Democratic Underground - Hedge funds flock to riskiest derivatives

http://today.reuters.com/misc/PrinterFriendlyPopup.aspx?type=bondsNews&storyID=uri:2006-03-31T094154Z_01_L30408338_RTRIDST_0_MARKETS-DERIVATIVES-CORRELATION.XML

LONDON, March 31 (Reuters) - European hedge funds are piling into the riskiest parts of complex structured derivatives as pressure to generate higher returns offsets concern over interest rates and record levels of mergers and acquisitions.

Dealers report a rise in sales of equity tranche protection in synthetic collateralised debt obligations (CDOs), the same investments that were hit last year following the downgrades to junk of U.S. auto makers Ford <F.N> and General Motors <GM.N>.

Sellers of CDO equity protection agree to reimburse buyers for the first 3 percent of defaults in a portfolio of up to 125 companies. The investments are lucrative because they are risky -- just one default can cause a 20 percent loss.

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Investors that sell more equity protection are said to be long correlation (i.e., they think spreads are more likely to act in a correlated way), even though the current wave of European mergers and acquisitions, impacting individual companies, makes that seem counter-intuitive.

"You might say that these moves represent a shift in fundamental views, but what you have to remember is that these are highly technical markets," said Lorenzo Isla, a strategist at Barclays Capital. "What these investors are thinking about is relative value within the CDO universe -- the fundamentals come second."

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