April 16 (Bloomberg) -- Knight Capital Group Inc., the brokerage that makes markets in 17,000 equities in the U.S., reported an unexpected increase in first-quarter profit as trading gains outweighed losses at its hedge fund unit. The shares rose 12 percent.

Net income increased 2 percent to $32.5 million, or 35 cents a share, compared with $31.9 million, or 31 cents, a year earlier, the Jersey City, New Jersey-based company said today in a statement. Knight was expected to earn 30 cents, according to the average estimate of seven analysts surveyed by Bloomberg.

A surge in trading allowed Chief Executive Officer Thomas Joyce to overcome a decline in revenue from Deephaven Capital Management LLC, which had to close one of its hedge funds. Knight benefited from near-record trading and less competition from hedge funds, which allowed its electronic trading systems to exploit stock price swings to quickly buy and sell shares at a profit.

``We feel very confident in the sustainability of our model assuming that the volume and volatility profile in the market doesn't change a lot,'' Joyce told investors today in a conference call.

Shares Rally

Knight rose $1.73 to $16.76 at 4:05 p.m. in composite trading on the Nasdaq Stock Market, the largest increase since Jan. 16, when it reported 2007 results. For the year, the stock has gained 16 percent, compared with a 25 percent drop for the American Stock Exchange Broker/Dealer Index, which tracks 12 rivals.

Total revenue fell 7 percent to $224.9 million as performance and asset management fees declined. Deephaven had a pretax loss of $4.1 million, compared with a profit of $18.9 million a year earlier. Joyce told investors today that Deephaven had ``one of its most difficult'' quarters in its 14-year history.

The brokerage unit, which accounts for more than 80 percent of revenue, had a profit before taxes of $78.9 million. Knight handled about $1.02 trillion in stock trades in the U.S. during the quarter, shy of its record $1.09 trillion the prior quarter.

``Knight appears to have turned a corner in generating recurring high margins amid a volatile environment,'' Goldman Sachs Group Inc. analyst Daniel Harris, who has a ``neutral'' rating on the stock, said in a report to clients today. ``We believe that Knight will deliver better-than-estimated results over the next few quarters.''

Deephaven had $3.1 billion under management as of April 1, down from $3.9 billion a year earlier. Joyce said Deephaven has unwound about 30 percent of its Event Fund and plans to return all of its assets to investors ``over the next several months.''

Hedge funds are private, largely unregulated pools of capital whose managers can buy or sell any asset and participate substantially in profits from money invested. Clients typically pay fees equaling 2 percent of assets and 20 percent of investment profits.

To contact the reporter on this story: Edgar Ortega in New York at ebarrales@bloomberg.net; Joyce Moullakis in London at jmoullakis@bloomberg.net

Last Updated: April 16, 2008 16:59 EDT