With the recent announcement of the investment bank Bear Stearns that two of their hedge funds High-Grade Structured Credit Enhanced Leverage Fund and High-Grade Structured Credit Fund had become nearly worthless, the discussion about hedge funds was newly rekindled. The funds were mainly invested in the market for mortgages loans to debtors with a medium or low degree of credit worthiness, the so called sub prime lending. They traded with collateralized debt obligations (CDO), which bunch the risk of those loans. Due to the decline in prices of properties and the increase in interest rate debtors got into trouble. Therefore the CDOs lost worth and the funds became bankrupt. Even if that is very problematic for the investors and the investment bank some economists think, that there could occur bigger problems. Meanwhile there are rumours that other funds got into trouble and economists worry that they could destabilize the whole financial system, due to their close relations to other financial institutions. Banks, in particular, which financed the funds, are in danger of being affected.
Whether this small crisis will spread or not can actually not be answered. In the next days and months that remains to be seen.
But for sure the discussion about hedge funds will be renewed. Therefore this essay will deal with that complicated topic. It is tried to explain what hedge funds are and how they work. For this purpose, first of all a proper definition for hedge funds is given. Secondly, the origin of hedge funds will be described and then the typical characteristics will be elaborated. Next, there is a short overview of the common strategies and about the development of hedge funds given. In the last part, the positive and the negative aspects will be described. Finally a short summary and a future outlook will end this paper.
Table of Contents
1. Introduction
2. Hedge Funds
2.1 Definition
2.2 History
2.3 Characteristics of hedge funds
2.3.1 Absolute return target
2.3.2 Flexibility in investment
2.3.3 Use of Leverage
2.3.4 Illiquidity of the invested capital
2.3.5 Little transparency
2.3.6 High minimum investment
2.3.7 Performance linked compensation
2.3.8 Less regulated environment
2.4 Strategies of hedge funds
2.4.1 Relative Value
2.4.2 Event Driven
2.4.3 Directional or opportunistic Strategies
2.4.4 Multi-Strategy
2.5 Positive Aspects
2.5.1 Option for portfolio diversification
2.5.2 Increase market efficiency
2.5.3 Negative feedback trading
2.5.4 Supply markets with liquidity
2.5.5 Overtake risk for other market participants
2.6 Negative Aspects
2.6.1 Increase of market volatility
2.6.2 Transmission of instability
2.6.3 Market risk
2.6.4 Complicate political desired corrections
3. Conclusion
Objectives and Topics
This paper aims to provide a comprehensive understanding of hedge funds, their functional mechanisms, and their role within the global financial system. The primary research focus lies in exploring the balance between the economic benefits these funds provide and the systemic risks they pose, particularly in light of high-profile financial crises.
- Definition and historical evolution of the hedge fund industry.
- Detailed analysis of typical hedge fund characteristics and investment strategies.
- Evaluation of positive impacts such as market liquidity and portfolio diversification.
- Examination of potential risks including market volatility and systemic instability.
- Discussion of international regulatory challenges and the necessity for global policy solutions.
Extract from the Book
2.4.1 Relative Value
Funds using these strategies try to make profit out of price differences between different financial assets or out of anomalies of relating securities. They try to reduce or eliminate the market-, the interest-, currency risk, etc. as far as possible. The background is the assumption that the prices tend in the medium or in the long term to their natural balance and that the mispricings are corrected.
Depending on the financial instruments they use, one can distinguish between the strategies in a more accurate way.
The strategy “convertible arbitrage” focuses on convertible bonds. The managers try to make profits by simultaneously buying or selling the convertible bonds and going long or short in the underlying share. Thus, they try to use wrong assessments of the value in order to make a profit.
Similarly, the strategy “fixed income arbitrage” uses bonds or comparable financial instruments with different durations, ratings and volatilities to make use of the price differences. Also different prices of one bond at different markets are used to make profits.
“Equity market neutral”-strategies try to exploit market inefficiencies in the equity-market and hold therefore portfolio of the same size with on the one hand short positions and on the other hand long positions. Due to the adequate long/short positions they are called market neutral, which means not without risk.
Summary of Chapters
1. Introduction: This chapter introduces the current relevance of hedge funds triggered by recent financial market crises and outlines the scope and structure of the essay.
2. Hedge Funds: This comprehensive main section defines hedge funds, tracks their historical development since 1949, and elaborates on their specific characteristics and diverse investment strategies.
2.1 Definition: Provides a formal definition of hedge funds as private pooled investment vehicles that operate outside traditional regulatory frameworks.
2.2 History: Details the origin of the industry with Alfred Winslow Jones and tracks the growth of assets and fund numbers over recent decades.
2.3 Characteristics of hedge funds: Identifies core attributes such as absolute return targets, leverage, illiquidity, and performance-linked compensation.
2.4 Strategies of hedge funds: Categorizes the primary operational approaches: Relative Value, Event Driven, Directional Strategies, and Multi-Strategy.
2.5 Positive Aspects: Highlights the contributions of hedge funds to market efficiency, liquidity supply, and risk transfer capabilities.
2.6 Negative Aspects: Critically evaluates the risks posed by hedge funds, focusing on market volatility, systemic instability, and potential market distortions.
3. Conclusion: Summarizes the dual nature of hedge funds and emphasizes the requirement for international regulatory cooperation rather than single-nation intervention.
Keywords
Hedge Funds, Absolute Return, Leverage, Financial Stability, Market Efficiency, Risk Management, Short Selling, Portfolio Diversification, Systematic Risk, Financial Markets, Offshore Centers, Asset Management, Market Liquidity, Investment Strategy, Regulatory Framework.
Frequently Asked Questions
What is the primary subject of this academic paper?
The paper examines the nature, functional characteristics, and economic impact of hedge funds within the context of global financial markets.
What are the core thematic fields covered?
The work covers hedge fund definitions, historical development, structural characteristics, specific trading strategies, and the debate surrounding their positive versus negative economic contributions.
What is the central research question?
The work explores how hedge funds function and evaluates whether their benefits for financial systems are outweighed by the potential systemic risks they generate.
Which scientific methodology is employed?
The essay utilizes a qualitative descriptive approach, drawing upon existing academic literature, historical data, and current industry reports to synthesize an overview of the hedge fund industry.
What topics are addressed in the main body?
The main body systematically details the definition and history, common structural features, classification of investment strategies, and an analytical comparison of positive market impacts versus negative systemic risks.
Which keywords best describe this research?
Key terms include Hedge Funds, Absolute Return, Financial Stability, Market Efficiency, Systematic Risk, and Leverage.
How does the "Relative Value" strategy attempt to generate profit?
This strategy seeks to exploit temporary price anomalies or mispricings between related securities, assuming that market prices will eventually revert to their natural equilibrium.
Why is a global approach to regulation recommended in the conclusion?
Because financial markets are globally integrated, individual nations cannot effectively regulate hedge funds on their own without risking capital flight or ineffective policy implementation.
What is the significance of the "high-water-mark-principle" mentioned in the text?
It ensures that performance-linked compensation for fund managers is only paid when the fund's performance exceeds previous peak values, aligning the manager's incentives with investor gains.
- Quote paper
- Daniel Detzer (Author), 2007, Characteristics, Strategies and Aspects of Hedge Funds, Munich, GRIN Verlag, https://www.grin.com/document/118396
