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

A hedge fund buys a convertible bond and shorts 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 aim is to earn returns from the bond's embedded option being cheap relative to the implied volatility of the stock. Which description best fits this position?

A convertible arbitrage position that is long the bond and short delta shares is long gamma and long volatility. Rebalancing the hedge as the stock moves earns profit when realized volatility exceeds what the option price implies, since the fund owns the embedded call.

  1. ALong gamma and long volatility, with the delta hedge rebalanced as the stock movesCorrect
  2. BShort gamma and short volatility, collecting option premium
  3. CLong credit spread exposure hedged by shorting Treasury futures
  4. DShort convexity, funded by borrowing at the repo rate

Explanation

A long convertible holds a long embedded call, which gives positive gamma and positive vega. Shorting delta shares neutralizes small stock moves, and rebalancing as the stock moves captures gains from realized volatility. The short-gamma option is wrong because the fund owns, not sells, the option.

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