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

A fund runs a diversified merger arbitrage book of 20 deals, each earning a 3% spread over 4 months if completed and losing 15% if it breaks. Historically about 97% of deals complete. During a market sell-off, regulatory risk rises and deal breaks become correlated. Which conclusion is most accurate?

Expected return per deal is 0.97×3% − 0.03×15% = 2.46%. However, when deal breaks become correlated in market stress, diversification offers much less protection, so the portfolio shows short-put-like, negatively skewed payoffs with fat left-tail losses.

  1. AExpected return per deal is 2.46% at 97% completion, and correlated breaks make diversification overstate protection, producing left-tail losses like short put optionsCorrect
  2. BExpected return per deal is 3%, and diversification fully eliminates break risk regardless of correlation
  3. CExpected return per deal is 2.46%, and correlation reduces portfolio tail risk because breaks offset one another
  4. DExpected return per deal is negative, so the strategy cannot earn a premium

Explanation

Expected return = 0.97×3% + 0.03×(−15%) = 2.91% − 0.45% = 2.46%. When breaks cluster in stress, diversification fails and the payoff resembles a short put with fat left tails. Option B ignores both breaks and correlation.

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