Question

Discuss whether hedge funds are good or bad for the liquidity of markets.

Answer 1

Hedge funds are good for the liquidity of markets.( Especially for investors as they require less Securities and exchange regulations than other funds.)

Hedging

• Hedging is a technique of managing the risk attached to assets including foreign exchanges. In short, hedging means covering or eliminating or reducing the risk.
• Hedging is done with derivatives.
• The act of preventing an investment against unforeseen price changes is known as hedging.

Importance of Hedge funds

• It is a means to control price risk.
• It Protect against price changes.
• Hedge funds provides better evalutions in the equity markets.
• They offer wider investment oppurtunities than other type of funds.
• Goal of most of the hedge funds is to maximize return on investment.

Strategies for Hedging
Hedging typically is associated with reducing risk (Reducing price,volatility). However,
those who employ futures markets have different strategies and different goals in order to
implement a hedging programme. Market participants practice four overlapping strategies;

Reduction of risk: the primary use of futures for hedging is to reduce the price variability
associated with the cash asset position. Naive, regression, and duration methods determine
the appropriate; number of futures contracts for a hedge position. The objective of the
regression and duration methods is to minimize the risk associated with a cash position.

Selective hedging: hedging only during those time periods when a forecast determines
that the cash position will lose money is called selective hedging. If the forecasts are correct
then risk is minimised during the hedged periods; meanwhile the asset earns positive returns
during the un hedged periods. If the forecasts are incorrect, then risk is not reduced. Many
institutions employ some type of market timing to decide when to use selective hedging

"Speculating on the basis": when the returns from the hedge are a consideration in
whether the hedge will be undertaken, then this approach is equivalent to predicting the
change in the basis during the hedge period.

Optimal risk-return hedging: the optimal hedge decision considers both the reduction in
risk and the return from the combine cash-futures position. Such an optimal position is
associated with portfolio analysis.

The above strategies also can be designated as passive or active strategies. A passive strategy
is independent of cash market price/interest rate expectations. Passive strategies depend on
the risk attitude of the hedger and the volatility of the cash markets. Active strategies require
a forecast of future cash price/interest rates for implementation.

The forecast helps the money manager decide when and how much of the cash position to hedge.Thus, an active hedging strategy readjusts the hedging position over time.