Any help with this would be great: Table: Hedge Fund/ Return/ Std Dev/ Beta/ Max Drawdown Long short Equity/ 14.6%/ 9.1 %/ 0.1/ -10.3% Fixed Income Arb/ 6%/ 4.1% / 0.0/ -14.4% Equity Market Neutral/ 8.1%/ 3.2% / 0.6/ -9.7% Distressed Securties/ 12.1%/ 5.6%/ 0.4/ -12.8% S &P 500 Index/ 10.4%/ 15.5%/ --/ -44.17% Question: Based on Table above, which hedge fund has the greatest risk if a major market disruption were to occur? a. L/S Equity b. F I Arb c. Equity Market Neutral d. Distressed Sec I don’t understand the answer given at the end of the book.
C or D. C because it has highest Beta, which means the disruption will have highest influence. D because I do not know what a max drawdown is. But I assume it is the highest degrade the fund can take each time? I will go with C
Maybe B, since it has the largest possible drawdown? I’m just throwing answers to the wall tonight to see what sticks.
B?
Beta is the sensitivity of the hedge fund returns to the changes in market sentiments. B has a beta of 0. So it’s not at all correlated to the market, irrespective of whatever happens to it, though a STD of 4.1% means it has some firm-specific risks that could take the company down, and the max drawdown would be 14.4% … hmmm interesting, which one to pick… well … I’ll go with C?
I figured that beta doesn’t mean much in times of a ‘major market disruption’.
Yeah I saw B to due to the Max Writedown.
I’ll go with C (also because of the highest beta). The drawdown is a measure of the biggest ‘peak to trough’ fall that the fund has had historically (not a forecasting measure). Ironically, the historical betas and other correlation data usually get thrown right out the window in major market events. It seems that downside correlation is pretty much 1. But the CFAI probably isn’t testing something that silly.
Fixed Income Arb/ 6%/ 4.1% / 0.0/ -14.4% Looks like a Taleb distribution to me! B
The answer from the book: B I also thought C because of the higher beta. Can those who answered B explain the connection between max drawdown (defined in Schweser as the largest decrease in investment value from peak to trough in a specified period that has ever occurred for a fund) and major market disruption (if that’s the reason for choice B).
I haven’t done this topic yet, I just used common sense. If you look at the low standard deviation of B, and the large max drawdown, it means that the distribution of returns probably has some significant kurtosis. So in a shit storm, it’s the one that looks nasty.
I figured that the max drawdown is exactly what happens in a market disruption (e.g. the credit crisis…). Everything downside correlates to 1 as tsx explained and therefore beta is no longer useful.
Thanks heaps. Makes more sense to me now. Reminded me also that HF returns are not normally distribiuted.
wongie Wrote: ------------------------------------------------------- > Reminded > me also that HF returns are not normally > distribiuted. What asset’s returns are?
Agree with your point. Only the ones in theory Wonderland.