The dispute between UBS and Paramax Capital International is one of a growing number of such legal spats between banks and hedge funds.

UBS asked Paramax Capital International to sell it protection on $1.3bn of the most highly rated slices of a CDO that the investment bank underwrote. Now UBS is taking Paramax to court, seeking to compel it to pay up as the securities dropped in value, alleging breach of contract.

Paramax claims that, from the beginning, the UBS hedge was cosmetic. By hedging the risk fully through the credit derivatives market, banks may be able to remove such exposures from their balance sheets and do not have to set aside capital.

In May 2007, Paramax had only $200m under management and its agreements with its own investors limited it to commit no more than $40m to any single deal. Thus, it could never compensate UBS fully for any meaningful loss in value of the $1.3bn UBS was trying to insure, Paramax said. They also claim that UBS promised that if the lender needed a "real" hedge, it would tear up the agreement.

Paramax is charging UBS with negligent misrepresentation and a lawyer for Paramax said its allegations were supported by both written and oral statements.