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CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition by CAIA Association

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37.4 SOURCES OF RETURNS

Some quantitative equity hedge fund strategies appear to have had success in the past but these previously profitable strategies eventually become extremely difficult to successfully implement. As market participants move from company to company, knowledge dissipates very rapidly across the industry. It is not uncommon for quantitative equity managers to join a firm, attempt to implement a model, experience a drawdown, and be shown the door, all within six months. The high turnover within the industry lubricates the knowledge-transfer mechanism. This section begins with a discussion of potential strategies.

37.4.1 Latency Arbitrage

One example of arbitrage trading is latency arbitrage, whereby a manager who has a deep understanding of the technology infrastructure of the exchanges can identify trading opportunities. For example, in the FX markets, it is well known that across electronic exchanges, globally refreshed quotes are not in sync, as some exchanges refresh quotes in real time, while others refresh quotes every 100 milliseconds. So, if one has linked all the distinct exchanges when a given currency rate moves quickly, taking offsetting positions on both the slower-refreshing exchanges and the faster-refreshing exchanges may provide opportunities. For example, if a price moves up on a quickly changing exchange, the latent arbitrageur can simultaneously sell the security on the quickly responding exchange and buy the security on the more slowly responding ...

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