Question

Comment on the nature of hedge funds and the role they play in the modern financial sector. You may illustrate with, or focus on, the story of Long Term Capital Management (LTCM).

Answer 1

Hedge is defined as the process of offsetting the financial losses against the financial gains derived from the financial instrument portfolio.

hedge includes financial instruments of type stock, insurance and forward contracts.

Let's take a famous example of hedging in pricing agriculture commodity. we all know the financial environment is full of risk facing. due to the movements in prices because of change in demand and supply of commodities. a farmer takes a long position of taking risk when he commits to produce a particular commodity such as rice and wheat due to unavailability of perfect information about which product will yield better benefits. farmer uses forecasting technique to assess the conditions and potential sales level of the commodity.Then, undertakes the risk by making decision which product to produce.In that case, if the estimated price and sales level happens to be somehow same. then, the farmer will get large amount of return. but, in case the prices of commodities changes over the time drastically such that prices might fall below the desired levels then, the farmer will incur huge amount of loss such that it will have to resort to its personal assets to pay of the borrowed money in case taken.

Hence, hedging can be used to protect farmer from this uncertainty of low prices by entering into a forward contract with the investor to sell the quantities produced at a predetermined amount after the completion of production.

The same ideology used for the incorporation of hedge funds.Hedge funds are the Fund that pools capital investment from investors whether public or private and government entities and invest in assets portfolios with variable returns to earn a stable benefits with minimum risk.

The hedge funds are open-ended in nature as these funds allows the additional investment and withdrawals on periodic basis such as monthly, Quarterly and yearly. Hedge funds are more often used as the asset management technique due to the kind of risk involved in money markets. Under this kind of fund the value of the investor's funds is directly related to the net asset value of the underlying investment fund in which company is dealing with stakeholders and shareholders.

As of 2018 investment in these funds amounting around $3.23 trillion.

financial market consists of capital market and money market. Capital market is a financial market in which the debentures, stock, bonds, futures  and other types of financial instruments are bought and sold by the brokers registered under the security exchange board on the behalf of the investors.

Hedge funds used these markets to purchase a portfolio of securities with minimum risk and a stable rate of return in order to obtain more money from investors.

Capital market is divided into two parts primary and secondary.

Under primary market company issues new stock and other financial instruments to investors while under secondary markets the same stock can be sold and bought by investors at a strike price determined by the company's financial position.

The government may use these markets to sell bonds and equity to hedge funds for raising the capital to finance the welfare projects and budget financing.

The role of Hedge funds in primary market:

a.) fund manager invests large amount of money to manipulate the prices of stocks ,equity and other financial instruments in order to build a complex portfolio for each individual with a view of minimizing the risk.

The role of hedge funds in 2008 crisis:

a.) fund managers in late 2000's uses the short position for selling the options to investors by borrowing from brokers such that stock exchange incurs losses due to late repayment.

b.) In late 2000's the demand for home mortgages increases due to lower interest rates such that hedge funds used funds to invest in more risky but high return financial instruments in order to provide funds dearly with low level of financial security such that due to restricting policies imposed by parity in power to restrict credit on risky investments. the sudden outburst occured resulted in high level of defaultment on mortgage funds by the public resulted in financial crises.

Long term capital management: It is large hedge fund led by Nobel prize winning economists and wall street traders. it has attracted around $1 billion in span of four years of early 1990's. it is used with primary motive of arbitrage to reduce the risk associated with trading of financial instruments in markets. The most useful case of LCTM was interest rate swaps by two counter parties in order to reduce the risk. the series of interest payment under a stock is linked with currency exchange rate index and then present values of these payments are derived using fixed exchange rate and then using floating rate Then,

Present value under interest rate swaps= present value under fixed exchange rate - present value under floating exchange rate

Due to its arbitrage opportunites , LCTM was a big success in late 1990's with its total worth around $1 trillion and net borrowed assets worth $120 billion.

Downfall of capital management : LCTM suffers sudden crises in late 1990's due to financial crises in Russia which leads to their own default on borrowed assets. LCTM incurres huge losses and subsequently bailed out by federal reserve bank and its assets are later auctioned in order to pay amount borrowed towards investors.