Skip to content

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

A hedge fund manager runs a cash-deal merger arbitrage book. Which description best captures the typical payoff profile of this strategy?

Merger arbitrage typically earns small, frequent gains when deals complete and suffers occasional large losses when a deal collapses and the target price falls. This payoff resembles writing a put option, or selling insurance against deal failure, so it has negative skewness and fat left tails.

  1. AFrequent small gains when deals close, with occasional large losses when announced deals fail, resembling a short put option positionCorrect
  2. BFrequent small losses with occasional large gains when deals fail, resembling a long put option position
  3. CSymmetric payoffs driven mainly by the overall direction of equity markets
  4. DGains driven primarily by changes in the target's credit spread relative to the acquirer's

Explanation

Merger arbitrageurs earn the spread between the offer price and the market price if the deal closes. If the deal breaks, the target price falls sharply, producing a large loss. This asymmetric profile resembles selling a put option or selling insurance. The second option reverses the payoff pattern.

Did you get it right without looking?

One question tells you little. A timed set on Hedge Fund Investment Strategies shows your real accuracy, how long you take and where you lose marks.

Practise Hedge Fund Investment StrategiesFree diagnostic mock

More Hedge Fund Investment Strategies questions