Hedge Funds - Literature review Example

Hedge Funds Name Institution Date Introduction According to the Man Group (2015, p.1), a hedge fund can be described as an alternative vehicle forinvesting that operates by pursuing absolute returns on primary investments. A hedge fund involves all absolute returns that are invested in the financial markets with the application of portfolio management methods that are not traditional including leveraging, swaps, arbitrages and short selling among others. Hedge funds are known to make up a huge part of customer portfolios both private and institutional. They are commonly used in the context of portfolios instead of being considered as single investments (Stromqvist 2009, p.87). This essay aims at selecting a topic that talks about hedge funds and then providing a discussion based on it. Specifically the essay will be based on the article written by King, M., & Maier, P, 2009, ‘Hedge funds and financial stability: Regulating primebrokers will mitigate systemic risks’, which appeared in the Journal of Financial Stability. The essay will give an explanation of what the article attempts to achieve. It will also provide a summary of related literature that addresses the same topic. It will then outline the key results from the article along with the assumptions that are needed to generate them. This will involve discussing how the article contributes to our understanding of the topic, as addressed by the relevant literature. Finally, directions will be suggested for future research. The selected article aims at reviewing the major characteristics that define the hedge fund industry as well as identifying situations where the sector has a likelihood of posing a threat to financial stability. The article also aimsto explain why direct regulation of the hedge fund industry is not appearing feasible even though it increases transparency. The article attempts to explain how direct regulation of hedge funds has led to the problem of a moral hazard as well as reducing market liquidity.It also aims to provide a solution to the risks that have been experienced by the hedge fund sector. Significantly, the article describes the importance of indirect regulation of the hedge fund sector by prime brokers as well as market discipline through investors, creditors as well as counterparties. The article establishes that these measures have been found to effectively limit the risks encountered by the hedge fund sector. Additionally, the article suggests that so as to minimize systemic risks, there is need for increasingly regulating through prime brokers for the purpose of avoiding competitive dynamics that weaken the counterparty practices of risk management. Other researchers have addressed the topic of hedge funds and their impact on financial stability. Garbaravicius & Dierick (2005) undertook one such study. Further, in their research, Garbaravicius and Dierick emphasized a perspective based on the dimension of the European Union. The role of hedge funds in the financial markets is seen to be essential. The importance of hedge funds has increased the attention given to them by public authorities as well as the financial community. The reason is that there is a huge uncertainty in relation to the implications of hedge funds for financial stability.The study noted that hedge funds are usually addressed in offshore centers since they are lightly regulated with favorable tax regimens.There have been challenges when it comes to assessing the impact of hedge funds on financial stability. This is because there is incomplete information regarding their activity, their financial structure as well as how interactions occur in banks. The study done by Garbaravicius & Dierick on hedge fund and their impact of financial stability revealed both positive as well as negative effects of hedge funds on financial stability. Hedge funds are active market participants and often occupy contrary positions. Therefore, they affect financial stability positively by contributing to market liquidity, dampening of market volatility as well as counterbalancing of market herding. Hedge funds provide a diversification of possibilities as well as allowing the achievement of new risk return combinations. This is a good method that leads to financial markets that are more complete. Hedge funds have also been identified as helping in reducing market inefficiencies hence contributing to financial market integration. Using the example of the almost collapsed LTCM in 1998, Garbaravicius and Dierick argued that hedge funds have the capacity to seriously harm the stability of financial markets as well as financial institutions. Specifically, these occur through banks that operate like prime brokers or those that operate in a similar way in the market to hedge funds. The researchers further argued that the management of bank exposure in relation to hedge funds is complex hence requiring a continuous improvement as well as vigilance for the purpose of keeping up with developments. The increase of hedge funds in exploiting the market has a possibility to affect specific markets when simultaneous selling occurs. Assessment of how hedge funds are affected by leverage, credit risk, market risk and liquidity risk interaction is challenging. In an effort to find solutions to address problems that are related to hedge funds, it has been established that regulation is difficult. The reason is that hedge funds can easily change their domicile as well as avoid regulation. The initiatives suggested therefore focus on indirect regulation that works by targeting the counterparties of hedge funds and specifically banks. The aim of regulating indirectly serves to enhance practices of risk management in banks as well as improving the disclosure by hedge funds. The study recommended that if direct regulation was to be used, then stronger coordination at the international level would need to be implemented. The indirect availability of hedge funds to retail investors requires measures that address investor protection. This view was supported by Edwards (2003, p.2) who argues that market failures due to hedge funds occurred because they were not well understood by investors, bankers as well as the derivative counterparties. MTCM created leverage that hindered its investments from meeting the demands of its creditors as well as derivatives counterparties. The Federal Reserve took the measures of intervening so as to organize a credit bailout by the largest creditors of LTCM and the derivatives counterparties hence preventing the extensive liquidation of LTCM’s positions. Ferguson & Laster (2007) conducted a study about hedge funds and systemic risk. It revealed that hedge funds are rapidly growing and also facing many challenges due to market disruptions that were caused by the Long Term Capital Management (LTCM) in 1998. This leads to hedge funds contributing to systemic risks hence affecting the financial stability of financial markets and financial institutions. To deal with this problem, the researchers suggested that regulatory authorities should encourage banks to improve their monitoring of hedge fund customers by introducing limitations on their leverage. This is an effective measure that prevents the occurrence of any ripple due to hedge funds in the wider financial markets. On the other hand, the study did describe various positive effects of hedge funds on financial stability by contributing to the robustness of financial markets in different ways. Hedge funds provide investment alternatives that are attractive as well as improving risk sharing in the wider economy. They also promote the stability of the financial market through the assumption of risk that other participants in the market are not able to bear. Bussière et. al. (2014) undertook a study about the commonality in hedge fund returns, driving factors as well as implicationsfor financial stability. They found out that the commonality of hedge funds has been increasing over the years. This is as a result of them being exposed to equities in the emerging markets which is a common factor in the returns of hedge funds. The results of the study showed that illiquidity is a major factor that affects hedge fundswith high commonalitydisproportionately.This leads to them exhibiting negative returns in the subsequent financial crisis hence giving few benefits of diversification to the financial system or investors. Kambhu et. al. (2007) published a study about hedge funds, financial intermediation and systemic risk. It revealed that hedge funds have been highly used in global capital markets. They are unregulated funds that differ from others in the market since they use various trading strategies as well as instruments that are complex. This is in relation to leverage, opacity to outsiders as well as convex compensation structure. These differences in the operation of hedge funds worsen the possibility of market failures arising from externalities, agency problems as well as being a moral hazard. The study suggested that counterparty credit risk management (CCRM) practices can be usedin limiting the exposure of hedge funds to market disruptions that have the potential of causing systemic risks that influence the stability of financial markets. Hedge funds are identified as causing market failures that lead to exposure of counterparty credit risk to the funds making them more difficult to be managed by regulated institutions as well as policy makers who are concerned with systemic risks. According to the researchers, market failures like the ones surrounding LTCMin 1998 may cause imperfection of the CCRM. However, this is not the case and CCRM practices are effective measures that limit hedge funds from causing systemic disruptions to the financial markets. The primary article written by King, M., & Maier, P, 2009, ‘Hedge funds and financial stability: Regulating prime brokers will mitigate systemic risks’ presented various results concerning hedge funds. Hedge funds are highly used in the global financial market (Table 1). As of 2008, the average size of hedge funds had grown to $200 million. Hedge funds have a higher rate of failure when compared to other financial actors (Table 2). Hedge funds have been identified as having the potential for causing systemic risk that influences the stability of financial markets through direct and indirect channels. The collapse of hedge funds can lead to forced liquidation of their positions at fire sale prices. This is a direct channel that causes systemic risk through leverage. Systemic risk is indirectly caused when hedge fundsare seen to exacerbate market volatility as well as reducing the liquidity of other financial markets. Hedge funds are the largest type of securities sold in the financial market (Table 3). Their absolute size contributes to the great possibility of their causing risk in the financial market. This helps us in understanding the empirical literature on the topic of commonality in hedge fund returns, driving factors and implications on financial stability (Bussièreet. al. 2014).The greater counterparty exposures experienced by hedge funds in the market are highly affected by illiquidity and exhibit negative returns in the following financial crisis. Hence, the financial stability of the market is affected by reduced chances of diversification in the financial system.This also helps us in understanding the liquidation of hedge fund positions that increase in volatility when assets are sold at fire sale prices. These findings contribute to our understanding of the topic of hedge funds and financial crisis, as outlined by Stromqvist(2009). Stromqvists’ article identified various factors that led to systemic risk in the hedge fund industry. This explains the finding in the empirical research on the topic of hedge funds and their implications for financial stability according to Garbaravicius and Dierick (2005). Stromqvists’ study confirmed factors such as herding behavior, absolute size, liquidity shocks, inadequate counterparty risk management practices, and excessive leverage as influencing systemic risks in the financial markets that impact on financial stability. Systemic risks are major contributors to negative effects on financial stability. The results of the primary study done by King & Maier (2009) explain the findings of the empirical literature whereby adequate counterparty risk management practices were recommended as effective measures for dealing with hedge fund problems. Specifically, these results contribute to our understanding of the topics of hedge funds, financial intermediation and systemic risk as reported by Kambhuet. al. (2007). It was found in their work that CCRM practices help financial institution in limiting counterparty exposure of hedge funds hence reducing market disruptions that have the potential to lead to systemic consequences. The primary article by King & Maier (2009) revealed that regulators should be more concerned with hedge funds that operate in systematically essential markets whereby the counterparty exposures reduce their likelihood failing. This finding contributes to our understanding of the topics of hedge fund and systemic risk as discussed by Ferguson and Laster (2007) whereby the authors recommended that regulation of counterparties should be enhanced and vigilance exercised regarding risks that may emanate from the hedge fund industry. It also contributes to understanding the topic of regulation of hedge funds described by Edwards (2003). Regulation measures need to be set out so as to prevent hedge funds from extensive liquidation that may affect financial stability. Conclusion All in all, the discussion makes it clear that hedge funds impact both positively and negatively on the financial stability of markets and institutions. With indirect regulation and improved CCRM practices the problems of hedge funds can be resolved in the markets hence achieving financial stability. The topic of hedge funds and financial stability has been addressed by various researchers who came up with similar results.Possible directions for future research could be based on better ways of reshaping the hedge fund industry as well as on how investors could be better protected so as to participate directly in the sector. References Bussière, M., Hoerova, M. & Klaus, B., 2014, Commonality in Hedge Fund Returns, Driving Factors and Implications, European Central Bank, Working Paper Series, No 1658, Available at: < https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1658.pdf> Accessed on [12-9-2015] Edwards, F., 2003, The Regulation of Hedge Funds: Financial Stability and Investor Protection, Columbia University, Graduate School of Business, New York. Ferguson, R., & Laster, D., 2007, ‘Hedge Funds and Systemic Risk’, Financial Stability Review, Special issue on hedge funds, Vol. 10 No.1, pp.1-16. Garbaravicius, T. & Dierick, F., 2005, Hedge Funds and Their Implications For Financial Stability, European Central Bank, Occasional Paper Series, No. 34. Retrieved from https://www.ecb.europa.eu/pub/pdf/scpops/ecbocp34.pdf Accessed on [12-9-2015] Kambhu, J., Schuemann, T. & Stiroh, K., 2007, ‘Hegde Funds, Financial Mediation and Systemic Risk’, Economic Policy Review, Vol.13, No.3. King, M. & Maier, P, 2009, ‘Hedge Funds and Financial Stability: Regulating Prime Brokers will Mitigate Systemic Risks, Journal of Financial Stability, Vol.5, No. 1, pp.283–297. Man Group. The, 2015, What is a Hedge Fund? Available at: https://www.man.com/2/what-is-a-hedge-fund p.1, Accessed on [12-9-2015] Stromqvist, M, 2009, ‘Hedge Funds and Financial Crises’, Economic Review, Vol.1. No.1, pp. 87-103. Read More