AuthorTopic: Level II question on Hedge Funds
ines
@2014-12-30 22:36:06
Why would a negative Jensen's alpha hedge fund reflect an overvalued portfolio? Wouldn't it be the opposite? Can you please help?
dblueroom
@2015-01-04 13:08:57
well they didn't test hedge fund, the PE question on the exam was quite easy. I hope you did well on that at least.
paulhugan2k
@2015-01-16 23:26:31
Hi. First, Jensen's alpha = expected return - required return (required return base in CAPM for example)

Second, do remember the security market line (SML) ?. SML graphs the required return for a specific sensitivity risk (Beta). When a security's expected return is below the SML it's overvalued and undervalued when it's over the SML. That's the principle in your affirmation.

Now, why an expected return higher than required return means an undervalue security and a lower return the opposite ?, i'll give you 2 examples:

Example 1:
Expected return = 10%
Required return (CAPM) = 12%

If you use a DCF model with discount rate equals to expected return then present value will be higher than if you use required return as the discount rate. As you expect the expected return will converge to required return the the present value will decrease, that's why whe qualify the asset as overvalued.


Example 2:
Expected return = 12%
Required return (CAPM) = 10%

If you use a DCF model with discount rate equals to expected return then present value will be lower than if you use required return as the discount rate. As you expect the expected return will converge to required return the the present value will increase, that's why whe qualify the asset as undervalued.

CFA Discussion Topic: Level II question on Hedge Funds

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Colin Sampaleanu

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