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

A fixed income relative value fund holds a long position in an off-the-run 10-year Treasury and a short position in the on-the-run 10-year Treasury, with equal DV01. The off-the-run bond yields 4.30% and the on-the-run yields 4.22%. The fund finances positions at repo, and the on-the-run bond trades special so that the fund receives a lower rate on cash from shorting it. Which statement is most accurate?

The 8 bp yield pickup is reduced by the lower repo rebate from shorting a special on-the-run bond, and the position can lose if the liquidity premium widens in stress. Matched DV01 removes parallel rate risk but not liquidity or financing risk.

  1. AThe convergence profit of the 8 bp yield pickup is reduced by the cost of shorting a special issue, and the trade can lose if liquidity premia widen in stressCorrect
  2. BThe trade is risk-free because DV01 is matched and both are Treasuries
  3. CThe trade profits if the liquidity premium on the on-the-run bond rises
  4. DThe special repo rate increases the carry earned on the short position

Explanation

The trade earns the off-the-run yield pickup (8 bp) as the liquidity premium converges, but a special on-the-run bond means the short earns less on cash proceeds, which cuts carry. In stress, the liquidity premium on the on-the-run can widen, causing mark-to-market losses. Matching DV01 only removes parallel curve risk, not liquidity risk.

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