A: There’s growing concern in bond land. The stock market is firming, some investors are shifting cash from bonds to equities, and interest rates, still near all-time lows, likely will move higher over the next few years if the economy keeps improving, analysts say. That would push bond prices, which move in the opposite direction of rates, lower.

A first step is to trim bonds with longer maturities. “Because bond prices are sensitive to interest rates, short-term bonds will not be as badly affected” by rising rates, says Scott Miller Jr., a managing partner of Blue Bell Private Wealth Management LLC in Blue Bell, Pa.

Some advisers say exposure to junk bonds should be reduced. Don’t sell them all, though. High-yield bonds usually are viewed as quasi-stocks. As such, they will be helped if the stock market continues to rebound. Instead, some analysts recommend the Pimco 0-5 Year High Yield Corporate Bond Index HYS +0.23%(HYS), an exchange-traded fund that tracks the performance of short-term junk bonds and sports a yield of over 5%.

Jeff Fishman, president of JSF Financial LLC, a Los Angeles-based financial-advisory firm, says one way to profit from a drop in Treasurys is to buy an ETF that rises in value as Treasurys fall in price, such as the ProShares Short 20+ Year Treasury (TBF), which buys derivative investments in the hope of achieving a return that’s the inverse of the daily results of Barclays’s benchmark index of 20-year Treasurys. More adventurous investors may choose to buy the ProShares UltraShort 20+Year Treasury (TBT), which aims for daily returns that are twice the inverse of the Barclays Treasurys index.

Yigal Newman, JSF’s chief investment officer, cautions that these ETFs are much better at tracking markets over shorter periods than longer periods. That makes these ETF trades ideal for investors looking to protect their portfolios over short periods, but more questionable as long-term investments.

Mr. Newman says investors may wish to purchase “put” contracts on ETFs tracking the Treasury market, such as the iShares Barclays 20+ Year Treasury Bond Fund (TLT). These put contracts could rise in value when the ETF falls.

Mr. Miller is a fan of “kicker” bonds, also known as “cushion” bonds. These are long-term bonds with high coupons that may be called, or redeemed, by the issuer in the near term. Because these bonds may be called, they tend to trade at a yield that’s higher than comparable bonds. And if interest rates rise and the bonds aren’t called, their yield increases, or kicks up.

“In a rising rate environment, kicker bonds should provide a cushion” compared with other bonds, Mr. Miller says.

Mr. Fishman urges investors to make sure their portfolios are diversified across various fixed-income products to reduce risk. He says emerging-market bonds and funds that invest in senior bank loans, which have floating rates that reprice every 90 days, typically hold up better than other bonds in bear markets.

Shorter-term corporate bonds of top-rated issuers also should hold up in a bond-market tumble, says Richard Platte Jr., portfolio manager of the Ave Maria Bond Fund (AVEFX).

Step-up bonds, which pay an initial rate or coupon and “step up,” or readjust to a higher coupon rate until maturity, also are a potential way to protect a portfolio in a rising-rate environment, advisers say, as are floating-rate preferred stocks, which also see their yields rise.

John Lekas, who manages the Leader Short Term Bond Fund (LCCMX) and Leader Total Return Fund (LCTRX), recommends floating-rate notes tied to 10-year Treasury notes. “The coupon will move up and they will increase in value as interest rates rise,” he says.

Mr. Zuckerman is a special writer for The Wall Street Journal in New York. He can be reached at gregory.zuckerman@wsj.com. Send questions about alternative investing to reports@wsj.com.

After a choppy run last week, the Dow Jones Industrial Average is up 7.5% for the year while the Standard & Poor’s 500-stock index is up 6.5%. The Dow is now just 75 points from its all-time high, reached on Oct. 9, 2007, while the S&P 500 is 47 points away from its record, set on the same day six years ago.

Behind the sharp recent gains: impressive corporate earnings, a rebounding U.S. housing market and improvements in Europe and China. Continued indications that the Federal Reserve isn’t eager to raise interest rates any time soon also are helping stocks, by keeping bonds unattractive and allowing companies and individuals to borrow money at puny rates.

The climb has come despite hand wringing about a string of issues, from a political squabble that has forced cutbacks on the government to a U.S. economy dealing with lackluster growth.

Stocks remain reasonably priced, despite the market’s gains since November, so investors shouldn’t race for the exits, some analysts say. Stocks in the S&P 500 index trade at less than 15 times their earnings over the last year, and about 13.5 times their expected earnings over the next 12 months. Both are reasonable multiples based on historical ratios.

Stocks also look attractive based on cash flow, which many investors argue is a better barometer of a company’s strength than reported earnings. Stocks trade at a “cash-flow yield,” which reflects a stock’s cash flow as a percentage of its price, of about 7%.

That figure has come down over the past year, suggesting that stocks have become less attractive during that time.

But the 7% figure is in line with the average of the last three years and higher than the entire previous decade. For the first time on record, the cash-flow yield of stocks is higher than yields that junk bonds currently pay, suggesting that stocks are more attractive than junk bonds, according to BMO Private Bank.

Stocks are fairly priced relative to traditional metrics, like earnings and revenues,” says Jack Ablin, chief investment officer of BMO Private Bank. “They’re cheap relative to bonds.”

Meanwhile, the dividend yield of the 100 largest companies in the S&P 500 is expected to be about 2.6% this year, well above the 1.9% yield of 10-year Treasury notes. That’s another reason to think stocks are more reasonably priced than bonds, a reason money has shifted to equities from bonds.

A spate of recent mergers and buyouts is more good news, some argue. Billion-dollar deals for Dell, H.J. Heinz, Virgin Media and other companies suggest to some that stocks are attractive because savvy buyers are willing to make these big purchases.

“If investors, treasurers and arbitragers get more optimistic, we could see more” buyouts, takeovers and stock buybacks, which might help stocks, Mr. Ablin says.

While individual investors are beginning to get more excited about stocks, they’re still sitting on piles of cash, suggesting more money could move into the stock market. Over the past four years, investors have plowed more than $1 trillion into bond mutual funds, while pulling $500 billion from U.S.-oriented stock funds, according to Citigroup.

“Investors may be on the cusp of a major reallocation back toward equities,” argues Tobias Levkovich, Citigroup’s chief U.S. equity strategist.

To be sure, the valuation picture isn’t quite as rosy based on other metrics. One favored by Robert Shiller of Yale University that measures stock prices against average corporate earnings of the last decade shows stocks trading at nearly 23 times earnings, well above the historical average of 16. Some favor this measure because using a decade of profits makes it less volatile.

Bears also worry that profit margins are at record peaks and likely to fall, and that the U.S. and global economies remain fragile. Economists expect the U.S. economy to grow about 1.5% this year, a meager figure that comes on top of growth of just 0.1% in the fourth quarter of last year. Goldman Sachs predicts growth will be 2.9% next year and that investors will begin to anticipate the improvement later this year.

For now, markets have largely shrugged off the continuing tussle in Washington between the Obama administration and congressional Republicans over the budget, though the resulting across-the-board budget cuts—which started taking effect on Friday—will serve to further slow the economy.

In the bond market, there’s more evidence of danger. Junk bonds and other riskier debt have been so popular, and the volume of new sales of junk bonds has been so strong that some economists and analysts have turned wary. In early February, Federal Reserve Governor Jeremy Stein said “we are seeing a fairly significant pattern of reaching-for-yield behavior,” or investors buying riskier debt with higher yields.

William Gross, manager of the world’s largest bond fund at Pimco, recently wrote that stock and bond valuations are becoming stretched, but not yet at levels where investors should sell the bulk of their portfolios.

“On a scale of 1-10 measuring asset price ‘irrationality,’ we are probably at a 6 and moving in an upward direction” he wrote.

What investors need to do, Mr. Gross argues, it to stay invested in the market, but temper their expectations about future returns.

“Recent double-digit returns are unlikely to be replicated,” Mr. Gross wrote, pointing to potential annual gains of 5% to 6% over the next few years.

Over the next few months, James Paulsen, chief investment strategist at Wells Capital Management, argues, the fiscal drama and Europe’s challenges won’t matter as much for the market as whether the U.S. job picture improves. What to watch out for: housing and retail sales further strengthening, and investors shifting even more of their holdings from bonds to stocks.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

The apparent reservations of Bruno Iksil, who earned the nickname after making outsize wagers in debt markets, are among the details being examined by the Senate Permanent Subcommittee on Investigations, according to people familiar with the probe.

In one instance, Mr. Iksil told another trader that the size of his bets was getting “scary,” according to emails in a Jan. 16 report by J.P. Morgan and to the people familiar with the emails.

Mr. Iksil’s emails, according to people familiar with them, show there was concern within J.P. Morgan’s chief investment office before Chief Executive James Dimon dismissed as a “tempest in a teapot” reports on the whale trades, including an April 6 article in The Wall Street Journal. The New York company first disclosed the trading losses in May, and Mr. Dimon subsequently said he was wrong to have played down concerns raised by the news report.

The panel, led by Sen. Carl Levin, D-Mich., also is looking into whether J.P. Morgan failed to disclose crucial information to its primary bank regulator, the Office of the Comptroller of the Currency, and whether the OCC failed to press the bank for details about how it managed its risks. The bank acknowledged previously that its information was wrong early in 2012.

The OCC prepared an assessment of its performance and shared it with the subcommittee, said people familiar with the OCC report. It isn’t known if the subcommittee intends to release the OCC document. The subcommittee declined to comment.

Mr. Iksil kept trading early in 2012 even as he expressed doubts to his bosses, and managers didn’t stop his trading until late March, the emails show, according to the people familiar with them.

Even Mr. Iksil didn’t seem prepared for how heavy the losses eventually would become, according to the emails, suggesting that he, too, was surprised by the deep and sudden trading losses.

The Senate report is expected to offer details about the skepticism of Mr. Iksil, whose trades ultimately led to the losses and the departure of several executives and traders.

A J.P. Morgan spokesman said the company already has commented extensively on the matters in prior reports, one of which highlighted a trader’s worries without naming the trader.

Emails reviewed by the subcommittee and J.P. Morgan show Mr. Iksil was worried about the trades as early as January 2012, according to the people familiar with them.

Mr. Iksil and another London trader, Javier Martin-Artajo, also suspected in early 2012 that other traders in a different part of J.P. Morgan leaked their positions to outside hedge funds and took opposing positions to those held by Mr. Iksil’s group; both later communicated these suspicions to internal investigators, said people familiar with the case. News of the alleged leaks was reported this week by Reuters. Those concerns were conveyed to the U.S. Securities and Exchange Commission and the U.S. attorney’s office for Southern District of New York, one of these people said.

J.P. Morgan, the U.S. attorney’s office and the SEC declined to comment on those allegations.

J.P. Morgan’s report following its own investigation, which included interviews with Mr. Iksil, showed traders raising questions early in 2012. The bank redacted the names of London traders in its 129-page report released in January after a British regulator asked J.P. Morgan to keep the names out.

Messrs. Iksil and Martin-Artajo were key members of the London team that built a complicated, bearish position in an index that tracks the health of a group of investment-grade companies. Last year, the bets morphed into a not-easily-liquidated position on corporate credit. The wagers accumulated losses when the traders added to their positions instead of unwinding them and the market went the other way.

On Jan. 30, 2012, according to emails in J.P. Morgan’s report and the people familiar with the emails, Mr. Iksil said to Mr. Martin-Artajo that the size of the positions was becoming “scary” and suggested that the bank’s chief investment office should take losses, or “full pain,” immediately. Mr. Iksil then asked for a Feb. 3 meeting with his managers, including Chief Investment Officer Ina Drew.

Mr. Iksil told Ms. Drew the portfolio could lose an additional $100 million and that it was possible J.P. Morgan didn’t have the right positions in place. To Mr. Iksil, Ms. Drew didn’t appear overly concerned by this potential $100 million loss. Ms. Drew, who left the bank following the disclosure of the losses, didn’t respond to a call seeking comment.

One week later, Mr. Iksil told those who attended the Feb. 3 meeting aside from Ms. Drew that he would need to expand his positions. He was told to proceed, while concentrating on managing profits and losses. He and the other traders added to their trades in February. Losses reached $169 million by the end of that month.

At one point, Mr. Iksil told a trader to stop trading a certain credit index because he wanted to observe its behavior. He told Mr. Martin-Artajo about his plans, but Mr. Martin-Artajo, who was Mr. Iksil’s direct superior, told him to keep trading.

In March, traders overseeing the positions began to discuss whether they should place higher estimates for the values of certain trading positions of the CIO group, a step crucial in how they viewed the positions and reported them to investors and other outsiders. On the last day of the first quarter, Mr. Martin-Artajo asked Mr. Iksil to reduce an estimate of losses that day to $200 million from $250 million and encouraged him to keep trading despite orders from Ms. Drew to stop. The loss reported at the end of that day was $138 million.

After the Journal reported on April 6 that Mr. Iksil’s trades were roiling debt markets, Ms. Drew told the bank’s operating committee that losses were manageable. On April 8, Mr. Iksil sent a draft presentation to Mr. Martin-Artajo saying additional losses could hit $500 million but were more likely to be $150 million to $250 million.

But on April 10, losses mounted again, and traders were at odds over how bad it could get. The estimates for that day ranged from $5 million to $700 million; the final number landed at roughly $400 million.

After Mr. Dimon told analysts on April 13 that concerns were a “tempest in a teapot,” losses ballooned by $117 million the following week. Then, on six trading days between April 23 and April 30, losses went up by nearly $800 million more. The losses caused Mr. Dimon and other top executives to question whether the traders “adequately” understood the trading portfolio “or had the ability to properly manage it,” J.P. Morgan said in its Jan. 16 report.

That has been a painful stance lately. But Monday finally brought some good news for the well-known hedge-fund manager and other gold bulls.

Gold jumped as high as $1,596 an ounce in electronic trading, after settling up $13.80, or 0.9%, at $1,586.20. Concerns about elections in Italy and big spending cuts in the U.S. helped drive the rally.

It was a contrast to the declines seen over the past few months, as an absence of worrisome news helped damp enthusiasm for gold. Prices have fallen 5.3% this year and are down 16% from a record closing high of $1,888.70 set in August 2011. The final three months of 2012 were the metal’s worst quarter since the 2008 financial crisis.

While many investors remain skeptical about the long-term prospects for gold, some large hedge funds are beginning to pay a bit more attention as the price has slid.

Behind the troubles for gold have been an improving global economy and stock market, which have left investors searching for riskier investments, such as stocks, and selling safe-harbor investments, like gold. Meanwhile, some who bought gold as a hedge against inflation have dumped the metal because consumer prices have been tame. Others say stocks will do at least as well as gold if inflation rises.

The dollar also has held up, which reduces gold’s allure. And interest rates have moved higher, making it more costly to hold gold, which earns no return. Gold-mining stocks have been even more disappointing, partly because of management flubs and poor cash flow in recent years.

Despite all the gold negativity, Mr. Paulson’s firm, Paulson & Co., remains among the biggest fans and is holding on to much of its gold stash. Paulson continues to hold the largest position in the SPDR Gold Trust GLD +0.05%exchange-traded fund, or GLD, with almost 22 million shares, a position he didn’t change last quarter. The firm’s large positions in gold miners AngloGold Ashanti Ltd., ANG.JO -1.00%Detour Gold Corp., DGC.T -0.92%NovaGold Resources Inc. NG.T +0.51%and Barrick Gold Corp. ABX.T -0.31%were barely changed last quarter, according to filings.

It isn’t clear if Mr. Paulson has adjusted his gold-derivative positions, which are considered large. But Mr. Paulson has told clients that he believes gold will rise over the long term, as global central banks expand their respective money supplies and inflation eventually picks up. He hasn’t, however, been making a new push into gold, his investors say.

A few of Mr. Paulson’s colleagues on Wall Street agree with this stance. Giant hedge fund Och-Ziff Capital Management Group LLC OZM +1.61%added to its position in GLD in the fourth quarter, but the firm has less than 1% of its overall holdings in the ETF, according to FactSet.

Vishaal Bhuyan, who runs $20 million hedge fund Nariman Point LLC, says he has been buying physical gold “on dips,” or as gold prices dipped recently, on a bet that interest rates won’t soar.

“If you look at gold as protection, you need to own it in coins or bars and not an ETF,” says Mr. Bhuyan, who is holding gold as a long-term investment but acknowledges prices could fall to $1,350 an ounce.

The bulls are in the clear minority lately, though. Money managers tracked by the Commodity Futures Trading Commission this month cut their bullish bets on gold futures and options to the lowest level in more than four years. Funds slashed their net bullish bets by 32% during the week ended Feb. 19 to about 42,000 contracts, the lowest November 2008.

Big-name hedge funds and other traders have turned away from gold in recent months, and some say they are staying away.

Steve Mandel’s Lone Pine Capital LLC dumped its entire position in the GLD ETF, in the fourth quarter, or nearly 2.6 million shares, according to securities filings. Other well-respected hedge funds, including Moore Capital Management LP and Scout Capital Management LLC, also sold all their positions in GLD in the quarter, according to filings. Representatives of the firms declined to comment.

“Gold has been a momentum trade and people are getting bored with it,” says the head of a major hedge fund.

George Soros’s $24 billion Soros Fund Management pulled about $100 million from its holdings in GLD in the fourth quarter, or roughly half of its position. The move, however, didn’t reflect a souring on gold, according to people close to the firm, which in the past has used a variety of investments and derivatives to buy and sell gold.

Mr. Paulson made his reputation by scoring about $20 billion in profits betting against subprime mortgages. He padded those gains by buying gold in early 2009, well before it began to rally. Mr. Paulson began a dedicated gold hedge fund, which manages about $1 billion, to wager on gold.

The gold weakness has cost Mr. Paulson. His own money represents more than half the gold fund, according to investors. And Mr. Paulson has told clients more than half of his personal wealth is in his firm’s gold-denominated funds.

In the options market, bearish sentiment has been on the rise. In the past month, the average ratio of trading in bearish options relative to bullish options has risen to its highest level since October 2011, according to options-data firm Trade Alert.

Some large hedge funds say they have become more interested in gold as it has slid and sentiment soured, but they are waiting for a sharper downturn before doing any serious buying.

Daniel Arbess, who manages the PWP Xerion hedge fund, bought physical gold in late 2008 but sold his investment last year. Xerion is avoiding gold in anticipation that central banks may eventually need to ease off their monetary policy, driving rates higher.

“We don’t want to be in gold ahead of the normalization” of rates, Mr. Arbess says, though he may come back into gold at a later date as a hedge against inflation as the Fed sells some of the bonds it has purchased.

—Write to Gregory Zuckerman at gregory.zuckerman@wsj.com and Matt Day at matt.day@dowjones.com

Wagering against the yen has emerged as the hottest trade on Wall Street over the past three months. George Soros, who made a fortune shorting the British pound in the 1990s, has scored gains of almost $1 billion on the trade since November, according to people with knowledge of the firm’s positions. Others reaping big trading profits by riding the yen down include David Einhorn’s Greenlight Capital, Daniel Loeb’s Third Point LLC and Kyle Bass’s Hayman Capital Management LP, investors say.

The growing trade has itself helped pressure the yen, which has slid almost 20% in about four months. That, in turn, is helping fuel what could become a world-wide currency war. Countries such as Germany and France have criticized Japan’s policies, while others have threatened to take action to reduce the value of their own currencies to remain competitive with Japan. Like Japan, many countries depend on exports, which are more profitable when their own currencies are lower.

Investors began jumping into the trade late last year, ahead of the election of Shinzo Abe as Japan’s prime minister. When Mr. Abe and others were unusually open in their rhetoric about driving down the currency, traders added to their positions, helping the yen weaken. Soon, salespeople and traders at banks were telling hedge funds and other investors that the time was right to make big bets against the yen.

Mr. Abe’s election, and the selling by hedge funds, had a big impact. On Wednesday, the dollar bought about 93 yen, from about 79 yen in mid-November. “It’s a bet on Abe-nomics” someone close to the Soros firm says.

Many others have come to the same conclusion. Among the most vocal proponents of the trade is Robert Ettinger, the head of Bank of America’s BAC +1.23%options trading group for currencies in the Group of 10, investors say. Mr. Ettinger has spoken about how he “loves” the bearish yen trade, according to an investor who heard him speak recently. Bank of America’s trading desk also has made money on the trade, according to people with knowledge of the firm’s positions. Mr. Ettinger declined to comment.

Few investors, though, have made as much money as Mr. Soros. The 82-year-old investor’s $24 billion Soros Fund Management has made close to $1 billion of paper profits since mid-November wagering on yen weakness, according to people close to the matter.

The firm, which returned cash to outside investors last year, still invests money for Mr. Soros and his family. It manages about $15 billion itself and allocates the rest to other investors. Soros Fund Management has been led since last summer by Scott Bessent, who increased the yen position late last year. The Soros firm also has done well owning Japanese stocks, which have been rallying. Japanese shares represent about 10% of the firm’s internal portfolio, according to people close to the firm.

Betting against the yen isn’t for the faint of heart. Japan had for years failed in its efforts to lower its currency and reignite its economy and stock market. Many who adopted short positions on the yen and on Japanese government bonds during that period got pounded when the currency and the bonds instead strengthened. Shorting Japan became known on Wall Street as a “widow maker.”

“You aren’t a macro trader if you haven’t lost money betting against Japan,” one trader said.

Knockout Punch
One popular way investors have been betting against the yen is by purchasing so-called reverse-knockout options. These options do well as the yen falls, but become worthless if the currency tumbles too much. The lid on profits made the option relatively inexpensive when it first came into vogue in November, especially among those who weren’t convinced the yen would show dramatic weakness that would render the option worthless.

The following is an example of how a reverse-knockout option with a strike price of 90, and a knockout price of 92, worked, step by step:

In November, investors paid to buy two-month reverse-knockout options.
On Jan. 18, the yen fell to 90 to the dollar, scoring big paper gains for those holding these options.
Those who exited the option at that level or rolled the options into other trades scored profits.
On Feb. 1 the yen fell to 92 yen to the dollar, making the option worthless for those still holding it.

Japan’s new economic policies are expected to be widely discussed at this weekend’s meeting of the Group of 20 finance ministers in Moscow. This week saw rocky trading in the yen after a series of conflicting reports about whether the smaller Group of Seven nations were supportive of Mr. Abe’s policy. After global criticism, Mr. Abe and his advisers have toned down their talk about weakening the yen. Instead, its central bank has promised a significant new easing in monetary policy by buying bonds—similar to strategies enacted by the U.S. Federal Reserve and the European Central Bank—which policy makers say is aimed at ending Japan’s long bout of deflation and often has the side effect of lowering a currency.

As quickly as investors raced to short the yen they could just as easily rush to end this trade, sending the currency higher again, especially if investors conclude the Japanese government is backing off its antideflation campaign.

The prospect of inflation in Japan as the yen weakens may prompt people to turn to gold as a currency hedge. The WSJ’s Clementine Wallop talks about what to expect from gold demand in India and China as well as Japan.

Some hedge funds already have been trimming their bearish yen positions. “People recognize there are concerted efforts on hand to end two decades of deflation,” Chris Ayton of Alternative Investment Group, which invests in hedge funds for clients. “But I don’t see genuine belief out there yet that this time is different. There’s still a significant amount of skepticism.”

It isn’t clear who is feeling pain as the yen falls. Some Japanese exporters with receivables tend to sell dollars and buy yen in the futures market, which could mean they currently are sitting on losses, some traders and analysts say.

“Japanese exporters need to buy yen, and they’ve been doing that a bit more recently, believing the yen weakness wouldn’t last,” says David Woo, Bank of America’s head of global rates and currencies research.

Shares of exporters have been helped by the recent rally in Japanese stocks, of course. The Japanese economy isn’t as export-dominant as it once was, reducing the impact of a falling yen, some analysts argue.

Unlike Mr. Soros’s early short of the British pound, the recent moves by Mr. Soros and other hedge funds are unlikely to destabilize Japan or its currency, partly because trading of Japanese yen is a deeper market that is harder for investors to dictate. Nearly all of Japan’s debt is owned by domestic investors, another reason short positions on the country by bearish investors haven’t had much impact.

At the same time, Mr. Soros’s gambit against the pound was in opposition to policies of the Bank of England, while hedge funds now are making trades in hopes the Bank of Japan succeeds in its policy of defeating deflation.

Lately, a rush of new investors has become involved in the yen trade. As more investors jump on the bandwagon and search for ways to place their own wagers against Japanese currency, some worry the latecomers may regret their newfound ardor for shorting the yen, much like those who piled into shares of Apple Inc. AAPL +2.64%just before its recent tumble.

Many investors bailed out of earlier bearish-yen trades a while ago, unable to withstand losses they suffered. It is similar to how some mortgage specialists removed long-held bets against subprime mortgages before the housing market finally weakened in 2007. They then missed out on the profits when the market turned.

Others, like Greenlight Capital’s Mr. Einhorn, have held on. His firm gained over 3% in January thanks in part to his yen bet.

“We put the trades on about three years ago and the trade wasn’t fun for the first two years and number of months,” Mr. Einhorn says. He expects further weakness.

Investors have wagered against the yen in various ways, from complicated derivatives to simple put options, the kind that Mr. Einhorn says he bought.

Others have had to switch gears, quickly. Bridgewater Associates, the world’s largest hedge-fund firm with $141 billion, had expected strength for the yen for most of 2012, but removed its bullish yen positions in the fourth quarter of last year. Bridgewater is “now modestly short” the yen, according to a January letter to investors.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com and Juliet Chung at juliet.chung@wsj.com

Few investors have made as many mistakes navigating markets over the past two weeks as Philippe Jabre.

Mr. Jabre, one of Europe’s best-known hedge-fund managers, bought Japanese stocks on news of the earthquake, and then suffered when the Nikkei Stock Average quickly tumbled 13%. Making matters worse, Mr. Jabre got nervous and sold his shares last week, just before a rebound in Japanese stocks. The miscues cost his firm about $300 million, the worst few days of his career.

But as Mr. Jabre reflects on his decisions, he isn’t sure he made many mistakes.

“I keep thinking about it, what could I have done differently?” said Mr. Jabre, who manages $6 billion hedge fund Jabre Capital Partners SA. “I spent all last weekend asking questions” of friends, colleagues and clients, he said. “We couldn’t take the risk of the Tokyo Stock Exchange closing down, so we sold” Japanese shares.

Investors have been forced to negotiate treacherous markets over the past few years, perhaps none more uncertain than those of the past two weeks. They made on-the-fly judgments about the extent of the devastation from March 11′s earthquake and tsunami, the impact of the unfolding nuclear crisis, and their effects on the global economy.

A former star trader at British hedge fund GLG Partners, Mr. Jabre, 50 years old, left to start his own firm in early 2006. When most rivals were racking up huge losses in 2008, the Lebanese-born investor scored gains in one fund of 3%, 46% in 2009 and 4% last year.

Suddenly, however, many of his decisions are losers. At the end of February, Mr. Jabre’s firm was cautious about Japanese and U.S. markets. He told a colleague he was hoping for a pullback in prices, so he could plow some money in.

On the Friday the earthquake hit, Mr. Jabre saw his opportunity as stocks weakened. At the time, one of his funds, the JabCap Global Balanced Fund, held futures contracts on the Japanese market that would profit if prices declined, a form of protection for the fund. Mr. Jabre, who last year criticized investors for being “too scared” about the European debt crisis, was convinced Japan would rebound.

That day, he stole a few minutes in his private office and lit a cigar. He weighed his options before taking his spot on the firm’s trading floor, with a full view of the mountains and rivers surrounding old Geneva. Mr. Jabre, who once survived an avalanche while skiing, directed his traders to exit the bearish futures trades, believing prices would rise.

“We can take off our hedges and be 100% long,” he told a colleague at the time. Without the hedge, which had reduced his fund’s Japanese exposure to 9% of his portfolio, Japanese shares became 15% of his portfolio, a sizable wager.

News over the weekend soon arose about problems at Japan’s Fukushima Daiichi nuclear plant, taking Mr. Jabre by surprise. Monday and Tuesday brought big losses in Japan and elsewhere. Trying to assess the impact of the damage, Mr. Jabre consulted four nuclear scientists.

By Wednesday, the Nikkei had dropped 13% in four trading days. Several of Mr. Jabre’s funds faced losses, one of them as much as 10% for the month. To his traders, Mr. Jabre appeared calm. He wasn’t.

“I felt horrible, but I don’t express happiness or frustrations,” he said. “Emotions are the enemy of a balanced person.”

During the 2008 U.S. stock-market collapse, Mr. Jabre bailed on his positions after 10% losses, enabling the fund to survive a market that felled some rivals.

Mr. Jabre reasoned that if radiation spread to Tokyo or a nuclear reactor exploded, authorities could close the Japanese stock market, freezing his shares for months. “If we touch negative 10%, we get very, very, very nervous,” said Mr. Jabre, who promises his investors to keep losses to a minimum.

Last Wednesday, Mr. Jabre cut positions in Japanese and global shares, eliminating his firm’s entire exposure to all stocks.

“If we’re wrong [and the market rallies], we set the firm back,” Mr. Jabre remembers telling a colleague. “But we’ll be alive to fight another day.”

“People like us tend to sell high and buy low; to sell low feels very odd,” he said. “But this is the firm’s style, even if there’s just a one-in-six chance of a nuclear explosion, we couldn’t take the risk.”

Two days later, however, Japanese and foreign monetary authorities took steps to stem the rise in the yen, helping shares rebound. By this week, the situation at the nuclear plant showed signs of stabilizing, bolstering global markets, though Friday brought new concerns of a radiation leak. The Nikkei index is up almost 5% since Mr. Jabre bailed. “We got whipsawed,” he acknowledged.

Mr. Jabre bought global shares on Monday of this week, but he remains cautious about Japanese stocks and the yen. It isn’t clear how recent events will impact Japanese companies, Mr. Jabre said.

He now is calling clients, who include wealthy investors and institutions, to explain the recent losses. He acknowledged he shouldn’t have turned bullish so quickly after the earthquake. As for bailing out early, “it’s the first time a nuclear meltdown was at risk,” Mr. Jabre said. “It was hard to assess the consequences.”

The rebound in U.S. shares over the past week has helped his funds. A convertible fund that had dropped 5% during the worst of this month’s trading now is slightly positive for the year.

But the JabCap Global fund, one of his biggest with $1.5 billion in assets, remains down 7% this month and has lost 3% this year, worse than most competitors. Most of his investors understand his recent moves, Mr. Jabre said. Few have asked to pull their money and some are adding more cash, he said.

“The reason we’re still around is our risk management,” he said. “We’re telling clients that we’ve lost six months of performance, but we’ll be back.”

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

As financial markets struggle to digest the catastrophic effects of Japan’s earthquake, growing violence in the Middle East and resulting jolts to global economies, traders like John Brynjolfsson and Samer Nsouli are engaged in a furious fight to try to stay ahead of events.

Wednesday afternoon, Mr. Brynjolfsson was in the lobby of a Denver office building, waiting to meet a potential investor for his hedge fund, Armored Wolf LLC. Rather than review notes for the meeting, however, Mr. Brynjolfsson couldn’t take his eyes off a television screen flashing market prices.

Soon he was calling contacts at Wall Street banks, searching for information about what he describes as “a freefall panic” in currency markets that sent the yen soaring to its highest level in years, and the dollar tumbling, all between 5:10pm to 5:20 Eastern time on Wednesday.

Mr. Brynjolfsson dialed his trader, Tim Alford, who was back in the office in Aliso Viejo, California. Their $500 million fund already was short the yen, costing it money. Now Mr. Brynjolfsson wanted to add more bearish positions.

“It’s not worth it,” Mr. Alford told his boss, urging caution.

Around the same time, Mr. Nsouli was at his trading desk in New York, watching the historic plunge of the dollar against the yen.

“I can’t believe this,” Mr. Nsouli said to a colleague in the office of his $80 million hedge fund, Lyford Group International Ltd. Rather than make a currency move, Mr. Nsouli quickly sold U.S. stocks, expecting the dollar’s drop to weigh on shares. In a matter of minutes he would learn if he was right.

Mr. Brynjolfsson and Mr. Nsouli are called “macro” traders because they bet on global macroeconomic events. Unlike most mutual funds and other vehicles, these investors can trade stocks, bonds, currencies and commodities around the globe, a freedom that helps explain why they’ve seen a rush of money from investors, as global political and economic events have more impact on markets than ever before.

But with the freedom comes added pressure. Mr. Brynjolfsson and Mr. Nsouli hold hundreds of millions of dollars of positions in global markets, forcing them to react instantaneously to different events around the globe.

A coordinated intervention in the world’s currency markets as the G-7, in a very rare move, agrees to a concerted effort to drive down the yen. WSJ’s Jake Lee and Hong Kong Bureau Chief Peter Stein discuss.

One example is oil. The nuclear accident in Japan suggested to some traders that the prices of oil, natural gas and coal would rise, as Japan and other nations move away from nuclear power, putting new pressure on already stretched energy markets. Some investors have bid up these investments. Other traders countered that the falloff in demand in Japan is quite small, or that the events there would cause a slowdown in overall economic activity, something that should hurt oil prices.

“A nuclear leak can cause oil to rally or sell off, usually in the same time,” said Mr. Brynjolfsson, citing moves in Thursday’s oil market. “And instead of typical 25-cent or 50-cent moves it’s $1 or $3.”

As they desperately search for an edge, the investors are turning to new sources of information. Mr. Nsouli, a native of Lebanon, has begun to rely on Al Jazeera’s coverage of the events. And he’s using insights from emails sent by his cousin, who lives in Bahrain, about the violent protests in that country.

One email yesterday afternoon read: “hey buddy. situation has gone from bad to worse, and in the past 48hrs it has really spiraled out of control.”

Mr. Brynjolfsson has taken to peppering questions at his 84-old father, Ari, who spent 40 years as a nuclear scientist, asking about the potential impact of Japan’s nuclear crisis.

“The amount of confusion is extreme,” Mr. Brynjolfsson says.

Mr. Brynjolfsson and Mr. Alford spent much of Wednesday debating what to do. Early in the day, while he was on the way to his meeting, Mr. Brynjolfsson listened as a European energy minister called the situation in Japan a disaster. Global stocks soon tumbled.

Seconds later, Mr. Brynjolfsson shot off an email to his portfolio manager: “Fade the rantings of the EU commissioner,” using trading lingo for ignoring the minister’s sentiments.”In five hours we’ll find out he has no information beyond last night’s Rachel Maddow show.” Don’t shift the firm’s positions, he told Mr. Alford. “The guy didn’t know what he was talking about,” Mr. Brynjolfsson explains.

He had been consulting with nuclear and medical experts, asking about the impact escaping radiation could have on citizens of the country and what could be done to help them prevent injury. He also consulted his father, who wasn’t panicked.

“We’re overdoing it,” Mr. Brynjolfsson concluded to a colleague, saying his fund should consider buying uranium. Mr. Brynjolfsson also was tempted to buy Japanese shares. But he worried that even if he didn’t think the nuclear threat was great, others might.

“If 90% of experts say don’t buy Toyota it doesn’t matter if they never find radiation on car seats,” he says.

As the yen soared late in the day, Mr. Brynjolfsson became more convinced he had to act. He long argued that Japan’s heavy debt, slow economic growth and demographic challenges eventually will cripple the nation’s currency and Japanese government debt. The Bank of Japan will be even more likely to spend money and reduce the value of its currency to help the country rebound from the recent disaster, Mr. Brynjolfsson argued.

Mr. Alford, his trader, was less convinced. He was on the phone with traders in Wellington, New Zealand, trying to figure out why the yen was plunging, concluded that it likely was because it came at a time of little trading in currency markets.

“Someone could be messing around” with the market, he said. He argued that the market was in such turmoil it would be hard to short yen at the prices quoted at that moment.

Mr. Alford also told Mr. Brynjolfsson that even if he was right in the long run, other traders could be piling into the yen, some of them scrambling to exit bearish positions on the currency, making a short bet on the yen a likely losing proposition, at least in the near term.

Shorting Japanese government debt “is where hedge fund managers go to lose money,” Mr. Alford says, citing years of losses by those making this trade.

“I’m tempted.” Mr. Brynjolfsson says. “But Tim’s trying to protect me.”

He stepped up a recent effort to slice the firm’s positions in almost every market, from stocks to emerging market debt, preparing for even bumpier times for the market. But because he clung to his relatively upbeat outlook for the Japanese crisis, Mr. Brynjolfsson warned his team to exit bearish positions before bullish ones.

Mr. Brynjolfsson flew back to California on Wednesday night, arriving at his fund’s office before 6 a.m. He and his team continued to trim the firm’s positions, while holding onto some bullish bets. That helped yesterday, as stock markets rallied. Trying to relax from the action, Mr. Brynjolfsson walked to a Zen garden in his office complex, sitting by a koi pond, waiting to hear if the Denver investors would become a new client.

Back in New York, Mr. Nsouli also was startled by the huge move in the yen late on Wednesday. Instead of trading that currency, he decided to add short positions on the Standard & Poor’s 500. Within minutes of the yen move, he had sold $45 million of futures contracts on the S&P 500. Just a half an hour later, the position had gained 1%, and Mr. Nsouli quickly sold it, pocketing a quick $450,000.

By Thursday, his focus was again focused on the Middle East, an area he thinks will have even more impact on global markets in the weeks ahead.

“The most underestimated and overlooked issue is what’s happening today in Bahrain,” he said yesterday afternoon. Mr. Nsouli argues that there’s a 20% chance that Iran enters the situation, something that could bring the U.S. into military conflict with the nation.

Such a scenario would send oil prices surging, he says. So Mr. Nsouli has been buying up oil contracts, using any dip as a reason to buy more. That move paid off Thursday, as crude prices soared 3.5%.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

Hedge-fund manager John Paulson personally netted more than $5 billion in profits in 2010—likely the largest one-year haul in investing history, trumping the nearly $4 billion he made with his “short” bets against subprime mortgages in 2007.

Mr. Paulson’s take, described by investors and people close to investment firm Paulson & Co., shows how profits continue to pile up for elite hedge-fund managers. Appaloosa Management founder David Tepper and Bridgewater Associates chief Ray Dalio each personally made between $2 billion and $3 billion last year, according to investors and people familiar with the situation. James Simons, founder of Renaissance Technologies LLC, also produced profits in that range, say investors in his firm.

By comparison, Goldman Sachs Group Inc., Wall Street’s most profitable investment bank, paid all of its 36,000 employees a total of $8.35 billion last year. James Gorman, chief executive of 76-year-old investment bank Morgan Stanley, is expected to receive compensation of less than $15 million for 2010.

Mr. Paulson and his fellow managers seldom take much of their profits in cash. Some of the profits are so-called paper gains, which reflect the rising value of their firms’ holdings, and could erode if those investments sour. Other gains come from selling investments, and most of those are rolled back into their funds.

Mr. Paulson and the other top managers made winning bets on commodities, emerging-market companies, bank shares and U.S. Treasury bonds, among other investments. These moves, along with profitable picks by other funds, are part of the reason the hedge-fund industry is back on its feet after a rough stretch. Assets managed by hedge funds have grown to a near-record $1.92 trillion, up 20% over the past year. Assets jumped almost $150 billion in the fourth quarter alone, the largest quarterly growth on record, according to Hedge Fund Research, Inc.

Still, the average fund gained just 10.49% last year, according to the research firm. That’s well below the 15% gain of the Standard & Poor’s 500 stock index, including dividends, and the 19% return of the average stock mutual fund, raising questions about whether the industry can profitably invest the influx of new cash.

Indeed, the enormous gains by Mr. Paulson and the other managers resulted from solid, though not spectacular, performance. Their personal gains came in part from the sheer scale of assets under their control. The largest hedge fund in Mr. Paulson’s $36 billion investment portfolio, Advantage Plus, grew 17% last year, while another big one rose 11%, falling below returns for the broader stock market.

Part of Mr. Paulson’s more that $5 billion profit came from his firm’s 20% cut of his funds’ profits, known in the industry as the “performance fee.” Those fees amounted to roughly $1 billion last year, according to a person familiar with the matter. An added plus for Mr. Paulson: A chunk of those profits are treated as long-term capital gains and taxed at a far lower rate than the standard income-tax rate.

More than $4 billion came from gains on Mr. Paulson’s investments in his funds.

Mr. Paulson amped up profits for himself and many of his investors in a novel way. He was worried about long-term weakness of the dollar and other major currencies, so he devised a way to embed a bet on gold into each of his funds—for those investors who opted for that approach. Mr. Paulson has placed the bulk of his own wealth in these gold-denominated funds and a separate gold-focused fund. Because gold rose sharply in value last year, the gold-denominated versions of his funds rose as much as 45%.

The performance last year, nevertheless, paled in comparison to his 2007 returns, when Mr. Paulson made a huge wager against subprime mortgages and his funds scored gains of as much as 590%.

Last year “wasn’t the greatest trade of all time, but to manage more than $30 billion and still have gains topping 30% is very rare in the hedge-fund business,” says Jeffrey Tarrant, who helps run Protégé Partners, a New York firm that invested in Paulson & Co. in the past.

One way to view the size of Mr. Paulson’s $5 billion profit: It is nearly as much as the $6.4 billion that Forbes magazine last year estimated as the total net worth of Steven Cohen, the well-known head of $12 billion hedge-fund firm SAC Capital. (Mr. Cohen likely added about $1 billion in 2010, one investor says, after 16% gains in his flagship fund).

Appaloosa’s chief, Mr. Tepper, who specializes in distressed-debt investing and manages around $16 billion, notched gains of about 30% by turning optimistic about U.S. stocks before many rivals. Mr. Tepper correctly anticipated the Federal Reserve’s recent efforts to boost the economy, steps that have helped the market rally.

Mr. Dalio’s Bridgewater Associates, which manages $86 billion in hedge funds and other vehicles, made an early shift to U.S. Treasurys, commodities and emerging-market currencies. He correctly anticipated that the Fed would flood the financial system with cash to help the economy, something that would boost bond and gold prices. Bridgewater also anticipated growth in China and emerging markets, which it figured would help commodities and currencies of those nations. Its hedge funds gained more than 30% last year.

Mr. Simons no longer runs day-to-day trading at Renaissance Technologies, which manages nearly $16 billion and specializes in lightning-quick computer-based trades, so his pay actually dropped a bit in 2010.

But Mr. Simons still owns the bulk of the firm and invests in its hedge funds. Renaissance’s two funds available to outside investors, Renaissance Institutional Equities and Institutional Futures funds, gained about 18% last year, following a disappointing 2009 when the firm considered closing them to outsiders.

Renaissance’s Medallion fund, which is primarily open to Renaissance employees like Mr. Simons and has long recorded big gains, climbed about 30%, according to people close to the matter.

The hedge-fund business now is so big that some managers are hinting they’ll return money to clients instead of investing it. Handling so much cash can make it hard to generate big gains in some trading strategies.

Mr. Tepper, for example, has told some investors to expect to receive some cash back in 2011. He returned $500 million to investors last year. This year, he may return several billion dollars, according to people close to the matter.

Other firms, such as Paulson & Co., have closed certain funds to new investors, but are actively raising new money for other funds. Mr. Paulson recently hosted a New York City event that featured speeches by former Fed chief Alan Greenspan and several chief executives of gold companies, aimed at boosting interest in his gold-focused fund.

Despite Mr. Paulson’s winning touch in 2010, he may face a challenge. Gold is down more than 6% so far in 2011, meaning he is likely starting out with losses.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

Mr. Ward’s Armajaro Holdings Ltd. shook up the commodities market in July by buying a $1 billion cache of cocoa, enough to make 15 billion Hershey’s milk-chocolate bars. But since Mr. Ward made his audacious bet, cocoa prices have dropped 26%.

Two hedge funds run by Armajaro, including its CC+ Fund, which focuses on cocoa and coffee, lost about 6% of their value during the first two weeks of August, according to investors who have viewed the returns. And since then, prices have continued to decline, suggesting Mr. Ward could be coming under more pressure.

It isn’t certain the drop in cocoa is to blame for the recent losses. And some analysts say the recent decline in prices may be short-lived. An Armajaro spokesman declined to comment.

The funds remained up about 12% on the year through the middle of August, the investors say.

Mr. Ward, a 50-year-old trader, has gained a level of prominence in the commodities markets, having made big bets on cocoa at least twice before, in 1996 and in 2002.

Farmers work on cocoa pods at a farm in San Pedro, Ivory Coast, earlier this month. Cocoa prices have fallen since a large purchase in July. (Reuters)

Armajaro in July took delivery of 240,100 metric tons of the commodity—accounting for almost all the cocoa stored in approved commodity-exchange facilities across Europe, and totaling about 7% of the world’s cocoa supply.

The purchase was the second-largest delivery of cocoa beans on record, according to figures from ABN Amro, ranking only behind Mr. Ward’s 1996 strike.

Around the time Armajaro took possession of the cocoa in July, cocoa prices had reached 33-year highs amid worries about wet weather in the Ivory Coast, the supplier of 40% of the world’s cocoa.

Armajaro bet supplies out of the Ivory Coast would dwindle, driving prices even higher.

But instead, the weather has improved markedly, and optimism is growing that the next Ivory Coast crop will be plentiful. That has coincided with concerns that a weaker economy could hit demand for chocolate in the U.S. and Europe. There are signs Asia-based processors that provide cocoa butter to some developed markets have reduced production recently, according to a person familiar with the matter.

Cocoa prices have fallen 11% since the end of July on the NYSE Liffe exchange. They settled Thursday at £2,021 ($3,122) a metric ton. Prices are down 10% for the year.

The situation could easily turn in Mr. Ward’s favor, either because of supply shortages or increases in demand. For instance, political tension has been roiling Ivory Coast for years, and elections are to be held at the end of October, introducing the potential for short-term disruptions.

It isn’t known whether Armajaro has sold some or all of the cocoa it bought in July. Armajaro also hasn’t disclosed the price at which it started buying the beans.

Mr. Ward’s funds are volatile, so they could stage a rebound after the recent setback. One Armajaro fund scored gains of 18% in June of this year after losing more than 12% in February.

Mr. Ward has made money on cocoa in the past. His 2002 cocoa play netted him $17 million on a £300 million purchase, according to news reports at the time.

While Armajaro runs a hedge-fund business, with about $1.7 billion under management, it also is a large player in the physical market for cocoa beans. It buys cocoa in Ghana, Ivory Coast, Nigeria, Indonesia, Malaysia, Vietnam and Ecuador. It then sells that cocoa to processors. The group employs more than 1,000 people, according to its website.

Mr. Ward started Armajaro in 1998 as a cocoa merchant and later moved into asset management, opening his first commodities fund in 2004, he said in an interview posted earlier this year by Opalesque, a website that provides news about alternative investments.

Opalesque TV (insert), Reuters

Anthony Ward, inset, in an interview with alternative-investment website Opalesque, in January touted his weather data. His bet on wet weather hurting Ivory Coast cocoa supplies has become cloudy as the forecast improved. Here, workers carry bags of cocoa in San Pedro, western Ivory Coast, earlier this month.

“Pretty much all of you around the world will have had product that’s been sourced by Armajaro,” Mr. Ward said in the interview, of the firm’s cocoa- and coffee-supply business.

The firm puts a premium on data about the weather because of its potential to affect crops, and therefore the balance between supply and demand, he said. “We invest hugely” in weather data, Mr. Ward said in the interview. “We even have our own weather stations, our very own, that no one else has, in some parts of the world.”

—John James in Abidjan, Ivory Coast, contributed to this article.
Write to Gregory Zuckerman at gregory.zuckerman@wsj.com and Liam Pleven at liam.pleven@wsj.com

By GREGORY ZUCKERMAN

A Canadian insurer is turning to a seldom-used strategy to make a big wager on falling prices over the next decade.

Greg Zuckerman discusses a Canadian insurer that has wagered on derivatives that profit from a decline in consumer prices.
As more investors worry about the possibility of deflation—or a sustained period of falling prices that could cripple stocks—Fairfax Financial Holdings Ltd. has spent nearly $200 million to buy derivative contracts wagering on a decline in the consumer-price index, an inflation indicator. The trade could lead to huge profits if deflation occurs.

Fairfax purchased some of the derivative investments in the first three months of the year, when few fretted about deflation and the cost of the contracts was cheap. It added more in the second quarter.

The derivatives now are catching the attention of some on Wall Street. They have gained more than 50% in value since Fairfax made its original purchases from a number of banks, generating paper profits of more than $100 million.

Prem Watsa’s Fairfax Financial has already made a $100 million paper profit by wagering on deflation.

The Fairfax bet, which aims to protect $22 billion of Fairfax’s investment portfolio, comes as investors grapple with a particularly challenging environment, with the economy fragile and stock indexes struggling. Few investors are willing to make big wagers on deflation, despite its potential, with many skeptical any deflationary period would last long. The U.S. hasn’t experienced an extended bout of deflation since the Great Depression.

Still, Fairfax isn’t selling its deflation protection, despite its recent run-up in value. It thinks bigger gains could be ahead if the U.S. experiences a painful bout of deflation.

“We are extremely concerned about a double dip in the economy and about a deflationary environment,” says Paul Rivett, chief operating officer for Fairfax’s investing department.

Derivative bets on inflation aren’t new. Some companies and investors pay small premiums to buy inflation “caps” or “floors” that pay off if inflation rises above or falls below a certain level. Others buy derivatives betting on moves in economic indicators like the CPI, the inflation indicator that is now running at an annual rate of about 1%.

But interest is growing among some larger investors for deflation derivatives like those Fairfax bought. Today it would cost about $330 million to protect the same $22 billion, dealers say.

Traders can sell these contracts to others in the “interdealer market,” where banks trade with each other, something that was rare for such contracts six months ago. About $4.5 billion worth of these contracts have been trading each month in the interdealer market, up from $2.5 billion a month last year, according to traders.

Fairfax was founded in 1985 by Prem Watsa, who has made a series of acquisitions; its name derives from the phrase “fair, friendly acquisitions.” Mr. Watsa’s investments for Fairfax have led some to dub him Canada’s Warren Buffett.

But in the U.S., Fairfax also has drawn attention for heated battles with short sellers; it has claimed these bearish investors helped drive down the insurer’s shares several years ago before they turned higher in 2006. Fairfax shares have soared to more than 400 Canadian dollars (US$377) a share from about C$100 four years ago.

The insurer has a solid track record anticipating bad economic times. In 2003, Fairfax bought credit derivatives wagering on weakness among lenders including Countrywide Financial, scoring several billion dollars of profits when the housing market cracked in 2007.

Lately, the company has been studying bouts of deflation suffered in the U.S. and, more recently, in Japan, and it is getting worried.

“People say they understand deflation, but they don’t understand how corrosive it is,” Mr. Rivett says.

The Fairfax team believes U.S. households have only begun reducing borrowing and increasing savings, a trend it expects will lead to less spending, higher unemployment and deflation.

Fairfax paid $174 million in upfront fees to protect $22 billion of its investment portfolio against the possibility of deflation over the next decade. In exchange, Fairfax will receive a payment amounting to the drop in CPI below 2%—the level of inflation when Fairfax bought its contracts—multiplied by the $22 billion.

If deflation averages 2% annually over the next 10 years, Fairfax’s contracts would rise in value the equivalent of 4% of $22 billion, or $880 million, each year over the next decade, according to traders familiar with Fairfax’s trades.

In that scenario, if Fairfax holds on to its investments during the 10-year period, it would reap nearly $9 billion from its $174 million investment.

The company wouldn’t get anything for its bet if inflation turns out to be higher than 2% over the next 10 years.
Fairfax wouldn’t comment on potential returns or how the trades were structured.

Some banks selling these derivatives say they are skeptical of deflation. Prices for the derivative insurance suggest a 20% chance of deflation over the next 10 years, traders say. The banks say they have hedged their exposure, or reduced their risk, by finding other investors skeptical of deflation to take the other side of the trades or by purchasing their own insurance.

But traders say there are no perfect hedges when selling these derivatives. Some could be on the hook in the event of steep deflation.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com