Relative Value Hedge Funds

Question 1

1. Describe the positions utilized in a classic convertible bond arbitrage trade.

Answer 1

• The classic convertible bond arbitrage trade is to purchase a convertible bond that is believed to be undervalued and to hedge its risk using a short position in the underlying equity.

Question 2

2. What are the three terms used to describe convertibles bonds differentiated by whether the implicit option in the bond is in-the-money, at-the-money or out-of-the-money?

Answer 2

• Equity-like convertible, hybrid convertibles, busted convertibles, (respectively)

Question 3

3. What is the difference between delta and theta in measuring the price sensitivity of an option?

Answer 3

• Delta is the change in the value of the option with respect to a change in the value of the underlying, whereas theta is the change in the value of the option with respect to the time to expiration of the option (i.e., passage of time).

Question 4

4. What is the term that describes when additional equity is issued at below market values causing the per share value of the holdings of existing shareholders to be diminished?

Answer 4

• Dilution

Question 5

5. List the components of the returns of a traditional convertible arbitrage strategy.

Answer 5

• Convertible Bond Arbitrage Income:
(Bond Interest − Stock Dividends + Short Stock Rebate − Financing Expenses)
+
• Convertible Bond and Stock Net Capital Gains and Losses: (Capital Gains on Stock and Bond − Capital Losses on Stock and Bond)

Question 6

6. What is the key difference between a volatility swap and a variance swap?

Answer 6

• Variance swaps are forward contracts wherein one party agrees to make a cash payment to the other party linearly based on the realized variance of a price or rate in exchange for receiving a predetermined cash flow. A volatility swap mirrors a variance swap except that the payoff of the contract is linearly based on the standard deviation of a return series rather than the variance.

Question 7

7. What is the primary term for financial arrangements that protect an investor’s portfolio from tail risk?

Answer 7

• Portfolio insurance

Question 8

8. What are the differences between duration, modified duration and effective duration?

Answer 8

• Duration is a measure of the sensitivity of a fixed-income security to a change in the general level of interest rates. Traditional duration may also be viewed as a weighted average of the longevity of the cash flows of a fixed-income security.
• Modified duration is equal to traditional duration divided by the quantity [1 + (y/m)], where y is the stated annual yield, m is the number of compounding periods per year, and y/m is the periodic yield. With continuous compounding, m is infinity, and traditional duration equals modified duration. Modified duration scales traditional duration to adjust for the compounding assumption used in the interest rate computations.
• Effective duration is a measure of the interest rate sensitivity of a position that includes the effects of embedded option characteristics. As such it is not generally equal to the weighted average longevity of the cash flows.

Question 9

9. What is the difference between a yield curve and a term structure of interest rates?

Answer 9

• The yield curve plots yields to maturity of coupon bonds, while the term structure of interest rates generally is used to denote actual or hypothetical yields of zero-coupon bonds.

Question 10

10. For what type of interest rate shift is a duration-neutral position best protected?

Answer 10

• A duration-neutral position is protected from value changes due to shifts in the yield curve that are small (infinitesimal), immediate (instantaneous), and parallel (additive).