A hedge fund has compiled a list of French firms that it believes will outperform the overall French stock market by 7 percent over the year. It also has compiled a list of French firms that it believes will underperform the overall French stock market by 7 percent. The hedge fund wants to invest in a market-neutral long/short strategy on the French stock market. It has a capital of €25 million for this purpose. However, it would like to retain a cash cushion of €1 million for unforeseen events. The hedge fund can borrow shares from a primary broker with a cash margin deposit equal to 20 percent of the value of the shares. No additional costs are charged to borrow the shares.
a. Outline the strategy for the hedge fund.
b. Compute the return on the hedge fund's capital of €25 million if the returns on both lists of stocks are as expected. Ignore the return on invested cash of €1 million, and assume that dividends on the long stocks will offset dividends on the short stocks.