A Canadian investment advisor is reviewing the performance of a hedge fund employing an 'arbitrage' strategy. The fund has consistently generated positive returns with very low volatility, exhibiting a Sharpe ratio significantly higher than broad equity markets. However, the returns have been modest on an absolute basis. Which of the following risks is most characteristic of such an arbitrage strategy, potentially leading to significant losses if mismanaged?

Question: A Canadian investment advisor is reviewing the performance of a hedge fund employing an 'arbitrage' strategy. The fund has consistently generated positive returns with very low volatility, exhibiting a Sharpe ratio significantly higher than broad equity markets. However, the returns have been modest on an absolute basis. Which of the following risks is most characteristic of such an arbitrage strategy, potentially leading to significant losses if mismanaged?

Answer options:

• Systematic market risk ✅ Liquidity risk
• Inflation risk
• Geopolitical risk

Correct answer: Liquidity risk

Explanation: Arbitrage strategies often exploit small price discrepancies and may rely on high leverage. If positions cannot be unwound quickly or at favorable prices due to market dislocations, liquidity risk can quickly transform small price differences into large losses.