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FRM Part II · FRM Exam Part II · Hedge Fund Investment Strategies

Which statement best describes the typical return profile of a statistical arbitrage equity market neutral strategy?

Statistical arbitrage uses many small, short-horizon mean-reversion trades across a diversified book, usually with leverage. It earns steady modest returns but is exposed to sharp losses when historical relationships break down or crowded positions unwind.

  1. AMany small, short-horizon mean-reversion bets across diversified positions, with risk of sharp losses when correlations break downCorrect
  2. BA few concentrated long-term bets on takeover targets
  3. CDirectional bets on aggregate market returns financed with futures
  4. DLong-only exposure to value stocks hedged with currency forwards

Explanation

Statistical arbitrage exploits temporary relative mispricing using many small, diversified, short-horizon positions, often with high leverage. Its tail risk arises when common crowded positions unwind or historical relationships fail, as in August 2007.

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