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James Walker is the Chief Financial Officer for Lothar Corporation, a U .S . mining company that specializes in worldwide exploration for and excavation of precious metals. Lothar Corporation generally tries to maintain a debt-to-capital ratio of approximately 45% and has successfully done so for the past seven years. Due to the time lag between the discovery of an extractable vein of metal and the eventual sale of the excavated material, the company frequently must issue short-term debt to fund its operations. Issuing these one to six month notes sometimes pushes Lothar's debt to capital ratio above their long-term target, but the cash provided from the short-term financing is necessary to complete the majority of the company's mining projects.

Yi Tang updates several economic parameters monthly for use by the analysts and the portfolio managers at her firm. If economic conditions warrant, she will update the parameters even more frequently. As a result of an economic slowdown, she is going through this process now.
The firm has been using an equity risk premium of 5.6%, found with historical estimates. Tang is going to use an estimate of the equity risk premium found with a macroeconomic model. By comparing the yields on nominal bonds and real bonds, she estimates the inflation rate to be 2.6%. She expects real domestic growth to be 3.0%. Tang does not expect a change in price/earnings ratios. The yield on the market index is 1.7% and the expected risk-free rate of return is 2.7%.
Elizabeth Trotter, one of the firm's portfolio Managers, asks Tang about the effects of survivorship bias on estimates of the equity risk premium. Trotter asks, 'Which method is most susceptible to this bias, historical estimates, Gordon growth model estimates, or survey estimates?'
Tang wishes to estimate the required rate of return for Northeast Electric (NE) using the Capital Asset Pricing Model (CAPM) and the Fama-French three factor model. She is using the following information to accomplish this:
* The risk-free rate of return is 2.7%.

Nigel Holmes, CFA, is an investment manager for a small money management firm in London. All of Holmes' clients are citizens of the U.K. Holmes urges all of his clients to maintain internationally diversified portfolios. In his efforts to find undervalued securities, he is currently analyzing a Canadian company called Slapshot, Inc. Slapshot produces hockey equipment at its Canadian manufacturing facilities. About 85% of Slapshot's sales are to the U .S . market, and the remainder are domestic (i.e., in Canada). Sales have been growing at 12% per year. Last year's sales were C$68,000,000. Holmes has gathered the following market information (inflation is perfectly predictable):
* /$ spot exchange rate = 0.8
* /C$ spot exchange rate = 0.4
* U.K. risk-free rate = 6%
* U.K. expected inflation rate = 4%
* Canadian risk-free rate = 9%
* Canadian expected inflation rate = 7%
* U .S . risk-free rate = 4%
* U .S . expected inflation = 2%
Holmes uses the international CAPM (ICAPM) to value international investments. For Slapshot, Holmes believes that the stock's returns are sensitive to the /C$ exchange rate. In order to apply the model, he estimates the following parameters using the as the base currency:
* World market risk premium = 6%
* Sensitivity of Slapshot to the world market = 1.2
* Sensitivity of Slapshot to changes in the /C$ exchange rate = 1.4
* Holmes' expectation for the depreciation of the C$ against the = 2%
* The ratio of the price of the U.K. consumption basket to the Canadian consumption basket is 0.3.
Holmes adds Slapshot stock to several client portfolios at a purchase price of C$ 100. One year later, the stock is trading at C$ 122. There were no dividend payments during the year.
If the real exchange rate remained constant, the GBP () return on Slapshot for Holmes' clients is closest to

Chris Darin, CFA, works as a sell-side senior analyst and vice president for a large Toronto brokerage firm researching mainly hedge funds and alternative investments. Darin recently hired Simon Nielsen for the position of junior analyst at the firm. Although Nielsen does not have experience evaluating hedge funds, Darin hired him mainly for his previous experience at a discount brokerage firm and for his passion for the industry. Darin frequently mentors Nielsen on market trends, investment styles, and on risks inherent in alternative investment vehicles. In a recent conversation, Darin makes the following statements:
Statement 1: One way to measure hedge fund investment performance is through Jensen's alpha. A portfolio with negative Jensen's alpha would plot above the Security Market Line (SML).
Statement 2: Both the Sharpe ratio and Jensen's alpha can be used to measure risk-adjusted hedge fund returns. Oneof the advantages is comparability between the two methods since both calculate return relative to systematic risk.
Their conversation later shifts to discussing hedge fund classifications and how derivatives affect hedge fund performance measurement. Nielsen mentions that put options are often more advantageous than short selling in a market neutral strategy because of their asymmetric returns.
The following week Darin asks Nielsen to research potential problems and biases in hedge fund indexes and general risks inherent in investing in hedge funds. Nielsen compiles the information and presents the following findings:
1. One of the data problems in hedge fund indexes is that managers often do not disclose negative fund performance.
2. The historical performance of hedge funds that are recently added to an index is often added to the past performance of the index.
3. Long/short equity hedge funds are subject to equity market risk. This risk is typically greater than with equity market neutral or risk arbitrage funds due to the higher standard deviations and market correlations inherent in long/short funds.
4. Fixed income arbitrage funds are also subject to equity market risk. These funds are short Treasuries and long high-credit-risk bonds. In an economic downturn the short position in Treasuries provides a buffer against the long position and provides a net gain.
Finally, the two discuss the risk-free rate and various risk measures in hedge fund performance evaluation. Darin explains that even in market neutral strategies, the risk-free rate may not be an appropriate measure of fund performance. Nielsen does not understand and asks him to clarify. Darin further states that risk measures such as Value at Risk have several limitations as a risk measurement tool.
Nielsen's findings on long/short equity funds and fixed income arbitrage strategies, respectively, are: