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IMF and Hedge Funds

by Laurent GUERBY Sat Jun 10th, 2006 at 02:39:24 PM EST

Via QuantLogic, a very interesting speech about hedge funds by Raghuram G. Rajan, Economic Counselor and Director of Research of the International Monetary Fund, some interesting bits:

I will argue in this talk that much of what is termed changes in "risk aversion" is likely to be changes in the structure of incentives and resulting behavior of investment managers--by "investment manager" I mean managers of financial assets ranging from those running insurance companies to those running venture capital and hedge funds. A primary driver of these changes is likely to be a change in the stance of monetary policy. Monetary policy thus might have effects outside the traditional channels, though the behavioral channel will amplify traditional effects. I will discuss what all this might imply for policy making.
For example, a number of insurance companies and pension funds have entered the credit derivative market to sell guarantees against a company defaulting. Essentially, these investment managers collect premia in ordinary times from people buying the guarantees. With very small probability, however, the company will default, forcing the guarantor to pay out a large amount. The investment managers are thus selling disaster insurance or, equivalently, taking on "peso" or "tail" risks, which produce a positive return most of the time as compensation for a rare very negative return.iiThese strategies have the appearance of producing very high alphas (high returns for low risk), so managers have an incentive to load up on them, especially when times are good and disaster looks remote.iiiEvery once in a while, however, they will blow up. Since true performance can only be estimated over a long period, far exceeding the horizon set by the average manager's incentives, managers will take these risks if they can.
Monetary Policy and Incentives

Thus far, I have highlighted four types of behavior--risk shifting, illiquidity seeking, tail risk seeking, and herding among investment managers. My conjecture, which needs to be tested econometrically, is that all these behaviors are amplified when interest rates are low (especially following a period of high rates), liquidity supply is plentiful, and both conditions are expected to prevail for some time. In reduced form, this behavior will look like an increase in risk tolerance. Conversely, if monetary conditions are expected to tighten substantially, we should see a reversal in this behavior, which would be attributed to increased risk aversion. Of course, part of this behavior would be accentuated by the genuine uncertainty surrounding any turn in monetary policy. Preliminary analysis suggests simple proxies for the risk aversion of financial markets in the United States, such as the VIX index, do seem to be positively correlated with the level of short-term interest rates, as with broad measures for liquidity.ivMoreover, the VIX explains a significant portion of the variation in emerging market debt spreads (see Kashiwase and Kodres (forthcoming)).

If verified empirically, however, this would suggest an additional "behavioral" channel for the transmission of monetary policy than the ones we are familiar with, the traditional money channel, the borrower balance sheet channel (Bernanke and Gertler (1995)), the bank lending channel (see, for example, Bernanke and Blinder (1988, 1992) or Kashyap and Stein (1997)), and the liquidity channel (Diamond and Rajan (2006)). I admit though that clever work would be needed to tell its effects apart from these other channels.

Nevertheless, from a policy perspective, this "behavioral" channel introduces new dimensions to thinking about monetary policy. For one, it could work entirely through institutions outside the banking system--through finance companies, insurance companies, pension funds, hedge funds, and venture capitalists. Equally important, it could have wider effects than through credit. In particular, it will affect asset prices, and could thus also amplify existing channels like the balance sheet channel, with the riskiest and most illiquid financial assets or borrowers affected the most. Finally, because emerging markets and developing countries offer risky and illiquid assets, there will be substantial spillover of industrial country policies to these markets.

Interest rates policy of ECB is something that isn't discussed much, but this speech echoes my intuition that the modern worldwide financial market - nearly anyone can buy and sell any financial instrument everywhere in the world with near zero transaction costs - has become a new phenomenon whose consequence haven't been fully sorted out yet.

Some other bits on Brad Setser's blog, with my comments about ... credit derivatives :).

I've got the majority of my investment funds securely locked into Tulip bulb options secured by shares of the state chartered French Banque Generale AND shares in the Mississippi Company.  (That John Law is a genius, isn't he?)

Derivatives are nothing but a huge leveraged bet against future price movements.  Sooner or later those bets will be wrong.  

And here is The Horrible Example:

Good ol' LTCM (for Long Term Capital Management, guffaw) took $4 billion in equity, borrowed another $125 billion, and leveraged it out to more than $1 trillion.  The Russian bond default of 1998 changed the entire global interest rate climate, all of their mathematical relationships based on past price movements - always a good idea <snark> - between differing interest rates in differing currencies went kerflooey, LTCM was on the wrong side (long) of the Russian default, all the rest of their positions went sour, LTCM went bankrupt, and for a couple of hours, the world was facing financial ruin from cascading bankruptcies in and of the Major Money Centers.

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Sat Jun 10th, 2006 at 11:53:54 PM EST
Yes people who do not hedge derivatives they own take most of the time lots of risk. Exception are structures where the capital is safe, these are less risky than stocks.

But my point about credit derivatives is that 1/ there isn't much hedging to do and 2/ since the introduction of credit derivatives there has been no real down in the credit market so we don't know what will happen then...

by Laurent GUERBY on Sun Jun 11th, 2006 at 05:04:11 AM EST
[ Parent ]
agree, i try to protect my ass most of the time, i.e. it was quite usefull last week ;-)
by fredouil (fredouil@gmailgmailgmail.com) on Sun Jun 11th, 2006 at 06:13:50 AM EST
[ Parent ]
First, I completely agree with your two points.

I'm pretty sure I've read about derivatives based on credit instruments (bonds/bills/notes/) butterflied out over several different currencies (US dollar/Euro/Yen) and different markets New York, Tokoyo, and London.  I admit its not something I have to follow anymore (thank God!) so I maybe wrong.

As far as a down, let me suggest the currency collapse in Indonesia a couple of years ago is a really good model of what happens in todays markets when a country's economic situation is re-valuated by the market.  When the US economy, say, is re-valuated all of the risk calculations instantly become incorrect and the derivatives and hedges of those derivatives go into unpredictable territory.  If everything is in unpredictable terrority who is going to step-up and be the other side of transactions?  For every seller there has to be a buyer (duh) and if nobody wants to assume the risk then the effective market value of the derivative or the hedge is zero.

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Sun Jun 11th, 2006 at 12:11:46 PM EST
[ Parent ]
Currency stuff you describe are what we call interest rate and exchange rate derivatives.

Credit derivatives are contracts where you get a yearly coupon payment (say 6%), but you loose the capital if some company (upon which your "credit" contract is based) goes chapter 11 or something like that.

So as long as the market is doing fine you get easy money, but when things go wrong, you loose 100% of your investment.

by Laurent GUERBY on Sun Jun 11th, 2006 at 06:01:49 PM EST
[ Parent ]
Given the leverage of some of these 'things' - I refuse to call them investments - I'm not sure the complete potential loss is limited only to the amount of the bet.  Especially in a revaluation cascade.

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre
by ATinNM on Sun Jun 11th, 2006 at 06:36:07 PM EST
[ Parent ]
My mother was wondering if she could raise hedge funds but finally she opted for a cheaper wooden barrier.
by Alex in Toulouse on Sun Jun 11th, 2006 at 06:32:35 AM EST
You sum up more or less my understanding of hedge funds... They must be an Important Thing in the real world out there...
by Nomad on Sun Jun 11th, 2006 at 11:14:52 AM EST
[ Parent ]
Ahh thanks for understanding the hidden message in my post, I was indeed making a point about me not knowing anything about hedge funds, though a finance-world friend of mine has mentioned them once or twice. I think they're important but I don't know if I want to know why. I'm resisting the urge to read this diary Laurent, please don't be disappointed, it's only the communist blood in me that's manifesting itself ;)
by Alex in Toulouse on Sun Jun 11th, 2006 at 11:35:42 AM EST
[ Parent ]
Well my father and my two grandfathers did vote for the French communist party :).

Anyway, as usual wikipedia is useful, the main thing being that those funds have little or no reporting and regulatory obligations, so investors in hedge funds are just giving money to someone blindly in the hope they'll make some more.

by Laurent GUERBY on Sun Jun 11th, 2006 at 12:07:43 PM EST
[ Parent ]
Derivatives and Hedge Funds are attempts to make money through mathematical constructs giving a computed monetary value of relationships(s) between different and, eventually, real financial assets.

It's a game.

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Sun Jun 11th, 2006 at 12:18:15 PM EST
[ Parent ]
Seems like a risky type of investment.

Something tells me that financial people, stock market people, are addicted to gambling.

by Alex in Toulouse on Sun Jun 11th, 2006 at 12:25:26 PM EST
[ Parent ]
Gambling: exorbitantly done by wealthy men dressed in suits and ties who squander with a certain air of recklessness in a process that has no solid guarantees on the outcome.

Stock market people: ... You see where I'm going...

by Nomad on Sun Jun 11th, 2006 at 12:31:03 PM EST
[ Parent ]

If one takes Catastrophe Theory seriously, as I do, it becomes readily apparent D & HF's are not fully computing the real Risk of these bets.

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Sun Jun 11th, 2006 at 12:39:44 PM EST
[ Parent ]
Derivatives are risk management tools : you can obviously increase the risk you take, but you can also decrease it (say less risk than holding on mutual or index funds).
by Laurent GUERBY on Sun Jun 11th, 2006 at 06:03:51 PM EST
[ Parent ]
That's the theory. That's the model.

We are about to see if that is the way it actually works during sharp and extended downwards pressure.  Greenspan kept the pressure off the last time by paying, through negative interest rates, major money banks to borrow and destroyed the foundations of the US economy doing by so doing.

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Sun Jun 11th, 2006 at 06:43:40 PM EST
[ Parent ]
The Sunday NY Times has an article about the returns from hedge funds. Because of the 1-2% management fee and the 20% performance fee that they charge, they yield less, on average, than do straight mutual funds.

They are being pushed by the financial markets not because they are good investments, but because they make the sellers rich at no risk to themselves.

Really rich people invest in things like real estate which has very good long term returns and modest risk.

My new motto: Only poor people can afford to gamble...

Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Sun Jun 11th, 2006 at 07:22:54 PM EST

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