Question
A hedge fund seeks to trade on the price discrepancy between two share-classes of the same firm. The hedge fund is planning on investing its
A hedge fund seeks to trade on the price discrepancy between two share-classes of the same firm. The hedge fund is planning on investing its entire capital ($100,000) in this arbitrage trade. Specifically, the fund enters an arbitrage trade when the relative price spread between the twins is greater than 5 %, and it closes the trade when the relative price spread converges to 2 %. This is a dollar-neutral trade. (Note: the weights in the risky assets do not add up to 100 %. The remainder is in cash, which you can assume earns a zero return).
The fund enters a trade on Monday when the price for X-A is $105 and the price for X-B is $100, and the fund successfully closes the trade on Friday when the price for X-A drops to $103.02 and the share price for X-B increases to $101.
Compute the hedge funds return. Hint: Use the portfolio return formula with two risky assets (Ch. 1-2, p. 5). The answer should be given in decimal form (e.g., use 0.05 instead of 5 %).
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