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

A convertible arbitrage manager explains that the fund's strategy is to buy convertible bonds and short the underlying stock, delta-hedged, earning returns from mispricing and carry. During due diligence, the analyst finds the fund's returns over the past 4 years had a beta of 0.6 to a high-yield credit index and negative skewness. What is the most reasonable conclusion?

The fund likely carries embedded credit and liquidity risk beyond what the strategy description implies. A 0.6 beta to high-yield credit and negative skewness resemble short-insurance payoffs, which is common in convertible arbitrage and inconsistent with a claim of being fully market neutral.

  1. AThe results confirm a market-neutral strategy with no credit exposure
  2. BThe fund likely carries embedded credit and liquidity risk that is not captured by the stated strategy descriptionCorrect
  3. CThe negative skewness indicates the manager uses long volatility positions
  4. DThe beta to credit proves the manager is violating the stated strategy

Explanation

Convertible arbitrage commonly bears credit spread and liquidity risk, producing credit beta and negative skew like selling insurance. This does not necessarily violate the strategy, but contradicts claims of pure neutrality. Long volatility positions would generally create positive skew.

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