Hedge fund jitters emerge, 7 years after big failure(WMD Dubya cannot control)

Yahoo ^ | 05/11/05 | AFP

[GovernmentShrinker]

Actually it's a "delta hedge", and usually works quite well. It very unusual for a stock to bounce at the same time the bond value drops -- since the basic principle of captial structure is that the bank debt gets paid first, bonds next, and stock holders last, decreases in prices normally start at the bottom (stock) and work their way up. In this case, it was an anomaly caused by Kirk Kerkorian's sudden announcement of a major increase in his investment in GM stock.

[Penner]

"One of the first things you learn about financial markets is that if there's smoke, there's fire," said Robert Brusca, chief economist at FAO Economics, who added that he had no knowledge of any specific hedge fund problems.

Yep. Get ready for another multi-billion dollar gov't. bailout ala the S&L's in the 1980's.

[bvw]

After I posted I though about it more. I'm right -- at least that in some scenarios it IS doubling down, this being one such scenario. You're right too. Something like almost the same hedge could have been viewed as a bet on a weak recovery by GM.

Because it is two seperate bets -- one to short the stock and two to long the bond that can be trumped by an energetic recovery in the stock, it is really more doubling down. Perhaps that trumping is what K2 played.

[GovernmentShrinker]

It's actually a genuine hedge, and extremely common. The fund collects the interest on the bonds, while protecting itself from principal loss via the hedge. Works as long as the bonds don't outright default, and as long as something really wacky doesn't happen as it did with GM -- the stock bounced up because of a big name investor's announcement, and a couple of days later the bonds got downgraded. In the normal course of things bond downgrades are accompanied by a drop in stock price (and vice versa). If the company does well, long stock price goes up (so the value of the fund's stock position goes down), while the bond price goes up. If the company does poorly, long stock price goes down (so the value of the fund's stock position goes up), while the bond price goes down. Hedge funds got their name from doing this stuff -- now most of them are making huge directional bets and doing little actual hedging.

[1L]

Hedge funds don't always equate to more risk. Often, they are just investing in things that more mainstream funds and advisors won't or can't put their clients in. For example: index futures.