Explanation:
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:
So the return is not purely from a mispricing that guarantees profit. Therefore, the best answer is D.
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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