FRM Part I · FRM Exam Part I · Fund Management
A hedge fund buys convertible bonds of a company and simultaneously shorts a number of the company's shares equal to the bond's delta times the shares into which it converts. Which statement best describes this convertible arbitrage strategy?
Convertible arbitrage is delta-hedged and long gamma: the fund earns from re-hedging as the share price moves either way and collects coupon carry. It does not eliminate credit risk or rely on a sharp share price rise.
- AIt is designed to profit from the bond's long gamma position, as share price moves in either direction allow re-hedging at a profit, while the fund earns carry from the bond's couponCorrect
- BIt is designed to profit only if the issuer's share price rises sharply, since the short position is only a partial offset
- CIt is a directional bet on a rise in interest rates, since the bond is hedged against equity risk
- DIt is designed to eliminate all credit risk because the short equity position offsets any default loss
Explanation
A delta-hedged long convertible holds an embedded long option, so it is long gamma and benefits from volatility by re-hedging, while collecting coupon income less the short stock's costs. It is not a pure upside bet, not a rate bet, and does not remove credit risk, since default losses can exceed the hedge gains.
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