Betting One's Hedges

There's a false sense of immunization
In many a hedge operation;
Positions one places
On ill-conceived bases
May end up as wild speculation.

JP Morgan Chase CEO Jamie Dimon stunned investors on Thursday with the announcement of a $2 billion trading loss in the bank's risk management unit. Some reacted with schadenfreude, in view of Mr. Dimon's previously dismissive attitude toward reports of the firm's massive credit default swap positions. The Chief Investment Office's head trader, Bruno Michel Iksil, had been dubbed "the London Whale" for his huge, market-distorting CDS bets on the so-called CDX IG 9 index of the credit risk of 125 companies. Mr. Iksil sold protection on the index during the first quarter, essentially writing an insurance policy that the indexed companies' credit would not deteriorate.

Based on his limited knowledge of this case, Dr. Goose is at a loss to explain how the selling of credit protection constitutes a risk management function for a bank (one would sooner expect them to be buying credit protection). Nevertheless, even the most well-intentioned hedge position can go awry if the underlying assumptions do not hold, and many a "hedge" entered into on the basis of a particular market outcome is just speculation by another name.