Chapter 19 CAIA Flash Cards - Relative Value Hedge Funds

Question 1

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

Moneyness

Answer 2

Moneyness is the extent to which an option is in-the-money, at-the-money, or out-of-the-money.

Question 3

Busted Convertibles

Answer 3

Bonds with very high conversion premiums (see Equation 19.1e) are often called busted convertibles, as the embedded stock options are far out-of-the-money. These bonds behave like straight debt because when the stock option is far out-of-the-money, the convertible bond’s value is primarily derived from its coupon and principal.

Question 4

Delta

Answer 4

Delta is the change in the value of an option (or a security with an implicit option) with respect to a change in the value of the underlying asset (i.e., it measures the sensitivity of the option price to small changes in the price of its underlying asset).

Question 5

Gamma

Answer 5

Gamma measures the rate of change in the value of delta as the price of the underlying asset changes. Gamma is near zero when an option is extremely far out-of-the-money and the delta is very small. Gamma is also near zero when an option is extremely far in-the-money and the delta is near one. Gamma tends to be largest when the option is near-the-money.

Question 6

Theta

Answer 6

That is, theta is a cost to the buyer of the option and a benefit to the seller of the option, as the time value decays as the option approaches expiration.

Question 7

Delta-Neutral

Answer 7

A delta-neutral position is a position in which the value-weighted sum of all deltas of all positions equals zero.

Question 8

Realized Volatility

Answer 8

Realized volatility is the actual observed volatility (i.e., the standard deviation of returns) experienced by an asset—in this case, the underlying stock.

Question 9

Implied Volatility

Answer 9

The implied volatility of an option or an option-like position—in this case, the implied volatility of a convertible bond—is the standard deviation of returns that is viewed as being consistent with an observed market price for the option.

Question 10

Short Squeeze

Answer 10

A short squeeze occurs when holders of short positions are compelled to purchase shares at increasing prices to cover their positions due to limited liquidity.

Question 11

Complexity Premium

Answer 11

A complexity premium is a higher expected return offered by a security to an investor to compensate for analyzing and managing a position that requires added time and expertise.

Question 12

Components of Convertible Arbitrage Returns

Answer 12

The components of convertible arbitrage returns include interest, dividends, rebates, and capital gains and losses.

Question 13

Net Delta

Answer 13

The net delta of a position is the delta of long positions minus the delta of short positions.

Question 14

Dynamic Delta Hedging

Answer 14

Dynamic delta hedging is the process of frequently adjusting positions in order to maintain a target exposure to delta, often delta neutrality.

Question 15

Volatility Arbitrage

Answer 15

Volatility arbitrage is any strategy that attempts to earn a superior and riskless profit based on prices that explicitly depend on volatility.

Question 16

Vega

Answer 16

Vega is a measure of the risk of a position or an asset due to changes in the volatility of a price or rate that helps determine the value of that position or asset.

Question 17

Vega Risk

Answer 17

Vega risk is the economic dispersion caused by changes in the volatility of a price, return, or rate.

Question 18

Marking to Market

Answer 18

Marking-to-market refers to the use of current market prices to value instruments, positions, portfolios, and even the balance sheets of firms.

Question 19

Marking to Model

Answer 19

Marking-to-model refers to valuation based on prices generated by pricing models.

Question 20

Volatility Risk

Answer 20

Volatility risk is dispersion in economic outcomes attributable to changes in realized or anticipated levels of volatility in a market price or rate.

Question 21

Correlation Risk

Answer 21

Correlation risk is dispersion in economic outcomes attributable to changes in realized or anticipated levels of correlation between market prices or rates.

Question 22

Tail Risk

Answer 22

Tail risk is the potential for very large loss exposures due to very unusual events, especially those associated with widespread market price declines.

Question 23

Portfolio Insurance

Answer 23

Portfolio insurance is any financial method, arrangement, or program for limiting losses from large adverse price movements. Portfolio insurance can be provided through dynamic trading strategies that hedge losses, such as taking short positions in corresponding futures contracts that are adjusted in size based on market levels.

Question 24

Correlations go to one

Answer 24

The term correlations go to one means that during periods of enormous stress, stocks and bonds with credit risk decline simultaneously and with somewhat similar magnitudes.

Question 25

Classic Dispersion Trade

Answer 25

The classic dispersion trade is a market-neutral short correlation trade, popular among volatility arbitrage practitioners, that typically takes long positions in options ​listed on the equities of single companies and short positions in a related index option.

Question 26

Short Correlation

Answer 26

Therefore, the classic dispersion trade is referred to as a short correlation trade because the trade generates profits from low levels of realized correlation and losses from high levels of realized correlation.

Question 27

Fixed Income Arbitrage

Answer 27

Fixed-income arbitrage involves simultaneous long and short positions in fixed-income securities with the expectation that over the investment holding period, the security prices will converge toward a similar valuation standard.

Question 28

Carry Trades

Answer 28

Carry trades attempt to earn profits from carrying or maintaining long positions in higher-yielding assets and short positions in lower-yielding assets without suffering from adverse price movements.

Question 29

Interest Rate Immunization

Answer 29

Interest rate immunization is the process of eliminating all interest rate risk exposures.