Mrs. Anne C Jansen, Mr. Donald J Mathieson, Mr. Barry J. Eichengreen, Ms. Laura E. Kodres, Mr. Bankim Chadha, and Mr. Sunil Sharma
Hedge funds are collective investment vehicles, often organized as private partnerships and resident offshore for tax and regulatory purposes. Their legal status places few restrictions on their portfolios and transactions, leaving their managers free to use short sales, derivative securities, and leverage to raise returns and cushion risk. This paper considers the role of hedge funds in financial market dynamics, with particular reference to the Asian crisis.
Mr. Barry J. Eichengreen and Mr. Donald J Mathieson
Hedge funds are collective investment vehicles, often organized as private partnerships and resident offshore for tax and regulatory purposes. Their legal status places few restrictions on their portfolios and transactions, leaving their managers free to use short sales, derivative securities, and leverage to raise returns and cushion risk. This occasional paper considers the role of hedge funds in financial market dynamics, with particular reference to the Asian crisis.
Mr. Barry J. Eichengreen and Mr. Donald J Mathieson
Each episode of instability in international financial markets heightens the attention of government officials and others to the role played by institutional investors, and hedge funds in particular. This was the case in 1992, following the crisis affecting the exchange rate mechanism (ERM) of the European Monetary System. It was the case in 1994, a period of turbulence in international bond markets. It was again the case in 1997 in the wake of the financial upheavals in Asia. In each case, it has been suggested, hedge funds precipitated major movements in asset prices, either through the sheer volume of their own transactions or via the tendency of other market participants to follow their lead.
This section presents an overview of the hedge fund industry, focusing on its current structure and recent performance. It provides a brief history of the evolution of hedge funds, considers available data on the size and structure of the industry, examines the performance of hedge funds, and discusses the behavior and individual performance of some of the large macro hedge funds against the backdrop of major macroeconomic events in which these funds have been ascribed key roles. The section ends with a summary of the main conclusions.
Perhaps one reason why it is difficult to arrive at a definitive characterization of hedge funds is the wide variety of investment strategies they undertake. Hedge funds, as portrayed in most press reports, have been variously discussed as “gunslingers” and “swaggering buccaneers” who routinely test the resolve of authorities in various countries.1 However, in truth, the managers of hedge funds employ a vast array of investment strategies with the goal of producing profits for themselves and their investors. Their strategies include trades aimed at taking a view about the macroeconomic policies of selected countries as well as seemingly arcane movements in the pricing of the cash and futures relationship for the 30-year U.S. treasury bond: hedge funds operate both as speculators as well as hedgers. Since hedge fund investment strategies are only limited by the constraints imposed in their own prospectuses, it should not be surprising that their strategies cover a myriad of markets and instruments.
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.
Most hedge funds, even those domiciled offshore, operate in developed financial markets and utilize the infrastructure of large financial centers to implement their investment strategies. This section describes in greater detail the regulation of hedge funds in the United States and the United Kingdom. The frameworks in these two countries should be seen as examples of rules and surveillance procedures, which are evolving to be sure, but which to date have allowed the operation of hedge funds and other collective investment vehicles while maintaining the integrity of markets.