A Canadian accredited investor is considering allocating 150,000 CAD to a hedge fund employing a convertible arbitrage strategy. This strategy typically seeks to profit from pricing inefficiencies between a convertible bond and the underlying common stock. Which of the following best describes a key risk associated with this strategy?

Question: A Canadian accredited investor is considering allocating 150,000 CAD to a hedge fund employing a convertible arbitrage strategy. This strategy typically seeks to profit from pricing inefficiencies between a convertible bond and the underlying common stock. Which of the following best describes a key risk associated with this strategy?

Answer options: ✅ Adverse interest rate movements making convertible bonds less attractive.

• Increased volatility in the underlying common stock.
• Significant leverage leading to magnification of losses.
• A sudden, unexpected downgrade of the bond's credit rating.

Correct answer: Adverse interest rate movements making convertible bonds less attractive.

Explanation: While leverage, volatility, and credit risk are generally applicable to hedge funds, convertible arbitrage funds are particularly sensitive to interest rate changes. Rising rates decrease bond prices, and can make the conversion option less attractive, negatively impacting the strategy's returns.