CFA Level II Exam · Hedge Fund Strategies

Relative Value Hedge Fund Strategies for CFA Level II

Updated 7 October 2026 · Fact-checked

Relative value strategies take offsetting long and short positions in related securities to profit when a pricing gap between them narrows, while staying largely neutral to market direction. Main types are fixed-income arbitrage, convertible arbitrage, volatility arbitrage and asset-backed approaches. In exam vignettes, find the mispriced pair, the hedge, and the risk that widens the gap.

Understand Relative Value Strategies

A relative value fund does not bet on whether the market goes up or down. It bets on the price gap between two related securities. The manager buys the one that looks cheap and sells short the one that looks rich. If the gap closes, the fund earns the difference. The market-wide move largely cancels out.

This is why these funds are called market neutral or low-directional. But the trades are not risk-free. The gap can widen before it narrows. Because the gaps are often small, managers use leverage to make the return worthwhile. Leverage turns a small adverse move in the spread into a large loss, especially when liquidity dries up and many funds exit the same trade together.

Fixed-income arbitrage exploits pricing differences among related bonds, such as on-the-run versus off-the-run government bonds, or bonds versus futures and swaps. A common idea is a yield curve trade, or a spread trade between similar issues. Returns look like small steady gains with occasional large losses when spreads blow out in a crisis, similar to selling insurance.

Convertible arbitrage is typically long a convertible bond and short the issuer's common stock. The convertible contains a bond plus an equity call option. The short stock position is sized using the option delta to offset equity price moves. The manager earns the bond coupon, the short rebate on the stock proceeds, and gains from gamma: re-hedging as the stock moves, buying low and selling high. Risks are widening credit spreads, falling liquidity, and costly or unavailable stock borrowing.

Volatility arbitrage trades the gap between implied volatility (from option prices) and the manager's forecast of realized volatility. If implied is too low versus forecast, the manager buys options and delta-hedges. If implied is too high, the manager sells options and delta-hedges. Asset-backed relative value takes long and short positions in securitized products, such as mortgage-backed or other asset-backed securities, based on views about prepayment, credit quality and spreads relative to similar instruments.

Do not confuse this group with event-driven funds. Event-driven managers profit from a corporate event, such as a merger or restructuring, and their outcome depends on that event happening. Relative value managers profit from a pricing relationship converging, with no specific corporate event needed.

Key formulas to remember

Convertible arbitrage hedge: Shares to short = Delta × Number of shares the bond converts into; Delta is the equity-option delta of the conversion feature. Short this many shares per bond to be delta neutral.
Volatility arbitrage signal: Implied vol < forecast realized vol → buy options and delta-hedge; implied vol > forecast realized vol → sell options and delta-hedge; The profit depends on realized volatility versus the volatility priced in at entry.
Convertible bond value: Convertible value ≈ Straight bond value + Value of call option on the stock; Conceptual decomposition. Issuer's call or investor's put features adjust the value.
Spread trade payoff idea: Profit ≈ Change in spread × Position size (per unit of spread sensitivity) − Financing cost; Gains come from convergence. Leverage magnifies both gains and losses.

How to solve Relative Value Strategies questions

Use this sequence for any relative value question in a vignette.

1Identify the strategy from the positions: bond plus short stock is convertible arbitrage; related bonds or futures is fixed-income arbitrage; options with delta hedge is volatility arbitrage; securitized products is asset-backed.
2Name the two legs: which is long, which is short, and what pricing relationship links them.
3Find the source of return in the exhibit: spread convergence, coupon and rebate income, gamma trading, or implied versus realized volatility.
4If a hedge ratio is needed, compute it from delta or the exhibit data, and check the direction of the short.
5Decide what happens to the position if the spread widens, volatility changes, or liquidity falls.
6Identify the main risk: leverage, liquidity, credit spread widening, borrow cost or model error.
7Match the answer to the vignette facts, and eliminate options that describe event-driven or directional bets.

Quickest way: Leg, link, risk check

When to use it: Use when a question asks which strategy, which position or which risk, and time is short.

Write the two legs in the margin, long and short.
Ask what the link is: same issuer, same underlying, or same cash flows.
Ask what must converge or what must be realized for profit.
Pick the risk: a spread widening with leverage is the default answer for losses.
Reject any option that needs a corporate event or a market direction.

Common mistakes in Relative Value Strategies

Calling relative value funds directional because they use leverage.
Leverage sounds like a bet on the market.
Fix: Leverage amplifies spread moves. The bet is on the gap between securities, not on market direction.
Mixing up convertible arbitrage with event-driven investing.
Both involve long and short positions in related securities.
Fix: Convertible arbitrage needs no corporate event. It profits from mispricing and hedged option value.
Shorting the wrong number of shares in a convertible hedge.
Students use the conversion ratio alone and forget delta.
Fix: Short delta times the conversion ratio for each bond.
Buying options when implied volatility is above forecast realized volatility.
Students link high volatility with buying protection.
Fix: Sell options when implied is too high relative to your forecast, and buy when it is too low, then delta-hedge.
Treating the strategies as low risk because returns look steady.
Small regular gains hide tail risk.
Fix: Remember the pattern of small gains and occasional large losses when spreads widen and liquidity vanishes.

Worked examples

Example 1

A fund holds 1,000 convertible bonds, each convertible into 20 shares. The conversion option delta is 0.60. The fund is short stock to be delta neutral. (1) How many shares should it be short? (2) If the stock rises and delta rises to 0.70, what happens to the required short? (3) Which risk can hurt this position even if the stock is hedged?

Show the solution

Shares underlying = 1,000 × 20 = 20,000.
Required short = 0.60 × 20,000 = 12,000 shares.
New required short = 0.70 × 20,000 = 14,000 shares.
Increase = 14,000 − 12,000 = 2,000 more shares sold short, which sells into strength.
Equity risk is hedged, but credit and liquidity risks remain: if the issuer's credit spread widens, the bond falls without an offset from the short stock.

Answer: (1) Short 12,000 shares. (2) Short 14,000 shares, adding 2,000. (3) Credit spread widening, along with liquidity and borrow-cost risk.

Example 2

A volatility arbitrage manager forecasts realized volatility of 18% for an equity index. Index options trade at an implied volatility of 24%. The manager trades options and delta-hedges. (1) Which option position fits? (2) What is the main source of profit? (3) What would hurt the trade?

Show the solution

Implied volatility 24% is above forecast realized volatility 18%, so options look expensive.
The manager should sell options and delta-hedge the position.
Profit comes from realized volatility ending below the 24% implied level, so the premium collected exceeds hedging losses.
The trade is hurt if realized volatility turns out higher than the implied level, or if the forecast is wrong.

Answer: (1) Sell options and delta-hedge. (2) Implied volatility exceeding realized volatility. (3) Realized volatility rising above implied, or model and forecast error.

Exam tips

Classify first. Most questions are solved once you name the strategy from the long and short legs.
In convertible arbitrage, remember the three income sources: coupon, short rebate and gamma trading.
For risk questions, favour leverage, liquidity and spread widening over market direction.
Use the relative value versus event-driven distinction: event-driven needs a corporate event, relative value needs convergence.
Check the direction of the volatility trade carefully: compare implied with forecast realized, then buy low and sell high.

Relative Value Strategies in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Relative Value Strategies: frequently asked questions

How does convertible arbitrage work?

The manager buys a convertible bond and shorts the issuer's stock in an amount based on the option delta. The bond pays coupons, the short earns a rebate, and re-hedging as the stock moves can add gamma gains. The main risks are credit spread widening and liquidity.

What is the difference between relative value and event-driven hedge funds?

Relative value funds profit when a pricing gap between related securities converges. Event-driven funds profit from a specific corporate event, such as a merger or restructuring. The first needs no event, the second depends on one.

Why are fixed-income arbitrage strategies risky?

Spread gains are small, so managers use leverage. If spreads widen and liquidity falls, losses are magnified and managers may be forced to close positions. This gives a return pattern of small gains with occasional large losses.

What is volatility arbitrage?

It trades the gap between implied volatility in option prices and the manager's forecast of realized volatility. The manager buys options when implied is too low and sells when it is too high, and delta-hedges to remove directional exposure.