April 2009 q2 Part iv TrustUs Bank runs into financial difficulty and is declared bankrupt. The trading desk has several over-the-counter (OTC) forward contracts, options, credit default swaps and total return swaps in place where TrustUs Bank is the counterparty. (iv) Describe the likely losses the trading desk will incur as a result of this bankruptcy. Part of the response There is potentially a significant delay in getting any assets back from the bankruptcy proceedings, which means the trading desk could be forced to unwind some of their current trades (as any capital loss will increase the overall leverage used in the strategy), potentially resulting in additional losses.The loss potentially increases if some or all of the assets are illiquid. [/B] I did not quite understand accurately what the portion highlighted in bold means. Could you please explain? Also, in the same problem, could convertible bond arbitrage be a strategy of being long on the underpriced one and short on the overpriced one?
There is potentially a significant delay in getting any assets back from the bankruptcy proceedings, which means the trading desk could be forced to unwind some of their current trades (as any capital loss will increase the overall leverage used in the strategy), potentially resulting in additional losses.The loss potentially increases if some or all of the assets are illiquid. [/b] I did not quite understand accurately what the portion highlighted in bold means. Could you please explain? There are always some bits of solutions that are put in there just in case someone comes up with the idea, even if its an unlikely one! I thiunk this is one of these statements. My opinion is that the statement refers to the idea that the trading desk may be carrying out "long short" trades on a leveraged basis. ie allowing a certain number of long and short positions for a given amount of capital. If the bank makes losses (deducted from its capital) as a result of the default of trustBank, then it has less capital and cant support the existing number of long/short trades that it has open. Hence it has to unwind some. (?!) Also, in the same problem, could convertible bond arbitrage be a strategy of being long on the underpriced one and short on the overpriced one? Unlikely. An arbitrage position aims to make an approximately risk free profit. Going long of one and short of another convertible is far from a risk free profit.
