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FRM Part II · FRM Exam Part II · Performing Due Diligence on Specific Managers and Funds

A fund reports an annualized return of 9% with annualized volatility of 6% when the risk-free rate is 3%. Its stated strategy is merger arbitrage. What is its Sharpe ratio, and how should the analyst interpret it?

The Sharpe ratio is (9% minus 3%) divided by 6%, which equals 1.0. Because merger arbitrage tends to have negative skewness and fat tails, the analyst should look beyond Sharpe to downside and deal-break risk.

  1. A1.0, which should be checked for tail risk because merger arbitrage returns can be negatively skewedCorrect
  2. B1.5, which is conclusive evidence of skill
  3. C0.5, which indicates poor performance
  4. D2.0, which indicates low risk

Explanation

Sharpe = (9% - 3%) / 6% = 1.0. Merger arbitrage often has negatively skewed payoffs, since small gains occur often and large losses when deals fail, so the Sharpe ratio may understate tail risk.

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