Credit Derivatives as Part of Hedge Funds’ Strategy

Credit Derivatives as Part of Hedge Funds' Strategy

Jeffry Merril Liando (2007)

High risk derivatives games and hedge funds as the players

For the last decade, hedge funds have entered indirect credit markets by speculatively playing with credit derivatives and more recently involved in the origination process. This has given a financial perception of double risk. Hedge funds are exposed to higher risks compared to other investment pools as badly as credit derivatives are seen riskier than other derivatives. The connotation of a hedge fund as a "player" implicitly depicts its aptitude to employ credit derivatives as an alternative asset class in its portfolio strategy and implementation.

The relationship between hedge funds and credit derivatives is symbiotic in the context of financial market as one is the user of the other for a mutual benefit. Hedge funds with their channelling and leveraging capacity are able to trade and play with credit derivatives as accessing credit markets in which they do not have the capability of originating the credits. Credit market for loans or bonds is in fact the biggest available market in capital market in terms of volume, outweighing equity market. Hedge funds may see an opportunity to take a big profit in credit market via credit derivatives as they can speculatively bet on default probability and interest rate movement. Credit derivatives on the other hand can provide lenders with a broader and liquid market for transferring credit risks in order to capture wealthy investors via hedge funds. Credit derivatives market needs hedge funds involvement in making market price as hedge funds can bid or offer a better price than other players such as commercial banks, investment banks, pension funds and insurance companies can do.

To see how hedge funds can play with credit derivatives, it is important to view the market environment as an over-the-counter market for private deals between two parties that agree to set an extended condition on new or existing loans or bonds. Whether as buyers or sellers, the unregulated hedge funds can more flexibly deal with the regulated counterparties and keep the derivatives in a portfolio or as a stand-alone investment without compliance of public disclosure. The appearance of hedge funds in playing credit derivatives can also be represented by private equity funds who can hold the underlying assets. However, hedge funds with a limited capital will have to borrow from banks for meeting sufficient collateral to chase bigger returns from a bigger contract size. The common forms of credit derivatives played by hedge funds are collateralised debt obligation (CDO), credit default swap (CDS), total return swaps (TRS) and synthetic CDO with CDS as the underlying assets.

This essay aims to discuss some forms of credit derivatives played by hedge funds with some examples and referenced evidence that can be gathered from available information and databases. A term of double risk is interpreted by pointing out some risk issues of credit derivatives played by hedge funds. The conclusion to be made is that a combined risk perception between credit derivatives and hedge funds is something that cannot be prevented by financial market community as long as the desire of hedge funds for excess returns and the need of lenders for liquidity in credit market can always be fulfilled. This essay is divided into four sections: hedge funds, credit derivatives, credit derivatives played by hedge funds and conclusion.

1. Hedge Funds

A hedge fund is an investment product like a mutual fund or a pension fund and not necessarily maintaining a hedge position. A hedge fund is an actively managed fund of a tailored investment pool which is organised by an investment advisor who sets up a company under a limited liability partnership to invest money that is privately placed by a group of not more than 499 accredited investors as the partners. Accredited investors mean individuals with net worth more than US$1 million or income more than US$200 thousand. The hedge fund manager or the investment advisor will be compensated by large incentive, normally 15%-25% of the fund's net profit. Because of its nature, hedge funds exempt from 1940 Company Act in order to minimise public disclosures and 1933 Securities Act in order to charge asymmetric performance fees.

Investment advisers who sell return hedge funds

Seemingly, it is quite simple to set up a hedge fund on the ground that one has excellent skills and knowledge in portfolio analysis, network relationship building and marketing. As an investment advisor or financial planner she may offer some of her wealthy clients to go to the next step in business relationship as her limited partners under a limited liability partnership. By having an excellent concept of what to hold, buy and sell in the portfolio, she may start to explore some better offers available in the market with counterparties, in the exchanges or over-the-counter, with ordinary securities or derivatives. She may build relationship with some exchanges, investment banks or other financial institutions for some chances in repurchase agreement, fund borrowing and margin facility. The most common trading strategy is by going long and/or short in the stock and/or derivatives exchanges, whether domestic and/or offshore. To avoid higher tax, she may choose some tax havens for the domicile of the funds. She may also need to test first that her managed portfolio is supreme before offering to her clients as they need some kind of proof of a sought-after investment. In practice, many hedge funds nowadays operate under the umbrella of investment banks which are investing in portfolio of hedge funds. All of the above shows some level of freedom in hedge fund transactions compared to ordinary mutual funds.

Unlike mutual funds that usually take long positions, hedge funds have more degree of freedom to take any speculative position for increasing investors' profit and managers' incentives from investment returns above average benchmark returns. Now is popular with the term of seeking alpha. They can go mainly long, mainly short or combination of both. A short position can be done by asking for a margin facility, entering a repurchase agreement.

To pursue a high leverage level, hedge funds are likely to go short and bet on a decreasing price or alternatively borrow directly from major banks to upsize the volume for a bigger chance return. For private equity funds, they can borrow funds for some percent of the equity they are willing to invest through a leveraged buyout (LBO). Creditworthiness of hedge funds could be viewed from the managers' skill to implement a good strategy for a big return. Hedge funds are somehow able to take other financial players as counterparts.

The nature of short position, high leverage and high incentives are similar to those in the first hedge fund set up by Alfred Winslow Jones in 1949. His strategy was a market neutral or hedge strategy by buying undervalued shares with an offset position of short selling overvalued shares. Since his long and short positions were applied to different shares, it was a leverage strategy as he possibly expected a profitable divergent movement of such shares.

High and abnormal return of hedge funds

A hedge fund is structured as a heterogeneous asset class by employing different approaches, strategies and instruments to explore opportunities to generate abnormal returns. Some hedge funds trade in shares and some do not trade at all but more focus on emerging market debt, fixed income and derivatives. Latter development shows that some hedge funds play in credit derivatives market offsetting positions with fixed income trading and through interest rate swaps.

Classification of hedge funds according to TASS, as follows: convertible arbitrage (between a convertible bond and equity), dedicated short, emerging market funds, equity market neutral (maintaining close balance), event driven (responding corporate event, e.g. merger, LBO), fixed income arbitrage (long/short related bonds), macro (directional movement in financial market and macro economic indicators), long/short equity (with a long bias), managed futures and others (risk arbitrage, statistical arbitrage, derivative arbitrage, distressed securities, fund of hedge funds). In 2004, the largest percentage of asset under management is long/short equity 32% followed by event drive 19%. There is a slight decline from the previous year in macro strategy from 11% to 10% and an increase in others from 8.5% to 10.1%.

Hedge fund industry has been growing rapidly along with investors' desire to enjoy excess returns or alpha. The spirit of seeking alpha becomes the main goal of hedge fund strategy. Assets under management of the hedge fund industry grew from US$456 with number of funds from 3,102 in 1999 to US$973 with 5,782 number of funds in 2004 according HFR database and it is estimated to be more than US$2 trillion at the end of 2006, 30 percent more than a year earlier. The average annual return from 1994 to 2004 for live hedge funds is 14.4% for TASS, 14.3% for HFR and 15.5% for CISDM. TASS, HFR (Hedge Fund Research) and CISDM (Centre for International Securities and Derivatives Markets) are three commercial databases for hedge fund research.

Table-1. Hedge fund returns

However, despite the prospect in generating excess returns hedge funds also experience some failures. This is due to the speculative risk in taking such positions that can offer big returns therefore also big risks. The survivorship bias return in the table-1 shows the average lost return deduction after some collapsed hedge funds. Some failures in the hedge fund businesses gathered from different news sources in the internet are as follows:

• Long-Term Capital Management in 1999 lost US$2.3 billion in equity value after its bet on narrowing credit spread after the Asian crisis being hit by Russian default.
• Tiger Management in 2000 failed to return US$6 billion in investors' assets after its strategy to go short in overpriced technology stock being hit by the bull market in technology.
• Aman Capital in June 2005 lost more than US$100 million from its leveraged credit derivatives strategy.
• Marin Capital in June 2005 closed its funds valued at US$1.7 billion after its bet on the outlook for General Motors by buying its bonds, shorting its stock, $500m long equity position and $1bn short mezzanine position being hit by GM junk bonds rate.
• Bailey Coates Cromwell Fund in June 2005 dissolved and lost 20% of US$1.3 billion asset due to wrong bets on the movement of US stocks.
• Amaranth Advisors in September 2006 lost the total of US$6 billion in two weeks after its bet on an appreciation natural-gas futures post Katrina Hurricane 2005 being hit by the depreciation of the futures.

Hedge funds in credit derivatives market

There have been some big changes in market environment after LTCM collapse as more hedge funds have been entering credit derivatives market. From the above facts, it can be noted some failures on credit derivatives, such as LTCM with total return swaps, Aman Capital with leveraged credit derivatives and Marin Capital with synthetic CDO. It seems LTCM has been the pioneer of hedge funds involvement in credit derivatives market and some hedge may have seen the opportunity to gain big returns assuming that their bet would never go wrong like LTCM's bet.

In spite of Warren Buffet's opinion in 2003 that credit derivatives are "financial weapons of mass destruction", players in capital market continue to use credit derivatives for speculating and hedging purposes. The general argument is that credit derivatives provide more liquidity for credit markets other than from financial institution's funding and also provide higher returns than the original securities or assets. Hedge funds with their investors' funds can be seen as the sources of credit liquidity. Here it can be seen that even in a nature of retail funding a hedge fund may access the wholesale credit market due to the advantage of high leverage.

Figure-1. Players of Credit Derivatives

In has previously been mentioned that total assets under management of hedge funds is estimated more than US$2 trillion in 2006. If the involvement of hedge funds is about 30% average between buyers and sellers (see figure-1) and the total market volume of credit derivatives is estimated US$20 trillion in 2006 (see figure-2), it can be projected that US$6 trillion of credit derivatives market is managed by hedge funds. If say 20% of hedge funds or US$400 billion assets played in credit derivatives, this may suggest that there is a 1:15 leverage applied by hedge funds with assumption that the 30% average hedge funds consists of offsetting long and short strategy. If it is assumed that hedge funds overall may have stand-alone strategies as buyers and sellers and the involvement becomes 60%, then it can be projected about US$12 trillion of credit derivatives market is managed by hedge funds with 1:30 leverage in trading. For example, a hedge fund selling a credit default swap (CDS) of a US$15 million loan value for US$1 million premium would have to face maximum US$15 million claim. If selling US$2 million mezzanine notes of a synthetic collateralised debt obligation (CDO) of two CDSs above, a hedge fund would have to face maximum US$30 million claim.

2. Credit Derivatives

The market volume of credit derivatives have shown a figure of exponential growth from 1996 to estimated 2008. From just US$0.2 trillion in 1996, it has been growing gradually to US$2 trillion in 2002 until rapidly jumping to US$5 million in 2004 and estimated to grow exponentially to US$20.2 trillion in 2006 and further to US$33.1 trillion until 2008. The size in 2006 is around 1.5 times annual nominal US GDP. However, this cannot be compared explicitly as there are factors of leverage and multiplier in credit derivatives that may bias the perception of the real volume of credit market and money circulation in the context of macro and monetary economy. The main driving factor of credit derivatives is in fact governments who sponsor the development in the countries that use alternatives of liquid funds available other than those in financial institutions and can be explored outside the countries. Hedge funds all over the world are one of the liquidity providers for credit derivatives market even though some tend to deal with a lot of speculations.

Figure-2. Market volumes credit derivatives (US$ trillion)

Credit derivatives market is a market of financial engineering and technology where the assessments of returns and risks are assigned by a set of complex mathematical formulae and computerised programming software. By modelling the probability of default, interest rate risk and timing risk, portfolio managers may find some ways of hedging by replicating portfolios in different positions.

By definition, a credit derivative is a derivative security that is primarily used to transfer, hedge or manage credit risk and whose payoff is materially affected by credit risk. Credit derivatives are traded over-the-counter (OTC) and privately negotiated. Historically, credit derivatives came up to capital market driven by the development in asset securitisation. Asset or credit securitisation is a process of transforming a series of cash flows derived from debt obligations into securities in the capital markets that pay interests to the investors. This process needs a special purposed entity (SPE) formed to channel the inflows and outflows between the packaged assets and the securities. The SPE normally holds the packaged assets in its liability to be sold in the form of securities to the investors paying investors' interest with payments from borrowers' interests or customers' premiums passed from the originators. The SPE pays the packaged assets to the originators with the sale of securities to the investors.

In its first development, asset securitisation has produced derivatives securities such as asset backed securities (ABS), mortgage backed securities (MBS), collateralised debt (bonds or loans) obligation (CDO), interest only (IO), principal only (PO). Financial innovations in the 90s then drove to the inventions of credit derivatives products such us: total return swap (TRS), single-name credit default swap (CDS), credit linked notes (CLN), first-to-default swap (FDS), CDS on basket of corporate names, CDS on ABS, synthetic CDO, index CDS, option CDS and the latest has been launched is collateralised foreign exchange obligation (CFXO). Some products discussed related to hedge funds will be discussed in the next section are CDO, TRS, CDS and synthetic CDO.

Asset securitisation used by lenders as a short-cut technique to remove credit risk. If lenders intentionally remove the bad credits and package them through securitisation process, they may face three kinds of risk as follows: (1) downgrading risk arises where an independent rating agency based on its observation, analysis and perception tends to downgrade rating, (2) cost risk arises when a high cost should be paid in the process of securitisation from originating, pooling, guaranteeing, credit enhancing and selling, (3) reputation risk arise when holding a bad reputation from investors' view as securitising bad credits. Meanwhile, the risk faced by investors of the securities would be similar to the risk of lending, such as, (1) default risk, (2) liquidity risk, (3) interest rate risk, and additional (4) risk of prepayment for long maturity credits, also (2) transparency risk when the credits condition and situation are beyond investors' visions.

A hedge fund basically does not carry out the origination of a credit unless it acts as a private equity fund who invests in a company in the form of equity. As a private equity fund, it may be exposed to the credit risk from the debt of the company it acquires and the loan it receives from banks when buying the company through a leveraged buyout. Then, it may buy protection for the credit risk of the company. Other hedge funds may then sell protection for the reason that the premium would be expensive; however, they can only evaluate the credit condition based on the rating information.

Simple hypothetical simulation of credit derivatives

To simulate securitisation process and credit derivatives, some hypothetical examples can be described in the forms of personal loans.

Scenario 1: with XXX

Ten students borrow $100 each at $15 interest from AAA. If the ten students pay back all of their debts, AAA willreceive $1000 plus $150 interest, totalling $1150. Knowing that AAA would have the $1150 at the end, he then asks XXX who has many friends to find some people who want to lend AAA some money. XXX finally finds 80 friends with $1 interest for $10 each and 20 friends with $2 interests for $10 each. Friends who choose the $1 interest will be paid first after those taking $2 interest if any of the students default. If not default, AAA would earn $30 (may be shared with XXX) from $150 interest deducted by $120 and the 80 friends would earn $1 each and the 20 friends US$2 each. If 2 students default, AAA would still earn $30 but the 80 friends with $1 interest would have to wait longer to get their $10 back.

Scenario 2: with QQQ

Other way to show a protection motive would be like this. AAA knows that there is a risk of the ten students not paying back the debts. The ten students would pay back the interest, but may not pay back some part of their debts. AAA then finds a special friend QQQ. QQQ asks AAA to pay $100 in advance as promising to cover any loss AAA gets at the end. QQQ may expect that AAA might just get $925 back of $1000 as paying the rest of $75 to AAA. If the ten students just pay $925 back, AAA still gets $1000. However, AAA's $150 income is to be deducted by $100 protection cost from QQQ who has promised to cover the loss, totalling $50. Meanwhile, QQQ would receive $100 from AAA and pays $75 to cover AAA's , earning $25 in total. If the ten students pay back all of the $1000, AAA's earning would be still $50 and QQQ's earning would be $100 without covering any loss. How about if the ten students just pay $700 back of $1000? QQQ may simultaneously buy protection at $50 from GGG who promises to cover the loss until $300. QQQ would earn $50 if default or not default whilst GGG would earn $50 if not default and lose maximum $250 if default.

Scenario 3: with HHH

Another instant way to alter the risk of default can be shown as another friend HHH pays AAA $100 now and $1000 at the end whatever the situation would be as AAA has to pass all of US$1150 at the end. AAA would get an instant profit of US$100 now and HHH would get a profit of US$50 at the end if the ten students do not default. To cover the loss if the ten students default, HHH may buy protection from GGG at US$30 to protect the loss until US$150. HHH would earn US$20 whether default or not and GGG would earn US$30 if not default and lose maximum US$120 if default.

Scenario 4: GGG as a dealer

The last two simulations shows that the price of GGG's protection may vary based on the probability of default of the students' debts over time. To some extent, the premium $50 for $300 is still reasonable. If the default probability decreases, it may apply premiums from $40 for $200 loss, $30 for $150 loss, $20 for $100 loss until $10 for $50 loss. Therefore, it can be set protection prices referred to the value of $1000 students' debts would default from $50 to $10. As a dealer, GGG may trade the protection with some counterparties. One may buy GGG protection for the students' debts at $20 for $100 default and sell it back to GGG at $40 once the students' debts are getting riskier to $200 default, earning $20 in total. GGG now holds protection $40 for $200 default. Believing that the students' debts would default maximum $100, GGG then may end up buying protection from ZZZ at $20 premium for $100 loss. If not default, GGG would receive $40 from QQQ and pays ZZZ $20, earning $20. If default by $100, GGG's earning is still $20 and ZZZ would face a maximum loss of $80.

3. Credit Derivatives and Hedge Funds

a. (Synthetic) Collateralised Debt Obligation (CDO)

A CDO is a derivative resulted from a securitisation process of a portfolio of loans or bonds which is being sold by a lender or issuer to an SPE who then issues securities in the form of notes collateralised by the portfolio of bonds or loans. A synthetic CDO refers to a portfolio of CDSs.

The notes issued by SPE are structured with different payoffs and prices based on the credit qualities of the underlying portfolio to give investors choices to invest in different risk profiles. By structuring a CDO, SPE can enhance the quality of a portfolio with mainly speculative grade loans or bonds by issuing notes with higher credit qualities. In an arbitrage CDO, the notes are usually priced over the yield of the underlying bonds or loans for SPE to gain. For example if the average yield of the bonds portfolio is LIBOR+5%, the CDO may be priced on average at LIBOR+6%, thus the PV of bonds portfolio is higher than the CDO. By purchasing CDO notes, investors may enjoy the advantage of higher expected return even without having the original assets. Despite there are complicated mathematical techniques for structuring and pricing CDO notes, a simple hypothetical example of an arbitrage CDO can be described as follows.

Structuring an arbitrage CDO and hedge funds' play

The underlying portfolio of $100 bonds matured in 2 years with $10 expected default consists of:

• $10 rating C bonds with expected return LIBOR+4%.
• $10 rating B bonds with expected return LIBOR+2%.
• $30 rating A bonds with expected return LIBOR+1%.
• $50 rating A+ bonds with expected return LIBOR+0.5%.

The notes issued in different tranches:

• Equity tranche: $10 note unrated at LIBOR+5% p.a.
• Mezzanine tranche: $10 note for rating B at LIBOR+3% p.a.
• Mezzanine tranche: $30 note for rating A at LIBOR+2% p.a.
• Senior tranche: $50 note rating A+ LIBOR+1% p.a.

With this simple structure assuming LIBOR is 4%, SPE may expect the net present value between the bonds portfolio and the CDO's tranches are still positive as the average rate of return of the bonds portfolio is lower the average cost of capital of the CDO tranches.

Buyers of the equity tranche may enjoy the highest return of 9% followed by mezzanine and senior tranches. However in default event of $10, equity tranche buyers may not receive back the $10 investment but senior and mezzanine tranches are still repaid. In default of $4, equity notes receive only $6 of $10 investment. Equity tranche buyers expose to default risk.

Sellers of equity tranche pay 9% or $0.9 but the $10 investment received from buyers would not be repaid if the portfolio defaults by $10. It means that only with $0.9 the sellers can generate $10. Meanwhile, by selling mezzanine and senior tranches at the existing notes' rate, sellers expect the rate will drop so that they can buy back and profit. But they may lose if the rate rises.

The most popular position played by hedge funds is long equity tranche and short mezzanine or senior tranche. The advantage of this position is that hedge funds can enjoy the high return from buying equity tranche by selling mezzanine or senior tranche with smaller cost. For example at LIBOR equal to 4%, a hedge fund receives $0.9 (9%) from long equity and pays $0.6 (6%) for short mezzanine rating B note, earning $0.3. If LIBOR rises to 6%, a hedge fund closes it positions and pays $1.2 for equity and receives $0.8 from mezzanine, costing $0.3. If the proportion of mezzanine tranche is bigger the equity, a hedge fund can profit if LIBOR increases. If the proportion of mezzanine tranche is smaller the equity, a hedge fund can enjoy the spread assuming LIBOR decreases or at least does not move. However, this position is still risky. Marin Capital in June 2005 held $500 million long equity position and $1 billion short mezzanine position betting on General Motors (GM) outlook. When GM was rated down to speculative grade, the equity and mezzanine tranches were repriced downward and Marin ended up with an enormous loss.

How CDO helps private equity's LBO and attracts hedge funds investment can be seen in figure-3 regarding the tranches financing structure of a target company's debt. By investing in equity tranche, private equity funds may enjoy the highest returns while banks and CLO may enjoy higher returns from investing directly to the company. In CLO is the portfolio of CDOs from several private equity's LBO. Hedge funds and mezzanine funds are the way to hedge position in the equity tranche.

Figure-3. Tranches financing structure of private equity's LBO

The first CDO hedge fund was launched by Ferrell Capital Management in 2001 when issued US$50 million of unrated junior notes which were based on the performance of a group of hedge funds. Then JPMorgan structured out hedge fund-of-funds CDOs for Grosvenor Capital Management and Ivy Asset Management. In Europe, Deutsche Bank financed CDO for Prime Edge private equity funds transactions. Credit Suisse First Boston structured out deal for US$500 million hedge fund-of-fund CDO deal for the Bahrain-based Invest Corp. Seemingly, the CDO is structured out of hedge funds of funds, which are normally held by major investment banks.

In May 2007 Merrill Lynch and Credit Agricole Asset Management launched a new type of CDO called the collateralised foreign exchange obligation (CFXO). If the product is successful in market it would be the first CFXO that may be followed naturally by other CFXOs. The underlying portfolio is made up of about 10 foreign exchange pairs combining the currencies of the Group of 10 developed countries with a number of emerging market currencies. The AAA-rated tranche is to pay 80 bps - 100 bps in coupons while the riskiest equity tranche is expected to return about 20 per cent.

b. Credit Default Swap and Total Return Swap

CDS

CDS is basically a derivative showing an agreement as one counterpart agrees to pay some regular protection premium as a percentage of the notional debt held as its asset to the other counterpart who promises to pay any defaulted part of the debt so that its assets are protected from losses. Figures-4 shows Acme Inc. agrees to pay premium to CDS dealer or seller to buy protection of Giant Corp's debt held as its asset. If Giant Corp. suffers a default, Acme Inc. is safe and CDS dealer suffers a loss. If Giant Corp. is fine, Acme Inc. still costs a protection and CDS dealer enjoys a protection payment.

Figure-4. Basic CDS cash flows

Hedge funds as CDS buyers usually purchase CDS to hedge portfolios of the bonds they currently own. Hedge funds also purchase CDS on corporate bonds designed to profit from a widening corporate credit spreads as CDS is cheap when the spread is narrow and expensive when widen. Some buy CDS on sub prime, mortgage backed, fixed-income securities and indexes as a way to profit when borrowers' credit quality falls. Some hedge fund managers also buy CDS on emerging debt to bet on a decline in a country's credit quality.

Hedge funds as CDS sellers like to receive protection income and expect no default in the bonds or loans. Meaning that, they bet on a good hope of bonds or loans to fulfil the obligation. Notwithstanding this intention, the bonds or loans default hedge funds may end up owning the bonds or loans and think the next strategy to recover the defaulted part.

Trading CDS on Sallie Mae's LBO can be related to the process tranche financing in CDO as to protect the tranches portfolio in three ways. First, hedge funds buy CDS before Sallie Mae's LBO at say 40 bps and sell it at say 60 bps after the LBO as the credit quality and risk of Sallie Mae increase. Second, hedge funds buying CDS on Sallie Mae debts expect students' debt would default as receiving default payment. They may be predicted from there not so many jobs for students and not so many bright students. Third, hedge funds selling CDS on Sallie Mae debts expect otherwise and receive protection income.

TRS

TRS is basically a derivative of a netting position between the bonds' fixed payment and the bonds' referenced floating payment. Any yield decrease may increase the bonds value and the receivers or buyers may profit whereas the payers or sellers may lose. Any yield increase may decrease the bonds value and benefit the sellers whereas the buyers may lose.

Figure-5. Basic TRS cash flows

Hedge fund buyers of course expect yield decreases, price increases and spread narrows. For example, a hedge fund pays at LIBOR+2%+$90 and if price increases and spread narrows it would receive at increasing LIBOR+2%+$95. On the other hand, hedge fund sellers should expect yield increases, price decreases and spread widens. Moreover, with small collateral hedge funds can trade for a huge value of bonds. For example, only with $1 million capital hedge funds can trade TRS for a face value of $100 million bond. Using 1:10 leverage hedge funds can upsize the TRS profit to 10 times. The collapse of LTCM may be regarded with TRS transaction. LTCM bet on narrowing spread after the Asian Crisis and then bought TRSs on emerging countries bonds. Unfortunately, Russian bonds then defaulted. Spread widened, yield increased and bond price decreased. Because of too much leverage LTCM lost US$2.3 billion with US$1.6 billion TRSs in the portfolio.

Conclusion

Physical development of the world in every economic sector grows rapidly in every country and can only be executed with funding provided through capital investments, whether foreign or domestic. Credit market as the biggest capital provider after equity market has been developed with financial innovations in financial engineering and technology that can turn an illiquid investment with low return into a liquid investment with high return. Bonds, which are low return investments, become more attractive as liquid high return investments in the form of CDO tranches. Moreover, credit protection can be traded into CDSs that can circulate in the market according to one's perception to the probability of default of such loans or bonds without holding them.

Hedge funds with their channelling and leveraging capacity are able to trade and play with credit derivatives as accessing credit markets in which they do not have the capability of credit origination. Hedge funds may see an opportunity to take a big profit in credit market via credit derivatives as they can speculatively bet on default probability and interest rate movement. Credit derivatives on the other hand can provide lenders a broader and more liquid market for transferring credit risks in order to capture wealthy investors via hedge funds. Credit derivatives market then needs hedge funds involvement in making market as hedge funds can bid or offer a better price than other players such as commercial banks, investment banks, pension funds and insurance companies can do.

The nature of speculation in hedge funds becomes the main issue and even a big issue when it meets the nature of leverage and indirect exposure in credit derivatives. History has noted the failure of credit derivatives played by hedge funds. Then, some people observed and analysed with what have gone wrong and can provide the causes of the failures. However before some failures, any strategy in credit derivatives was seemingly paramount for generating a reasonable big return. And after some failures, some new strategy is developed for anticipation. After all, hedge funds may still have some chances to get a big success in credit derivatives market, however, only for the sought-after players who have high analytical skills and freedoms.

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