T8 Q 27 practice

[razu]

Hi David

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%

In the answer to this question, the denominator used to calculate the reture is 180,000. Dont understand this. Shouldnt the denominator just be the margin of 50% i.e. 90,000

Thanks

 

[vallerano]

The $180,000 is your initial investment, you buy the shares of company A.

 

[razu]

Thanks for the response vallerano. But the question is what is the annualised return on the trade. The trade is long 10,000 in A in which case I pay $180K and short 7,500 in B in which case I receive $180 K. Hence I would think the calculation of the annualised return on the trade should not be calculated just on my investment in A. Please also see figure 8-20 of chapter 8 of Risk management and investment management GARP reading material which indicates the same. Happy to be corrected.

 

[David Harper CFA FRM]

Hi razu,

Yes, it looks like I made a mistake, note that LeeBritain agreed earlier in the year.
see source at http://forum.bionicturtle.com/threads/p2-t8-27-more-arbitrage-strategies-stowell.5693/#post-16282

I don't know why my XLS is missing. I need to put into an XLS, both exhibit 12.20 and this question but it sure looks to me like i neglected to deduct the funds received from the short (which is based on Stowell 12.20; and Stowell shows a $700 investment = 100*52 - 45*100, consistent with your point).

So i do agree with you, i'll annotate the source when I confirm the mistake, thanks,

 

[vallerano]

Thanks for the response vallerano. But the question is what is the annualised return on the trade. The trade is long 10,000 in A in which case I pay $180K and short 7,500 in B in which case I receive $180 K. Hence I would think the calculation of the annualised return on the trade should not be calculated just on my investment in A. Please also see figure 8-20 of chapter 8 of Risk management and investment management GARP reading material which indicates the same. Happy to be corrected.

Thank you, razu, you are right. I checked the Stowell example now, i skipped this bad quality size 4 print in the garp book at first go.