Funds Hub

Money managers under the microscope

Fewer arbs to iron out the bumps

February 5, 2009

rtryqvsThe decline in the hedge fund industry is starting to impact some markets in which these free-wheeling vehicles once played, as Jane Baird’s article “CDS price quirks abound as arbitrage withers” demonstates.

She points out that the $45 trillion credit derivatives market is now full of pricing quirks because many hedge funds, once big arbitrageurs in the sector, no longer play here.

Hedge funds have chosen or been forced to cut back on borrowing, while many must sell their holdings to meet client demands to withdraw cash.

Meanwhile, many banks are scaling back their proprietary trading desks as they cut costs during the downturn.

The result is abnormalities such as inverted spread curves on top-rated companies – where protection against BP defaulting on its debt in one year now costs more than in five years — or a higher ’skew’ — the difference between the price of credit default swap indexes and the protection on companies in those indexes.

Arbs would once have ironed out these differences, but no longer. 

Hedge funds have been accused of many things, but one of the most positive side-effects of their operations has to be their ability to help markets price more efficiently.

While the large abnormalities now present must be tempting for the remaining arbs still able to operate, they would have to be brave to try and play such discrepancies right now.

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