CFA Level I · CFA Level I Exam · Hedge Funds
A fixed-income arbitrage manager holds a long position in an off-the-run government bond and a short position in a similar on-the-run bond, expecting the yield spread to narrow as the liquidity premium fades. The manager's position is most likely exposed to the risk that:
The position is most exposed to spreads widening in a liquidity crisis. These trades capture small yield differences with leverage, so a widening spread, rather than convergence, can cause large losses and forced liquidation. Equity price and merger risks do not apply to government bonds.
- Athe spread widens during a liquidity crisis, forcing losses on a leveraged position.Correct
- Bthe issuer's equity price falls sharply, wiping out the long position.
- Cthe merger underlying the bonds is cancelled by regulators.
Explanation
Fixed-income relative value trades earn small spreads and are usually leveraged. In liquidity crises spreads can widen sharply, causing losses and margin calls. The equity and merger risks are irrelevant to government bonds.
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