Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

Under the binary option view of merger arbitrage hedge fund returns, when do event-driven funds gain?

1. If a merger occurs as the option is in-the-money, but lose if the merger fails.

2. If a merger fails as the option is out-of-the-money, but gains if the merger occurs.

3. If they invest in convertible bonds with substantial gains.

4. If event-driven strategies are profitable in bear markets.

The correct answer is: If a merger occurs as the option is in-the-money, but lose if the merger fails.

When considering the binary option view of merger arbitrage hedge fund returns, the concept hinges on the nature of potential events surrounding a merger. Event-driven funds strategically position themselves to profit from the outcomes of mergers, acquisitions, or corporate restructurings. In this view, event-driven funds gain when a merger occurs and is considered "in-the-money." This terminology relates to options trading, where "in-the-money" signifies that the option would lead to a profitable transaction if exercised immediately. Specifically, if a merger is successful, the hedge fund benefits from the price differential between the stock trades of the acquiring and target companies. Conversely, if the merger does not materialize (i.e., it "fails"), the hedge fund experiences losses due to the decrease in the stock price of the target company, which is typically priced higher in anticipation of the merger. Therefore, the binary option view clearly defines two outcomes: gain upon a successful merger (if "in-the-money") and loss if the merger does not occur. This understanding elucidates why the correct choice highlights gaining from a merger that successfully occurs while noting the loss from a failed merger.