As any one knows in the financial market, high returns always come with high risks. In order to avoid or minimize the risk of investment, investors choose to invest in the hedge activity. Under this position, hedge fund was formed. Hedge funds are managed by some hedge fund managers. These fund managers normally have strong economics or finance background and long term experience in the financial market. Some of them also have strong mathematics background. However, hedge fund does not mean no risk in the investment and it does not always get positive returns from the investment. The famous example of hedge fund is Long Term Capital Management (LTCM). It was successfully in some hedge fund investment but finally went to collapse in the 1998. This essay will discuss the history and operations of hedge fund. And use the LTCM as a case study to analysis how it operated fund in financial market and why it financial went to the collapse.
History of the Hedge Fund
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Hedge fund originated in the early 1950s in the United States. In the beginning, the purpose of the hedge was to reduce the risk and avoid the default in the investment by using futures, options, shares and other financial derivatives. The first hedge fund was created by Albert Wislow Jones in 1949. Albert Wislow Jones believed the price movement of an asset is dependent on two components. One is the overall market movement; the other is the asset itself. In order to reduce the effect of the overall market movement, he set up his portfolio by buying assets which he expected to be better than the market and selling assets he expected to be worse than the market. Under his operation, the price movement due to the overall market was cancelled. That because the losses on the shorted assets would be neutralized by the gains from the buying assets when the market rose. The hedge fund has emerged in the early 1950s, but it was not paid attention by investors in the following thirty years. Until the 20th century 80s, with the financial development, hedge funds have more opportunities in the financial investment. From the 1990s, the threat from the global inflation had been reduced while the financial investment became more and more mature and diverse. Therefore, hedge funds entered a rapid development stage. According to the statistics of the British "The Economist", from 1990 to 2000, there are more than 3,000 new hedge funds had been emerged in the United States and United Kingdom. And also according to the British "Financial Times", until year 2005, the total assets of the global hedge funds had reached 1.1 trillion US dollars.
The basic operation of hedge fund
At the beginning, in a basic hedge fund operation, fund managers purchase a kind of shares and then purchase a certain price and time of the put option of this kind of shares. The purpose of the purchase put option is when the stock price drop down to the put option price, the fund manager could sell the shares at a strike price in order to reduce the loss from the stock price fall down. In this operation the risk of stock price falling down can be hedged. In another hedge operation, fund managers select an expected bullish industry. They Purchase some high quality stocks from this industry, and then sell a percentage of poor stocks in the same industry. Under this combination, if this industry is going as well as expected. The price of high quality stocks will rise more than other stocks in the same industry. Therefore, the profit from the purchasing of high quality stocks will much greater than the loss from short selling poor quality stocks. In other words, if the expectation is wrong, the share price of the selected industry will fall down. Under this situation, the decline of the share price of poor quality stocks must greater than the higher quality stocks. Thus the gains from the short selling lower grade stocks are greater than the loss from purchasing high grade stocks. Because of this operation, the early hedge fund can be said is based on a conservative investment strategy.
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After several years of evolution, the hedge fund has lost its original connotation of risk hedge. Hedge fund has become to a new investment model. It uses the different kind of financial derivatives and leverage to face the high risk and high returns in the investment. Nowadays, hedge funds have the following characteristics.
The characteristics of hedge funds
The complexity of investment
In recent years, the investment structures become more complex. Several of financial derivatives such as futures, options, swaps and others have become to the main operational tools of hedge funds. These derivative products are designed for hedge funds. Their low cost, high return and high risk characteristics become modern hedge funds' effective tools. Hedge funds use the combination of these derivatives to invest. If the market forecast is correct, investors could receive excess profits in a short term.
Hedge funds often use bank credit to borrow high leverage loan, in order to times or several times expand their investment funds to achieve the maximum reward for the purpose. Because of the high liquidity of hedge fund assets, hedge funds can use their assets easily to refinance. For example, for a capital of only 1 billion hedge funds, fund manager can use its asset as security to repeatedly refinance then get billions of dollars loan. Under this high leverage, after the investment and deduct the interest of loan, the net profit is much greater than the gain of only use 1 billion funds to investment. And also because of the high leverage, if the investment failed the investors also face a huge risk of loss.
financing from private
Hedge funds structures are generally partnership. Fund investors provide money but do not participate in investment activities. Hedge fund managers are responsible for the fund's investment decision. As the operational requirements of hedge funds, in United Stated the partners of the hedge fund are normally control up to 100. And each partner's capital contribution must be more than 1 million US dollars. Because hedge fund is a high risk and high complexity investment, in order to protect the public investors, in many Western countries hedge funds are not available to finance their funds from the public. In order to avoid high taxes and the US Securities and Exchange Commission's regulation, most of US market's hedge funds register offshore, such as Bahamas or other low taxes and less control areas. And also these hedge funds finance their funds from investors who outside the United Stated.
Flexibility of operation
Hedge fund is different with normal investment fund. Normally investment fund focus on a specific portfolio. Such as balanced funds, in the fund portfolio the combination of stocks and bonds are generally half and half. And growth fund, its fund portfolio is focus on the high return investment like stocks. And also such as mutual fund, it can not use credit fund to investment. However, there is no restricting on the hedge fund. It can use any kind of financial instruments of the combination of them to investment. And also in order to receive the higher market return, hedge fund can maximum use the credit funds. Because of the high flexibility of operation and the effect of leverage, hedge fund played an important role in the modern global financial market.
Case study of LTCM
Long Term Capital Management (LTCM) was founded by John Meriwether in February 1994 and based in Greenwich, Connecticut, USA. John Meriwether is a brilliant financial investor. He was the vice-chairman and head of the bond trading at Salomon Brothers. LTCM's trading strategies are statistical arbitrage, pairs trading and fixed income arbitrage combined with high leverage. LTCM collected the financial market's historical data, some relative research data and academic report and market information then use these large amounts of combination information through the computer processing to create complete mathematical computer model of automatic investment system. In order to perfect operate the system, John Meriwether recruited two famous economists Myron Scholes and Rober C. Merton to join in the board of directors. They both worked in Salomon Brothers' fixed income trading department. And also they shared the Nobel Memorial Prize in Economic Sciences in 1997. Also he used his well established reputation to recruit several Salomon bond traders and some brilliant financers. Such as former vice Minister of Finance and Vice Chairman of Federal Reserve David W. Mullins, former director of Salomon Brothers bond trading department Eric Rosenfeld and so on. With these financial professionals, John Meriwether's group as seem as a dream team.
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The core strategy of the LTCM is the convergence trading. The LTCM used a large number of mathematic theories to provide a financial model to take the advantage of fixed income arbitrage deals, usually trade with government bonds. Government bonds pay a fixed amount of interest at a specified time in the future. Normally differences in the present value of the bonds are very small. As we know in the economic theory any difference in the price will be eliminated by arbitrage. LTCM's strategy does not care about a particular stock or bond prices rise or fall, it gambling in the stock or bond prices related to the normal convergence on. For example, the price difference between a United Stated 29 years's Treasury bond and a 30 years Treasury bond should be minimal. But a small difference arose between the two bonds because of a difference in liquidity. Therefore, LTCM use a huge amount funds to purchasing the cheaper 29 years US Treasury bonds and selling the more expensive 30 years US Treasury bond. It could make a profit as the difference in the value of the two bonds narrowed when a new bond was issued. LTCM's investment strategy was extremely efficient in the first several years.
In 1994, LTCM funds invested in the Italian Government bond BTP (Buoni Del Tesoro Poliennali). LTCM found the profit gap between BTP and fixed Lira interest swap. That because of the high credit risk of the Italian government. The higher credit risk let the BTP offered the higher rate of return. And whereas the interests on the fixed Lira interest swap would be bid down. The market provided an arbitrage chance to LTCM. LTCM get the privilege to purchase the BTP, and also it created a set of financial swaps to reduce the risk. Such as LTCM get the BTP and transfer those to another party and then LTCM also signed a repurchase contract. Under this swap strategy the LTCM got the interest from the BTP and paid LIBOR to another party, but LTCM still owned the BTP. At the same time, LTCM signed a fixed Lira interest swap to some other entities outside Italia. LTCM paid fixed Lira interest to outside entities and received LIBOR as return. Under these two swaps, the profit earned for LTCM was the difference between interest return on BTP and the payment on the fixed Lira interest swap.
There is a potential risk faced by LTCM under these swap transaction. When the profit between interest return from the BTP and payment of fixed Lira interest swap was closed to zero, LTCM should buy back the BTP and resell it. However, if the price of BTP decreases, LTCM had to pay the higher price to the party who hold the BTP. On the other hand, if the price of BTP increases, LTCM would benefit from surplus beyond the fair price. However, under that time's situation, the price of BTP was seemed to decrease. That because of the high credit risk of Italian, with the lower credit grade Italian government had to increase the interest rate to attract the investors. But the high interest rate stresses the government. Most of the BTP investors considered the possibility of default will be very high in the future. Therefore, they began to sell the BTP to the market rather than held it to maturity. Result in the price of BTP would be decrease in the future.
In order to avoid the price decrease of the BTP, LTCM tried to affect the price movement of the BTP on the market. In the European market, the squeeze activity was deregulated in 1990s. Under this situation, LTCM got a legal right to carry out squeeze on the BTP. Before the BTP was in the auction, many Italian financial institutions issued the put options on the BTP to protect the price decrease. However, LTCM arranged a large amount of capital to squeeze in the NTP auction. LTCM became the biggest Buyer of BTP; it could purchase the bond before any other buyers. Therefore, LTCM purchased a large amount of BTP and totally transferred them to the other company. As a result, the BTP was taken out of the market by LTCM. There is a few amount of BTP in the market. This operation pushed up the price of BTP. Soon after, many Italian financial institutions found they could not meet the requirement of the put options which they issued already. In order to keep the customers and avoid the default of put options, these financial institutions had to purchase the BTP from LTCM and sell at a fixed price to their customers. The price of BTP was under the control of LTCM and the movement of the market was affected by LTCM. The repurchase contracts held by LTCM became more valuable. Hence, LTCM achieved the perfect arbitrage in the BTP trading.
LTCM fund rose in the boom of the capital market, it was absorbed in increasing its capital. When a company wants to increase its investment capital, the efficient way is issue debt. Leverage is a useful method for a company to raise its capital, but it also brings the potential risks which are debt itself and interest payments. In the hedge fund market, leverage is almost the only way for investors to increase their investment capital. In the financial market the arbitrage chance is very small. It can not survive in a long term. When an arbitrage gap is occur, more and more investors will enter into until the gap closed. The investment capital is the key in the arbitrage. The investment fund needed to take highly leveraged positions to make a significant profit. And also leverage can reduce the tax payment. As LTCM, it can reduce the tax payment because of the investment profit from the debt funds are not taxed. Thus, LTCM reinvest its profits into the new investment so that these earnings were not taxed as capital maintains. The purpose for fund reinvestment of LTCM was not only the tax avoid, but also was the capital extent. The extended funds would bring in more profits. The LTCM funds were running in a reinvestment circle. With the capital extend of reinvestment; the amount of debt was increasing greater and greater. And also the potential risk of leverage was become larger and larger.
From 1994 to 1997, LTCM's business performance was glamorous. The annual investment rates of return were 28.5% in 1994, 42.8% in 1995, 40.8% in 1996 and 17% in 1997. At the beginning, the net asset of LTCM was 1.25 billion US dollars. But until the end of 1997, the net asset rose to the 4.8 billion US dollars. LTCM was known as the one of the top four international hedge funds in the world. They are LTCM, Tiger Fund, Quantum Fund and Omega Fund. With the successful on investment, LTCM attracted many investors invested in its fund. At the beginning of 1998, the firm borrowed over $124.5 billion, but its equity amount was only $4.72 billion. The total asset held by LTCM was around $129 billion. The debt to equity ratio (leverage ratio) was about 25:1. Most of debts borrowed by LTCM were invested in financial derivative products. Such as interest rate swap, interest rate derivatives and equity options. It had off balance sheet derivative positions with a notional value of $1.25 trillion. When these financial derivatives devalued, nothing would be paid back to the debt issuers. If LTCM get into a trouble in one of these financial derivatives, its debts issuers would ask for their money back immediately. This event would directly caused LTCM in a liquidity problem or even worse.
Although LTCM successful in several arbitrage investments on the financial market, its fund managers got mistakes on identify information for financial market. Mistakes were established in the 1997 Asian Financial Crisis and then these factors giving rise to the downfall of the LTCM in 1998 Russian Financial Crisis. In 1997, Asian financial crisis shook the global financial market, most financial institutions lose huge amount of money or even went to bankrupt. That also include the LTCM, some of LTCM's investments began to face a loss. In 1998, LTCM invested in the Russian bond market. It purchased huge amount of Russian Government Bonds (GKO). That because the situation of GKO was similar as the BTP. LTCM would like to gamble again. Because of the lower credit level of Russian government, GKO provided a 40% annual return on rouble. In order to avoid the depreciation risk of rouble, LTCM signed a foreign exchange rate contract. Under this contract, LTCM could exchange the rouble to US dollar at a determined price in the future. LTCM created a protection on the Russian government bond. But it absolutely did not expect in 1998 Russian government announced the devaluation of the rouble and stop trading on government bonds. As a Russian government bond holder, LTCM faced a huge loss on both stopped trading of bonds and the foreign exchange rate contract. LTCM's debt issuers could not wait for the firm to recover its loss. They asked for money back immediately.
As a result of these losses, LTCM had to liquidate a number of its positions at an unfavourable moment and suffer further losses. After the Russian government default its government bonds. Panicked investors lose confidence on the less liquidity assets. They change to invested in the high liquidity assets such as on the run US treasury bonds even it only provided a lower interest rate. In 1998, many investors sold their Japanese or European bonds and then purchased the US treasury bonds. Under this flight to liquidity trend, the price of the on the run treasury bonds rose and the price of the off the run fall down. Unfortunately, LTCM held a huge amount of off the run bonds. The loss was extremely prodigious. Until the end of August 1998, LTCM fund had lost $1.85 billion US dollars in capital. And in the first three weeks of September, LTCM's capital dropped down from $2.3 billion US dollar to only $ 400 million US dollar. The loss on equity increased the leverage ratio to about 250:1.
The large amount of debt could not be paid back, raise money by LTCM its own became impossible. After declined the purchase offer from Goldman Sachs, AIG and Berkshire Hathaway, Federal Reserve Bank of New York organized a bailout of $3.625 billion US dollar by major creditors to avoid a serious collapse in the financial market. Partners of LTCM invested about $1.9 billion of their own money in the fund, but they were all wiped out. The total losses of the LTCM fund were founded about $4.6 billion US dollar. After the bailout, LTCM continued to operate for one year. In that it earned 10%. In early 2000, the fund had been liquidated and the money financed by bailout had been paid back.
Hedge fund is still a famous financial investment product in the nowadays financial market. Although the word "hedge" is in its name, it is not a risk free investment. It also comes with the high potential risks. As the LTCM, it is the best example in the hedge fund market. LTCM was organized by some geniuses and they created an effective mathematic model in arbitrage investment. With these instruments and confidence, LTCM successful invested in arbitrage market such as Italian government bond (BTP). Although the leverage is the best way for firms to increase their capital in the hedge fund market, the high leverage ratio level established the high risk for the firm. When the financial crises occur, financial market will go to collapse. Thus the high debt level will become the pressure for the financial investors. Therefore, invest in the financial market; the risk control is the eternal theme. Because everyone or any kind of the financial instrument both have the probability of make mistake, risk control must keep in every financial investor's mind.
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