Answer-first summary for fast verification
Answer: No, because there are significant sources of return and risk unrelated to pricing inefficiencies
This is **not** a true arbitrage. A genuine arbitrage should be essentially risk-free and rely on a clear pricing discrepancy that can be locked in for a profit. Capital structure arbitrage strategies, such as shorting an equity put and buying CDS protection on the same firm’s debt, can be exposed to multiple risks: - **Credit/event risk**: the firm’s condition can deteriorate unexpectedly. - **Correlation/model risk**: the relationship between equity and credit spreads may not hold as expected. - **Liquidity and funding risk**: the trade may require financing and may be costly to maintain. - **Basis risk**: the two instruments may not move in perfect offsetting fashion. So the return is not purely from a mispricing that guarantees profit. Therefore, the best answer is **D**.
Author: Manit Arora
Ultimate access to all questions.
Question 139.1. In the investment topic of the L2 FRM, there is a review of hedge fund strategies, including capital structure arbitrage. An example of capital structure arbitrage includes this trade: Going short a put on a stock and going long on a credit default swap (CDS) by buying protection on the debt of the same firm. Is this technically an arbitrage?
A
Yes, because the primary source of return is pricing inefficiency
B
Yes, because if firm asset value increases, the gain in the short put hedges against the loss in the long CDS
C
No, because if firm asset value increases, the short put and the long CDS both gain in value
D
No, because there are significant sources of return and risk unrelated to pricing inefficiencies
No comments yet.