STATEMENT 2 BY CARR IS BEST DESCRIBED AS

36. Statement 2 by Carr is best described as:

A. correct.

B. incorrect, since convexity is sold by selling bonds with embedded options.

C. incorrect, since convexity may be sold by either buying or selling bonds with embedded

options, depending on the nature of the embedded option.

Portfolio Management—Equity

Question 7

Use the following information to answer the next six questions.

Jimmy Stripes, CFA, is the chief investment officer of an investment management firm that specializes

in running both active and passive equity portfolios. Stripes has been asked to present a short talk at an

investment conference regarding the issues involved in running an equity portfolio as part of a broader

investment portfolio.

Stripes divides his presentation time equally between passive and active equity strategies.

During his presentation on passive equity strategies, he mentions some well‐known stock market indices

that are often used as benchmarks for equity portfolios and discusses the different methods of weighting

equity indices. He concludes with the following comment:

“Although disadvantages do exist to float‐weighted methodology of constructing an index, it has become

the main method of index providers in markets today due to the lower portfolio turnover and better

representation of the manner in which equity portfolios are actually constructed. One drawback of the

float weighting method however is that it is likely to overrepresent the liquidity of smaller companies in

the index.”

With regard to passive equity investment, Stripes presents a short segment on the relative merits of

the approaches of full replication, stratified sampling, and optimization. He gives as an example of a

hypothetical client who wishes minimize tracking error against the CAC 40 index in France.

In his segment on active equity management, Stripes chooses to focus on the merits of long/short

investing. After the presentation, he is approached by Amir Butt, a long‐only fund manager who is

interested in expanding the scope of their investment offerings to include short‐selling equities.

Butt has many questions for Stripes, listed below:

Question 1: “I have heard there are many arguments for pricing inefficiencies being more abundant

on the short side of the market. Examples I have heard mentioned relate to buy‐side investors, sell‐side

analysts, and management of companies themselves.”

Question 2: “I am interested in the concept of alpha and beta separation. For example, if I have located a

superior small‐cap manager and I want to port the manager’s alpha onto a large‐cap systematic exposure,

how might I go about doing this?”

Question 3: “I have heard that short‐selling allows managers to avoid the constraints of long‐only

investing. I’m not sure why this would be the case, since the long‐only manager can take a negative view

on a stock by not holding it when it is part of the fund’s benchmark. Can’t they?”

Stripes enjoys his time at the conference and listens to many other speakers while he is there. He was

very impressed by a presentation given that addressed socially responsible investing (SRI), but is

concerned about style biases that may be introduced into portfolios by focusing on environment‐related

negative screening.