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Hedge Funds Expected To Act On Japan Index Rebalancing

Hedge funds will pile into the Japanese equity derivatives and cash market next month to take advantage of upcoming changes to the MSCI Japan index, according to officials at Merrill Lynch and Bear Stearns in Tokyo. The hedge funds are expected to enter total-return swaps, in which they pay the return of stocks leaving the index and receive the return of stocks joining, as well as equity basket options, according to Ken Chang, head of Japan and Asia Pacific equity derivatives strategy at Merrill in Tokyo.

Chang predicts the volumes of these trades will double to one a day by the end of November. The typical maturity of these trades will range from two weeks to a month with a notional size of approximately USD5 million. Susan Chan, managing director and head of equity derivatives trading at Bear Stearns in Tokyo, agreed that hedge funds will look to enter the trades next month. She noted that Bear Stearns executed over-the-counter derivatives trades to take advantage of a possible volatility spike back in August, declining to elaborate.

Some hedge funds will choose to execute these trades with OTC derivatives because this allows them to leverage their positions, according to Merrill's Chang. This is especially relevant with this trade because the changes are expected to take place over such a short time frame. However the majority of trading volumes will be in the cash market, with hedge funds borrowing stocks from their prime brokers.

On Nov. 30, 71 names will be added to the MSCI Japan index and 23 removed. Passive funds, which track the MSCI Japan, will have to wait until that day to change their position, Merrill's Chang added.

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