The wild ride for financial stocks lately has been triggered mainly by events on Capitol Hill and optimistic CEOs, but further fueled by hedge funds' bad bets.

There have been huge swings in high-profile financial names recently, with AIG ( AIG), Citigroup ( C), General Electric ( GE), Bank of America ( BAC) and Wells Fargo ( WFC) hitting months-long volatility heights, according to Bloomberg data.

During Thursday's session, AIG shares traded six times as high as a 33-cent low hit earlier this month, while Citi traded four times as high; BofA nearly triple; and Wells and GE both about twice as high as their March lows. All of the stocks closed lower, amid a broad market selloff.

The sharp rise in these stocks' value over the past month has burned hedge funds engaged in a newly popular arbitrage strategy -- if they didn't get out in time.

Those funds were shorting common stock while going long on other assets that are further up the capital-structure food chain, like preferred stock. Those assets are better protected in case of liquidation, and financials issued a bevy of preferred stock to the government in exchange for fresh capital. Citi and AIG preferreds were to be converted into common shares at prices much higher than the market rate, providing a double-digit differential as high as 20%.

As confidence in the financial system plunged in February, common stock followed suit, exacerbated by waves of short selling. By buying preferred stock, hedge funds were taking advantage of the differential between the conversion price on preferred shares at Citi and AIG, and the market price, which could be as high as 20%, according to one fund manager.

But the sharp, swift movement upward in recent days has turned a sophisticated, profitable strategy into a liability for fund managers who couldn't exit the positions quickly enough. At the other end, it has also been a profitable adventure for those who smelled a bargain when s share of AIG cost only a few dimes and Citi stock could be featured on the dollar menu.

"It's a smart trade, but it smacks of gut feel and instinct as much as science," says a report by financial-software firm Super Computer Consulting, which analyzed capital-structure arbitrage bets when they first emerged as a hot hedge-fund trend in the early 2000s.

A few issues heighten the risk for these bets in the current market: haphazard government bailout proceedings and unexpected news from companies that send stocks on rollercoaster rides; and a lack of liquidity in the credit markets, which make bonds and preferred shares even harder to sell, if necessary. As shares of financial firms climbed recently, funds that were shorting the stocks raced to cover their bets, further fueling the upswing.

Research by Manolis Chatiras and Barsendu Mukherjee, two associates at the Center for International Securities and Derivatives Markets who are experts on capital-structure arbitrage, notes that opportunities arise when there are significant variances in the pricing of different parts of a firm's capital structure. However, they note that "for any successful implementation of a hedging strategy risk, management is a critical component."

Managers who are incredibly nimble and attuned to the swift changes in market sentiment may have been able to get out in time -- or even profit on both ends. During the first two months of the year, funds with short-bias, convertible arbitrage and fixed-income arbitrage strategies were among the best performers, according to several hedge-fund research groups. But the swift turnaround in March may have ended that winning streak.

Joel Shulman, who is on sabbatical from a position at Babson College to work with a long-short hedge fund, notes that Long Term Capital Management was brought down in the late-90s by bad arbitrage strategies. A lack of liquidity, combined with unexpected events in the global capital markets, were simply too costly for that fund to survive.

"You see exceptionally bright guys who set up arb strategies," says Shulman. "And whether it's political risks or short squeezes, those parameters blow up and it's a tough place to be."

Even in ordinary times without government bailouts and unexpected events, when too many funds are chasing too few strategies, the yields start to diminish.

"In the beginning your risk vs. reward is very good, but as more and more people are doing this, it's inevitable that the reward will be a lot less," says Andrew Schneider, founder and managing partner of HedgeCo Networks, a service provider to the hedge-fund industry. "You just have too much money chasing after too few ideas."

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