D. Suppose that margin requirements remain at 20% over the year. Further, the overall stock market performs strongly, yielding a return of 15% for major stock indices. The market value of long positions increases by 15 % and the market value of short positions increase by 10%. The risk-free return is 4%, including on your cash proceeds from share sales and on your margin loans (i.e., there are no financing spreads).

I. What is the gross return of the hedge fund (ignoring transaction costs and fees)?

Hint (see. Ch.3-3, p.33):

II. Did the hedge fund perform well? Specifically, what was the hedge funds realized alpha with respect to the market. You can assume that all long and short positions have a CAPM beta of 1.

Hint: The CAPM regression is given by

The realized alpha (aka. the residual return) is obtained by re-arranging:

III. Suppose instead that the stocks that you short-sell are on special such that the cash proceeds from the short-sale earn a return of -0.20%. (In other words, the hedge fund pays 0.2 % for the cash proceeds from short-sale). The initial margin for short positions earns the normal risk-free rate. Moreover, the interest charged by the prime broker on margin loans is the risk-free rate + 30 bps. Under this scenario, what is the return over the year? What is the realized alpha? Compare your answer with that obtained earlier when the financing spread was zero.