TAKING THE HEDGE OUT OF HEDGED TRADES This is a glorious time for the trading desks: the ows are deep, the markets volatile yet optimistic. The Treasury traders nd themselves taking larger and larger positions and making more money than ever before. But the risks they take are as nothing compared to those taken on other desks. The real risks to a banks capital, and to its solvency, are usually found on the desks trading securities that carry credit risk, securities such as stocks, corporate bonds (ones issued by private companies), junk bonds (ones issued by private companies that are on the verge of bankruptcy), and mortgagebacked bonds.

There is one desk, though, that has a mandate to trade all of these dangerous securities, and not surprisingly it often lies at ground zero of any nancial crisis. This desk is located just down the aisle from Martin the xed income arb desk. Arb is short for arbitrage, a complicated and supposedly clever type of trading designed to prot from incorrectly priced securities. Arb traders do not provide prices or services for clients, as do ow traders like Martin and Gwen; rather, they trade for the banks own account, buying securities that seem cheap and selling ones that seem expensive, sometimes amassing huge leveraged positions, that is, ones nanced with borrowed money. The positions can end up being several times larger than the entire value of the bank itself. To put this leverage in perspective, these traders positions can be compared to a homeowner who borrows $20 million against the collateral of his $500,000 home, in order to buy some rental properties. Were the rental prop

5 per cent, the homeowners capital would be wiped out, bankrupting him. It was leverage on this scale that in 2008 bankrupted the investment bank Lehman Brothers.

Arb desks house the so-called rocket scientists, ex-physics or engineering quants who build models designed to spot pricing anomalies in, say, the yield curve or the volatility surface in the options market. Stefan, for example, the head of the desk, has a Ph.D in physics from the University of Moscow and has worked on Superstring Theory, a bewildering branch of quantum physics in which sub-atomic objects vibrate in ten dimensions. Arb traders, being inscrutable geniuses, have a licence to act inappropriately to go unshaven, dress down, show up for work at noon. Unlike ow traders, who must be clean-cut, well-dressed (but not too ashy Brooks Brothers rather than Prada) and capable of observing basic table manners when entertaining clients, arb traders are nurtured as the oors eccentrics. Whether or not they have the brains and