Hedge funds are increasingly stepping in to help banks manage the risks associated with deal contingent trades, a complex derivative sold to corporations and PE firms to hedge against market fluctuations during major mergers and acquisitions, according to a report by IFR.

This growing involvement is creating a secondary market for these risks, allowing banks to underwrite larger and more numerous deal contingent transactions.

According to industry experts, at least four hedge funds are now active in this space, up from just one a few years ago.

The report quotes the Global Head of Foreign Exchange Structuring at one unnamed major financial institution, as saying that: "We are regularly facing much larger deal contingent hedging opportunities than in the past. The increased appetite from banks for these risks is closely tied to our ability to distribute them to hedge funds, allowing us to handle larger deals through risk recycling."

Deal contingent options are particularly attractive for companies involved in mergers and acquisitions, as they offer protection against significant market shifts in currencies or financing costs between the announcement and completion of a deal. However, the inherent risk for banks lies in the fact that the acquirer can back out of the deal without paying for the hedge if the transaction falls through.

The growing participation of hedge funds comes at a crucial time, with demand for deal contingent hedges on the rise. Private equity firms, which have historically been the largest users of these structures, are ramping up deal-making activities after a slow period, while the current high-interest rate environment has prompted more companies to use deal contingents to hedge their future borrowing costs.

To compensate for the risks involved, banks typically charge clients a premium, which is calculated based on the cost of the relevant FX or interest rate derivative. By offloading some of these risks, banks can free up capacity to engage in more deal contingent business and underwrite larger hedges.

For hedge funds, taking on the opposite side of deal contingent hedges offers a way to diversify their investments while opening up new revenue streams.