EXERCISES

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

Preface to the Exercises

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. Exercises for Understanding Hedge Funds and Other Smart Money

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%

active fund before fees

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)?

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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

Name the securities most commonly used

Invests in liquid securities (1=highly illiquid, 5=highly liquid)

Has a large turnover (1=very low turnover, 5=high turnover)

Uses a lot of leverage (1=unlevered, 5=super high leverage)

Discretionary/heuristic or quantitative/systematic (1=gut driven, 5=model driven)

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

Name one or more hedge funds in this style

b. Explainthemainideabehindthethreeequitystrategiesandhowtheyaredifferent.Also,discuss
whythesestrategiesmightprofitoverthelongtermandwhytheymightnot.

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ExercisesforEfficientlyInefficient

c. Discusshowglobalmacroinvestorsandmanagedfuturestraderstradeandthepotentialdrivers
oftheirreturns.Explainthedistinctionbetweentopdownvs.bottomupinvesting.

d. Discussthecommonideabehindarbitragestrategies.Whatarethepotentialrisksoftradingon
anapparentarbitrageopportunity?Whatarethedifferencesacrossthethreetypesofarbitrage
strategies?

LasseHejePedersen

ExercisesforEfficientlyInefficient

2. Exercises for Evaluating Trading Strategies: Performance Measures

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

3. Exercises for Finding and Backtesting Strategies: Profiting in Efficiently

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?

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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)?

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ExercisesforEfficientlyInefficient

4. Exercises for Portfolio Construction and Risk Management

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).

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ExercisesforEfficientlyInefficient

Inoneplot,showthedrawdownsofemergingmarketshedgefundswithandwithoutdrawdown
control.Inanotherplot,showthecumulativereturnofthesetwostrategies.
c. ComputetheSR,averagereturn,andmaximumdrawdownforthestrategy withoutdrawdown
control(asintheexercisesforChapter2,wherexisalways1)andthecorrespondingnumbers
fortheriskmanagedstrategies.Commentonthedifferences.

LasseHejePedersen

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ExercisesforEfficientlyInefficient

5. Exercises for Trading and Financing a Strategy: Market and Funding

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.

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ExercisesforEfficientlyInefficient

7. Exercises for Discretionary Equity Investing

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?

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ExercisesforEfficientlyInefficient

8. Exercises for Dedicated Short Bias

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?

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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

Recallthat istheriskaversion,is istheriskofTWTR(i.e.,variance),and

istheexpected
such that
excess return. The absolute risk aversion is decreasing in the investors wealth
1/
.Further,thecurrentdividendyieldandriskfreeratearezerosoinvestorAsexpected
,where

excessreturnisgivenby
year.Finally,

var

First, his wealth is

(

0ishisexpectationofthevalueofasharenext

.ThesameexpressionsholdforinvestorBwithtwoexceptions.
and, second, his expectation is that the stock will be worthless next year
1 and his position is

0) so that his expected return 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:

where the margin requirement

depends on the volatility

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

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ExercisesforEfficientlyInefficient

9. Exercises for Quantitative Equity Investing

Backtesting Industry Momentum

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

All data is from http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

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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?

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ExercisesforEfficientlyInefficient

Pairs Trading and Statistical Arbitrage

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.

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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

11. Exercises for Global Macro Investing

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?

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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.

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22

ExercisesforEfficientlyInefficient

12. Exercises for Managed Futures: TrendFollowing Investing

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.

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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

14. Exercises for FixedIncome Arbitrage

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

15. Exerrcises forr Convertiible Bond

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

15.2 Convvexity. At tim

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%?

15.3 Cheapness.Supposethat stockmarketevolvesasintheinitialtreeabove,butthemarketpriceof

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?

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28

ExercisesforEfficientlyInefficient

16. Exercises for EventDriven Investments

Volkswagens Takeover of Scania

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.

a. Internal recommendation. Read the press releases Independentcommittee and

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?

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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?

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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

Ubid share price

$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