But you’re held captive by the laws of mark-to-market, and those laws don’t care about how your trade is supposed to work out. They don’t care that you can deliver what you own against what you owe. They only care that you’re showing losses. And you’re losing $5 on each $100 trade, or $20 on the whole position, since you’ve done the trade for a total of $400, of which $300 was borrowed. The $20 loss comes right out of your own capital, so anybody watching knows that you’re down 20%.

Now let’s go one step further. Your $100? Well, it wasn’t really yours. If it were, you’d probably be fine, because you know that your trade will work out. But it turns out that only $10 of that $100 was really yours - the other $90 came from investors looking for 11% returns risk-free. When they get their monthly statement telling them they’re down 20% in the first month of their investment, instead of the nice, steady 1% monthly return they expected, they’re not going to be happy. Some will call and yell at you just to get it off their chest. Those are the good ones. Others will demand their money back, perhaps because of internal rules requiring them to withdraw any investment that has lost, say, 10%.

Let’s say that of the $90 that came from outside investors, $20 is being pulled out. Since you’re down $20 on $100, that means they get back $16.

But that’s not the end of the story. The banks that loaned you $300 are calling. They were happy to loan you $300 on the basis that you had $100 of your own capital (including what came from your outside investors). But after you send them your newest financial statement, giving effect to the $20 mark-to-market losses on your trade and the withdrawal of $16 by your less-than-patient former partners, they see that your original $100 of capital has been reduced to $64.

“Wait a minute,” they say, “we thought this was risk-free, and we were only willing to lend you 3 times your capital. That means we can only have $192 of exposure to you now. Pay us back $108 immediately.”

Ideally, of course, the terms of your original deal with the banks prohibited this. Ideally, you matched their loan with the unwinding of your trade 1 year from now. But what if you didn’t - or what if you did, but the banks found some fine print forcing early repayment?

Well, if you have no other choice, and no other investors, you will have to raise $108 immediately. To make the math easy, let’s say you at least manage to talk the banks into accepting $100 now instead of $108. To raise the $100, you go and sell one of the shares of XYZ that you bought - it’s still trading there. But now you won’t have that share to deliver to the Canadian who bought it from you for one year’s forward delivery. So you have to go into the Canadian market and reluctantly pay $110 to relieve yourself of an obligation you’re no longer permitted to have.

You have just locked in a loss on a trade that’s essentially certain to end up being a winner because your investors (both the equity investors in your fund and the banks that loaned you money) had shorter time horizons than your trade itself and could not stomach the intermediate mark-to-market gyrations.

That, in a big nutshell, is what happened to leveraged convertible arbitrage funds.