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

A fixed income arbitrage fund is long an off-the-run Treasury and short the on-the-run Treasury of similar maturity, financing the long through repo, expecting the yield spread to narrow. Which risk is most important to this trade during a flight-to-quality episode?

The key risk is that the liquidity spread widens rather than converges. In a flight to quality, investors pay up for the on-the-run Treasury, so the off-the-run long loses relative value, and leverage with repo margin calls can force losses to be realized.

  1. AThe liquidity premium on the off-the-run bond widening, causing mark-to-market losses and possible margin callsCorrect
  2. BConversion of the bond into equity shares at a discount
  3. CDefault of the U.S. Treasury as issuer
  4. DDeal-break risk from a cancelled merger

Explanation

The trade is a liquidity-spread convergence bet. In a flight to quality, demand for the liquid on-the-run issue rises, widening the spread against the fund, and leverage plus margin calls can force liquidation at a loss. Issuer default is negligible, and conversion and deal-break risks belong to other strategies.

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