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Citi Stock's Wild Ride Explained in Arb Trade

Similarly, the debt markets seem to be aware that there are no guarantees that those bets will pay off. The price of credit default swaps on Citi -- protection against the company reneging on its debt -- hit new records on Thursday, according to Bloomberg, with investors paying $525,000 a year to protect $10 million of debt against default.

The scramble to cover short positions and get ahead of other equity holders has fueled huge swings in penny stocks like Citi and AIG (AIG - Get Report) as well as those of other high-profile firms where investors smell trouble ahead, like GM, Bank of America and Wells Fargo. For instance, a volatility measure for Citi stock was almost twice as high in mid-February as the average daily reading over the past year.

A catalyst for upticks in shares of troubled companies can be something as simple as an overall market bounce, or the passage of a government initiative that benefits financial institutions, like a change in accounting rules. Both of those factors are incredibly unpredictable, as are the debt markets.

But if hedge fund managers are lucky, it can be a lucrative bet -- reaping rewards of 11% to 20% on the difference between common and preferred shares, according to the hedge fund manager who discussed the trade.

"The institutions have been eating this trade up," the hedge fund manager says.

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