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Why hedging is so difficult

I am often asked why I say that hedging your position is so difficult (Ok not that often -- still) one thing for sure it can be a challenge to understand.  This week I was handed the perfect example; Peabody Energy -- which has a large HY debt exposure and is a publicly listed company with a sizable float (e.g. large percentage of shares widely owned).  Peabody is a coal company -- not exactly the market darling, in fact, its a bit of a dog.  At this current burn rate its tangible net worth will be negative within 6 months -- I'm speaking trend her -- it has $900 MM in TNW and is losing about $800 MM per quarter.  In 2014 it has more than $2.5 billion in TNW...

The debt market had been pricing Peabody in the dumpster, but there was still a bit of play, and so the obvious trade was go long the debt  and go short the equity.  In other words the price of equity will drop much more than the price of the debt (this relates to the fact that debt is more senior than equity and if there are failure the equity will be killed -- so will the debt, but far less).  So the trade here is buy the debt at 25 (25 for a instrument that is paying interest against 100...) and short the stock -- as you sell the stock (and borrow the stock) its price over time will fall, and you will make more money.  This is a close to cannot lose trade -- except when it doesn't work. 

It appears that the debt and equity markets have a very different perception about Peabody Energy's future [NYSE:BTU].  The debt is now priced at 3 -- giving investors a coupon of 269%, and the equity is up 40% at 4.51 (Tuesday).  

The hedge fund that put this position (about a month ago) is gone!  He has lost on the entire trade on the upside (the debt; 25 to 3) and on the equity from 2.21 to 4.51.  Just goes to show -- you know nothing!



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