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

A hedge fund runs a cash-deal merger arbitrage strategy. It buys shares of a announced target trading below the offer price and holds them until the deal closes. Which description best characterizes the risk profile of this strategy?

Merger arbitrage resembles a short put payoff: the fund collects a modest spread when deals close, but suffers a large loss when a deal breaks and the target falls back to its undisturbed price. This gives frequent small gains and occasional large losses.

  1. ASmall, fairly frequent gains with occasional large losses when a deal breaks, resembling a short put option payoffCorrect
  2. BLarge, infrequent gains with small frequent losses, resembling a long call option payoff
  3. CSymmetric returns driven mainly by the target's industry beta
  4. DReturns driven mainly by changes in the term structure of interest rates

Explanation

The arbitrageur earns the spread if the deal completes but suffers a sharp price drop to the undisturbed level if it fails. This asymmetry, small gains and rare large losses, is commonly described as like selling insurance or a short put. The long call description reverses the payoff.

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