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

A hedge fund buys a convertible bond and sells short a number of the issuer's shares equal to the bond's delta times the number of shares into which it converts. The manager's main objective is to capture value from the bond's embedded option being cheap relative to the implied volatility in the market. Which strategy is the fund running?

The fund is running convertible arbitrage. Buying the convertible and shorting delta-weighted shares neutralizes small stock price moves, leaving exposure to volatility, gamma, and carry, so the manager earns from the embedded option being undervalued relative to implied volatility.

  1. AConvertible arbitrage using a delta-neutral hedgeCorrect
  2. BMerger arbitrage using a stock-for-stock exchange
  3. CGlobal macro directional positioning on equity indices
  4. DDedicated short-bias equity investing

Explanation

Long convertible bond plus short stock at the delta ratio is the classic delta-neutral convertible arbitrage position. It profits from cheap implied volatility, gamma trading and coupon income less stock borrow cost. The other strategies do not involve this hedged structure.

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