    c. Pairs Trade
    d. Global Macro

    27.2. According to Stowell, the expected return on a cash merger is given by, expected return (R) = [C*G-L*(100%-C)]/(Y*P). Company A makes a tender offer at $24.00 per share for Company B, currently trading at $17.00. The deal is expected to close in three months (Y = 0.25 years). The stock of Company B immediately increases to $21.00. If the merger's chance of success is 80.0%, what is the expected return?

    a. 10%
    b. 15%
    c. 25%
    d. 30%

    27.3. An equity-neutral hedge fund manager conducts a pair trade. On January 1st, she decides that Company A trading at $18.00 is undervalued, while Company B trading at $24.00 is overvalued. She takes a long position in 10,000 shares of Company A and a offsetting short position in 7,500 borrowed shares of Company B. During the interim three months, each Company pays $1.00 dividend per share. Three months later on April 1st (0.25 years), both shares converge to trade at $20.00, validating her thesis, and she reverses the trade. There is a total cost of $2,000 for all transactions ($1,000 on Jan 1st and $1,000 on April 1st) plus margin costs of $900 for the short sale; i.e., short sale $180,000 * 50% margin * 4.0% * 0.25 years. Which is nearest to the annualized return on the trade?

    a. 38%
    b. 60%
    c. 85%
    d. 110%

    Answers:
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