Risks Related to Hedge Funds Essay

Risks Related to Hedge Funds

            Hedge fund is a term used in investment which characterized in many ways. These characteristics provide a broad definition of what hedge fund is all about.

            First, hedge funds are not mutual funds.These mutual funds are limited partnerships generally with a minimum investment of at least a quarter of a minimum dollars. They are not required to register with the Securities and Exchange Commission (SEC), as long as the investors have no more than ninety-nine (99). Hedge fund investor, however must be accredited by the Security and Exchange Commission (SEC). As under the current law, accredited investor has at least $375,000 in liquidating assets and is capable of risking it.

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            In hedge funds, there are no limits of what it may invest in or how they concentrate their holdings. For them, it is not necessary that they diversify. In some people in fact, consider their lack of regulation to be their principal advantage.

            The concept of hedge fund may said to be dates from about 1970. Originally, the term was generally referred to as investment funds that also used as a derivative assets such as futures and options for the purpose of hedging against market risk. In terms of the word derivatives, firms exposed to losses to changes in security prices when securities are held in investment portfolios, and they are also exposed during times when securities are being issued. In addition for this, firms are exposed to risk if they use floating rate debt to finance an investment that produces a fixed income stream. Risks such of this kind can often be mitigated by using derivatives. These derivatives are securities whose value stems, or is derived from the value of other assets. Thus, options and future contracts are derivatives, because of the reason that their values depend on the prices of some underlying asset.

            On the other hand, hedge funds are also involved in systematic risk exposures especially from the collapse of Long Term Capital Management. Systematic risk which is commonly used to describe the possibility of a series of correlated defaults among financial institutions, typically banks, that occur over a short period of time, that often caused by a single major event. The hedge fund industry is said to be  have a symbiotic relationship with the banking sector, and many of these banks now operate proprietary trading units that are organized much like hedge funds. As a result, the risk exposures of the hedge fund industry may have a great material impact on the  banking sector, resulting in new sources of systematic risks.

            In the rise of the hedge fund sector, some of its principal building block are management of credit, market and liquidity risks. Many of todays traders and investment managers are talented and experienced where they can used their skills and insights for these areas to create returns from structural and pricing inefficiences. This is one of the reason why risk management has been at the heart of the industry’s astonishing growth in recent years.

            The development of understanding of the main risk category of operational risk, has largely been missing from hedge funds’ risk management palette. These made to perception that hedge funds’ overall risk mangement leaves something to be desired.

            One of the important driver behind this closer scrutiny has been the funds of funds sector and the institutional investments into the hedge funds sector, which has fuelled investor pressure for greater transparency around of what individual hedge funds are doing. In line of this, the fund of funds and the institutional sector needs to be sure that each manager is doing what it said it would do, so that the performance monitoring can be correctly calibrated and evaluations checked. As the result of this, programs to monitor has been installed by sector and flag risk management systems at their hedge fund clients.

            The second driver is the regulatory pressure, notably from Security and Exchange Commission (SEC). Christopher Cox, SEC new commissioner, has indicated his desire to pursue the registration of hedge funds from February 1, 2006, in line with plans set out by his predeccesor. This for the reason of strengthening the already established trend for hedge funds to appoint Chief Risk Offices and Chief Complience Officers.

            The third driver is the fact that many of todays industry’s staggering expansion has caused hedge funds to hire more new staff that they can thoroughly train. As the result of this scenario, industry’s are vulnerable to reputational risk that caused by poor hiring decisions. Senior managers have become aware of this issue, these lead them to increased internal pressure for greater operational and business controls.

            One question still arises for hedge funds, What should hedge funds do to strengthen their risk management? Many answers has been proposed, one of this is the strategy to embrace principles laid down by professional bodies such as the Managed Future Association. They issue regularly updated guidelines on basic standards. Another strategy is to borrow expertise from other sectors within financial services, notably banking and insurance, which have already had to wrestle with holistic approaches to risk management. For hedge fund groups with affiliation, this might find relatively straightforward route to gain the required expertise. One thing that hedge funds can do is to seek to gain access to the complex risk management systems that have been developed both by independent software vendors and by large financial conglomerates.

            The bottom line of this is that hedge funds is facing an ongoing challenges. Many of the skilled and experienced investors is seeking to understand and manage operational risks more effectively. In today’s market, sophisticated investors and analysts are demanding that firm’s use derivatives to hedge certain risks. One good example is the Compaq Computer. The company was sued by share holder group for failing to properly hedge its foreign exchange exposure. The shareholder lost the suit, but Compaq got the message and now uses currency futures to hedge its international operations.

            In additional for this, CEOs, CFOs, and board members should be reasonably knowledgeable about the derivatives their firms use, should establish policies regarding when they can and cannot be used, and should establish audit procedures to ensure that the policies are actually carried out.

Sources:

1. Chan, Nicholas T., Getmansky, Mila, Haas, Shane and Lo, Andrew W., “Systematic   Risk and Hedge Funds”, 2005, MIT Sloan Research Paper No. 4535-05,       Available at SSRN: Http://WWW.ssrn.com/abstract

2. Hedge Funds’ Risk Adventure, Available at Http://WWW.deloitte.com/ddt/article

3. Mighan, Eugene F., and Houston, Joel F., 2001, Fundamentals of Financial Management,      9th edn., Harcourt Asia PTE LTD., Singapore

4. Rao, Ramesh K.,1997, Financial Management: Concepts and Application, 3rd            edn.,South-Western College Publishing, Cincinnati, Ohio

5. Strong, Robert A., 1998, Practical Investment Management, Southern-Western College          Publishing, Cincinnati, Ohio

6. Melicher, Romal W., and Norton, Edgar A., 2000, Finance: Introduction to     Institutions, Investments and Management, 10th edn., South Western College     Publishing, Cincinnati, Ohio