Convertible arbitrage hedge funds rely heavily on leverage to boost returns. When market conditions make financing unavailable, as was the case during the subprime crisis, the value of convertible bonds can plummet. This situation was further exacerbated by increasing redemptions, which further strained funding liquidity. Convertible bonds also have a limited 'clientele' among investors. When these investors develop an aversion to the product during a period of market stress, it becomes difficult to sell the product without significant price declines. The gap between the prices of convertible bonds and their replicating portfolios widened significantly, with no-arbitrage capital being brought into the market. The theoretical price is the value of the replicating portfolio, taking into account credit, risk-free rates, and the embedded option.

Choice A is incorrect. An increase in the target's stock price due to market corrections would not have caused significant losses for convertible arbitrage hedge funds during the subprime crisis. Convertible arbitrage strategies involve buying a company's convertible securities and short selling its common stock. If the stock price increases, it would offset losses on the short position with gains on the convertible securities.

Choice C is incorrect. The decline of an acquirer’s price as they filed for bankruptcy during the crisis could cause losses for some hedge funds, but it was not a widespread issue that affected most convertible arbitrage hedge funds during this period. Moreover, these types of funds typically do not take large positions in companies that are at high risk of bankruptcy.

Choice D is incorrect. Selling highly liquid assets wouldn't necessarily lead to significant losses unless those assets were sold at a discount or below their intrinsic value, which was not generally observed during the subprime crisis specifically for convertible arbitrage hedge funds.

Things to Remember

• Convertible arbitrage hedge funds involve buying convertible securities and short selling the underlying common stock to exploit pricing inefficiencies.
• These funds rely on leverage to boost returns, making them susceptible to market conditions that affect financing availability.
• Convertible bonds can experience significant price declines during market stress, leading to losses for arbitrageurs.
• Investor aversion to convertible bonds during crises can further exacerbate price declines.