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

During a market crisis, many convertible arbitrage funds face redemptions and prime brokers raise financing haircuts and restrict short selling in the underlying equities. Which outcome is most likely for convertible bond prices relative to their theoretical values?

Convertibles would likely cheapen relative to theoretical value. Leveraged arbitrage funds facing redemptions and higher haircuts must sell the bonds, while short-sale limits prevent proper hedging. Delta hedging removes only small price risk, not funding and liquidity risk.

  1. AConvertibles cheapen relative to theoretical value as leveraged funds are forced to sell, and the hedges may be hard to maintainCorrect
  2. BConvertibles richen as arbitrageurs buy more bonds with extra leverage
  3. CConvertible prices stay at theoretical value because the delta hedge removes all risk
  4. DImplied volatility embedded in convertibles rises as forced sellers bid for options

Explanation

The strategy is typically leveraged and crowded. Higher haircuts, redemptions, and short-sale bans force liquidation of long convertibles, pushing prices below model value, and hedges cannot be adjusted properly. Implied volatility in the convertible falls with the price, not rises. Delta hedging does not eliminate liquidity or funding risk.

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