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Answer: The payoff structure for a trend-following hedge fund with perfect foresight resembles that of a lookback straddle, which allows the owner to buy at the lowest price and sell at the highest.
## Explanation **A is correct.** Trend-following funds employ trading strategies that largely follow market trends. Over any observation period, a trend follower with perfect foresight would have been able to initiate (and to exit) trading positions at the best possible price. The payout function of a trend follower with perfect foresight therefore resembles that of a lookback straddle, which consists of a lookback call option and a lookback put option. A lookback call option allows the owner to buy the underlying asset at the lowest price during the life of the call option, while a lookback put option allows the owner to sell the underlying asset at the highest price during the life of the put option. The lookback straddle therefore allows the owner to buy at the lowest point during the lookback period and sell at the highest point during the same period. Empirical evidence has shown that the performance of lookback straddles in some asset classes, such as bonds, currencies, and commodities, was strongly correlated with the performance of trend-following hedge funds. **B is incorrect.** Managed futures managers are backward looking and global macro managers are forward looking. Managed futures fund managers, the majority of whom employ trend following strategies, tend to employ systematic trading programs that largely rely upon historical price data. However, global macro managers concentrate on forecasting how political trends and global macroeconomic events affect the valuation of financial instruments. Profits can be made by correctly anticipating price movements in global markets. Global macro funds generate low return correlation to equities. **C is incorrect.** In a merger arbitrage strategy, the stock of the target company typically trades at a discount to the acquisition price in order to account for the risk of the transaction failing to close. A merger arbitrage strategy attempts to capture this spread by going long the stock of the target company and going short the stock of the acquiring company, when the acquisition is being paid for with stock. **D is incorrect.** The statement about event-driven distressed hedge funds' correlation patterns is not supported by the provided explanation.
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A research analyst at a global financial consulting firm is preparing a report on hedge funds. The report covers different hedge fund strategies, including their application, their risk and return characteristics, and how their payoffs under different circumstances compare to those of other asset classes and option strategies. Which of the following statements would be correct for the analyst to include in the report?
A
The payoff structure for a trend-following hedge fund with perfect foresight resembles that of a lookback straddle, which allows the owner to buy at the lowest price and sell at the highest.
B
Global macro funds are backward looking and the returns they generate are highly correlated to those of equity indices.
C
In a merger arbitrage strategy, the stock of the target company is sold short with the expectation that the merger deal fails and the target company stock loses value.
D
The returns of event-driven distressed hedge funds tend to be positively correlated to the returns of lookback straddles and negatively correlated to the returns of high-yield bonds.
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