Macro Credit and Relative Value · Hedge Funds
Relative value strategies trade the relationship between instruments. A small pricing difference can become a large portfolio risk when leverage, financing and imperfect hedges are involved.
Define the relationship being traded
A manager may believe two related securities are priced inconsistently. The proposed trade benefits if the gap narrows. That requires a reason for convergence and a way to survive until it occurs. Prices can diverge further even when the original valuation argument remains plausible.
A spread is not automatically an arbitrage profit. Different liquidity, collateral treatment, embedded options and credit quality can justify a persistent gap. Identify which differences the model includes and which risks remain outside it.
A convertible bond example
A convertible bond combines debt features with an option to convert into shares under specified terms. A simplified convertible arbitrage position buys the bond and shorts some underlying shares to reduce equity sensitivity. The hedge ratio changes as the share price and other inputs change.
The position can remain sensitive to credit spreads, volatility, interest rates, borrowing costs and issuer actions. If the issuer’s credit quality deteriorates, a partial share hedge may not offset the bond’s loss. Borrow recall or expensive financing can disrupt an otherwise plausible valuation thesis.
Size the adverse move before the target gain
Imagine a convergence trade using $10 million of gross exposure against $1 million of capital. A movement that creates a $200,000 loss consumes 20% of capital. The target spread might be small, but the funding and balance sheet required to earn it need not be small.
Ask for stress tests in which the spread widens, financing haircuts rise and liquidity falls together. Review the maturity of funding against the expected life of the trade. An eventual convergence has limited value if the fund must liquidate first to meet collateral demands.
Try it yourself
A relative value position earns $60,000 from convergence but incurs $25,000 financing and $10,000 trading costs. What is the net result on $500,000 capital?
Show the worked answer
Net profit is $25,000, or 5% of capital, before other expenses and fees. The result alone says nothing about the largest interim loss or margin requirement.
Further reading
Educational material, not a recommendation to buy or sell a fund. Numerical examples are hypothetical. Fund terms, investor eligibility and tax treatment vary by product, account and jurisdiction.
