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Abstract
Market price dynamics can be affected by the strategies implemented by hedge funds and other institutional investors in two ways. The strategies can act to stabilize prices or they can potentially destabilize prices. There are also a number of institutional practices that may inadvertently act to destabilize prices. A short description of their attributes are included since many market participants, including hedge funds, may be subject to these practices. While understanding how strategies can affect prices is important, the implications for financial stability hinge on whether such strategies do, in practice, make prices more volatile. Existing empirical evidence directly relating hedge fund activity to price volatility is slim to nonexistent. However, there are several studies that examine whether large market participants, including hedge funds, “herd” with other participants or with their own kind—that is, whether they take similar positions simultaneously or following one another. Circumstantial evidence can also be obtained from a study that examines the returns earned by hedge funds, their stated strategies, and the returns of standard asset classes. A third study, analyzing the actions of a set of large foreign currency market participants (which may include hedge funds), also provides insight into the connection between these large players’ activities and subsequent exchange rate volatility.
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