CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

34.7 LEVERAGE AND CONVERTIBLE ARBITRAGE

Historically, convertible arbitrage and fixed-income arbitrage hedge funds have used a much greater degree of leverage than have many other hedge fund strategies. Ineichen (2003) estimates that convertible bond arbitrage funds routinely use leverage between 2 and 10 times fund assets, while fixed-income arbitrage strategies may employ more than 20 times leverage.

Ideally, the amount of leverage used in a strategy should be positively related to the degree of liquidity of the assets underlying the strategy. For example, managed futures and global macro strategies have the ability to use a large degree of leverage due to the high degree of liquidity in global futures markets. However, convertible bonds and mortgage-backed securities tend to have varying degrees of liquidity, with much less liquidity than desired during times of market stress.

Consider the example of 2008, when the Dow Jones Credit Suisse Core Convertible Arbitrage Hedge Fund Index fell by over 30%. Convertible arbitrage hedge fund managers had obtained leverage through prime brokers. The prime brokers extended loans to the hedge funds, which were secured by their convertible bond holdings. (Generally speaking, hedge fund managers need to carefully understand their relationship with prime brokers, as prime brokers typically reserve the right to liquidate whichever positions they deem necessary to reduce the leverage of a fund, and to change credit limits on short notice.) In ...