Hedge funds are private investment funds for wealthy investors, run by partners who have made big personal investments in the fund. They pool or put together their money and investors' money and trade in securities and derivatives, and try to get high returns whether markets move up or down. They are able to make big profits, but also big losses if things go wrong. Despite their name, hedge funds do not necessarily use hedging techniques - protecting themselves against future price changes. (See Unit 34) In fact, they generally specialize in high-risk, short-term speculation on stock options, bonds, currencies and derivatives. (See Unit 35) Because they are private, hedge funds do not have to follow as many rules as mutual funds.
Leverage, short-selling and arbitrage
Most hedge funds use gearing or leverage, which means borrowing money as well as using their own funds, to increase the amount of capital available for investment. In this way, the fund can hold much larger positions or investments. Hedge funds invest where they see opportunities to make short-term profits, generally using a wide range of derivative contracts such as options and swaps. (See Unit 35) They take a long position by buying securities that they believe will increase in value. At the same time, they sell securities they think will decrease in value, but which they have not yet purchased. This is called taking a short position. If the price does fall, they can buy them at a lower price, and then sell them at a profit.
Hedge funds also use arbitrage, which means simultaneously purchasing a security or currency in one market and selling it, or a related derivative product, in another market, at a slightly higher price. In this way investors can profit from price differences between the two markets. Because the price difference is usually very small (and would be zero if markets were perfectly efficient), a huge volume is required for the arbitrageur to make a significant profit.
Investors who do not have sufficient funds to join a hedge fund can buy structured products from banks. T hese are customized - individualized or non-standard - over-the- counter financial instruments. They use derivative products (futures, forwards, options, warrants, etc.) in a way similar to hedge funds, depending on the customer's requirements and changes in the markets.
"The bad news is it's all our clients' money."
37.1 Match the verhs in the box with the definitions below. Look at A and B opposite to help you
to take a short position
to take a long position
1 to put several people's resources together for shared use
2 to purchase securities, expecting their price to rise
3 to use borrowed money as well as one's own money to increase the size of one's investments
4 to sell securities that one has not yet purchased, anticipating that their price will fall
37.2 Are the following statements true or false? Find reasons for your answers in A, B and C opposite,
1 Hedge funds are so named because they protect against losses.
2 Hedge funds use their investors' money as well as borrowed money.
3 Hedge funds concentrate on making long-term investments.
4 The fact that investors can make a profit from arbitrage shows that markets are not perfectly efficient.
5 Structured products are individualized financial instruments offered by hedge funds.
37.3 Read the advertisement for structured products from the UBS website, and answer the questions below.
The most widely used structured products can be classified into four broad categories according to their intended purpose. Derivatives are used in order to achieve the desired structures, either in combination with the underlying securities or other derivative securities.
I The major groupings are:
• Capital Protection - This may be in the form of hedging, utilizing forwards, futures or swaps contracts, or it could be in the form of insurance using options.
• Yield Enhancement - This is usually achieved by writing (selling) options over an underlying asset. The premium from the written option provides the additional income yield.
• Full Participation - These are products that have similar risk characteristics as the underlying assets, but which allow the client the convenience of being able to trade unusual baskets of assets such as foreign stock indices or a specific market sector index.
• Leverage - These are generally products such as warrants, which require a low initial investment but which allow the buyer to participate in the purchase or sale of a significantly larger investment at a predetermined price in the future.
N.B. These products may carry higher risks than other classes of investment. They are not suitable and are therefore not available to every investor.
Which group of structured products would you use if:
1 you wanted the chance of big returns with only a small investment now?
2 you didn't want to lose any of your money?
3 you wanted to trade in a particular combination of assets?
4 you wanted the highest return?
Ov&r +o upu
If you had a lot of money to invest, would you take the risk of joining a hedge fund? If not, why not?