Hedge Funds and its impact on financial market

Discussion in 'Economics' started by yanninglau, May 14, 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. Thus, this gives them freedom to develop unconventional, sophisticated and proprietary investment strategies.

    The presence of hedge fund has contributed to the development of risk management tools and liquidity of over-the counter market aggressively. 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. However, the high fees charged by the fund managers have always to be criticized to hinder the growth of using this fund.

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

    For the Direct risk on credit institution, 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 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.

    Though there is lack of data with sufficient quality, the impact of hedge funds on the financial market can still be found in reports of some international organizations. Most of them are related to macro hedge funds which to depict the sustainability of the macroeconomics policies. In some cases, hedge funds compromised market integrity by engaging unfair trading practices such as collusion. Still, it is difficult to establish a line between seemingly unfair trades and rational economic behavior. For example, the Financial Stability Forum(FSF) declines to conclude that hedge funds have compromised market integrity in episodes it analyses as the true motives are difficult to be proved.

    In normal condition hedge fund, it seems lead to efficient functioning of financial markets. This is not the case in small or medium markets, in fact the actions of hedge funds can be destabilizing. The risk of abrupt developments prompted by high speculative can be minimized by widening the investor base in the market. On the other hand, the Hirschman-Herfindahl concentration published by BIS can also provide an early warning signal regarding the built-up of concentrated positions in some markets, thus investors can be aware of the risk incurred.

    For a long period of underperformance of hedge funds, the risk of a sharp reversal in inflows can not be decreased. Especially in small liquid market, such situation could cause liquidity strains if the reversals would occur over a short period.

    Last but not least, in response to the investment strategy for hedge funds, manager must evaluate the risks exposed in the fund, define which type of risks are acceptable or the type of risk they are going to hedge in the strategy. Lastly, hedge fund manager should also design strategies in order to hedge the unacceptable risks by using derivatives in the market.

    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