Characteristics of Hedge funds

Discussion in 'Trading' started by yanninglau, May 10, 2007.

  1. Hedge fund is a private investment partnership fund that can take long and short positions in various markets. It is only accessible for a limited range of investors and no registration is required for hedge funds under the US federal securities law.

    The presence of hedge fund has contributed to the development of risk management tools and liquidity of over-the counter market aggressively. Hedgers use derivatives to reduce the risk they face from potential future market movements in a market variable. In addition, Participants in this market often leverage the positions and change the investing portfolio compositions much more frequently then other funds, they arbitrage away from price differences for the same risk across markets.

    Impact on the market

    Hedge funds could affect the credit institutions rather directly or indirectly.

    Direct risk on credit institutions

    It is the most obvious channel where hedge funds could affect efficiency and the stability of the financial system. Due to credit institutions are the major lenders to hedge funds, some would argue risk management could have lowered the systemic risk raised by the fund, in which the other type of direct risk exposure of the institutions is the income flow derived from prime brokerage and other hedge fund-related services.

    Indirect risk on credit institutions

    Indirect risk mainly arises because of the credit risk through counterparties with large exposures on hedge funds. Even payment problem of major prime brokers could affect the stability of financial system.

    Secondly, the hedge fund¡¦s actions in the markets can affect the value of market positions in the prime brokers¡¦ portfolios. In other words, dislocation of hedge funds in the market is an indirect threat to the financial stability. Lastly, prime brokers may experience loss from the asset management business if hedge funds keep expanding and further transferring losses to the investors.

    Crowded trade

    Recently, individual hedge funds become more similar as now more funds attempt to adopt similar strategies to gain profit, while the growth of the industry also lead to diminishing return to push funds into greater risk taking through increases leverage.

    The reason is under stresses condition hedge funds usually cannot afford to wait when they begin to lose money, so they would rush for exit or leverage more to gain the same profit. The crowding of trades even amplifies this effect. One way to solve this is to consider patterns in pair wise correlation coefficients of individual hedge funds return performance between strategies. Rising correlation means the strategies are too similar and cannot have excess return. High correlation means hedge funds will liquidate at the same time when there is severe market shock, causing more liquidity to dry up. However, this was result over long periods where in 2004 there were still hedge funds with similar strategies can earn excess return as there is sufficient diversity in micro factors such as portfolio structure.

    There is also indication that hedge funds positioning has resulted in crowding of trades and leaving them cannot tolerate to adverse market dynamics, this is the greatest concern of credit strategies when the strategies have the highest leverage and significant gross positions, giving up the positions could prove disruptive for fixed income markets when hedge funds are involved.

    Ho CHAN (40619788), Yan Ning LAU(40699781)


    1) Garbaravicious, T. and F. Diereck, Hedge Funds and their Implications for Financial Stability, European Central Bank, Occasional Paper Series, August 2005.

    2) Hull, J, Options, Futures, And Other Derivatives, Federation Press, 6th edition, 2006