Page last updated at 17:48 GMT, Wednesday, 29 October 2008

Hedge funds make 18bn loss on VW

A VW Tiguan

Hedge funds have lost 18bn in two days of trading in Volkswagen (VW) shares that briefly saw the carmaker become the world's most valuable company.

VW shares rose 348% over Monday and Tuesday after it emerged that only about 5% of its shares were available.

Funds that had bet on the shares falling desperately needed to buy the shares to close their positions.

But VW shares fell 45% in trading on Wednesday as Porsche said it would help to solve the hedge funds' problems.

"In order to avoid further market distortions and the resulting consequences for those involved, Porsche SE intends - depending on the state of the market - to settle hedging transactions in the amount of up to 5% of the Volkswagen ordinary shares," Porsche said in a statement.

Inevitably some traders and investors are calling foul

Robert Peston, BBC business editor

"This may result in an increase in the liquidity of the Volkswagen ordinary shares."

Controlling stakes

On Sunday, Porsche announced it controlled more than 74% of VW shares.

VW's home state of Lower Saxony owns another 20%.

The panic buying was caused by traders who had short-sold VW shares desperately trying to buy them back so they could close their positions.

Before Porsche's announcement, many traders had been betting on VW's shares falling.

They had borrowed VW shares and sold them in the market, planning to buy them back when the shares had fallen, return them to the lender and pocket the difference.

But what actually happened was that the shares rose as a result of Porsche's effective takeover and the traders found themselves forced to buy the shares at any price.

"Each and any short-seller in the world is trying to close up their position and there is no way they can do it, except for trying to buy like mad," said Heino Ruland, an analyst at FrankfurtFinanz.

What is upsetting the hedge funds is that if between 10% and 15% of VW shares were on loan to be shorted and only just over 5% were available in the market, it is likely that many of the funds that shorted VW had borrowed the shares from Porsche.

It meant that because Porsche had not declared the proportion of VW shares it controlled, traders may have been indirectly and inadvertently borrowing shares from Porsche, selling them to Porsche, buying them back from Porsche and then returning them to Porsche.

None of this is currently outlawed by German authorities, but many commentators have described it as bringing German capital markets into disrepute.

The affair shows reform is needed in the way stock markets operate, according to Chris Day, chief executive of the hedge fund infrastructure providers PCE Investors.

"While there has been much talk that hedge funds should improve their transparency, perhaps the issue should be widened to include stock exchanges to help stop this sort of thing happening," he said.

Bigger than Exxon

VW's shares peaked on Tuesday at 1,005 euros, valuing the company at 296bn euros ($370bn; 237bn), which is well over the $343bn value of Exxon Mobil - previously the world's most valuable company.

Last Friday, VW's shares closed below 200 euros.

On Wednesday they closed down 430 euros, at 514 euros.

As an indication of how extreme the market valuation is, last year Exxon made profits of $41bn on sales of $390bn while Volkswagen managed profits of about $8bn on sales of $136bn.

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