In a study to be published in the Journal of Financial and Quantitative Analysis, Yong Chen, an assistant professor of finance, investigates how derivatives are used by hedge funds and focuses on the relationship between derivatives use and hedge funds’ risk-taking behavior.
Despite the widespread use of derivatives by hedge funds, Chen says, little is known about their effects on fund risks and performance. How do derivatives users differ from nonusers with respect to fund risks and performance? Do hedge funds that use derivatives demonstrate a greater propensity for risk shifting? Are derivatives-using funds more likely to fail? “Such questions, and their answers, are very important to investors, lenders, and regulators.”
Examining more than 5,000 hedge funds during 1994-2006, Chen found that 70 percent of them trade derivatives. On average, those that do so showed lower fund risks (as measured by fund return volatility, average market exposure, and market exposure during market downturns or extreme market events). “Overall, the evidence does not suggest that derivatives use by hedge funds leads to more risk-taking.”
His findings would be of broad interest, he says, given the current concern about the risk-taking activities of hedge funds and other quasi-bank institutions among lenders, investors, and regulators, who are seeking to increase government oversight of hedge funds.
“In the past two decades,” Chen says, “derivative markets and the hedge fund industry and have experienced explosive growth and wielded increasing influence on the market and economy.”
Deriving their value from other assets, derivatives are financial instruments that allow investors to speculate on the future price of an asset — commodities or shares, for example — without buying the underlying asset. Developed to allow investors to hedge, or insure against, risks in financial markets, derivatives such as futures, options, and swaps, have become investments in their own right.
Hedge funds, which use aggressive strategies to maximize returns in managing investments of wealthy private investors or institutions, have become major players in derivative markets, Chen says. “The pervasive use of derivatives by hedge funds stands in sharp contrast to mutual funds,” he notes, citing one study that found that only about 20 percent of mutual funds use derivatives.
The high-risk image of derivatives, Chen notes, resulted from a number of spectacular financial failures, all of which involved derivatives trading: the bankruptcy of Orange County, Calif., in 1994; the collapse of British-owned Barings Bank in 1995; the fall of U.S. hedge fund Long-Term Capital Management in 1998; the failure of another U.S. hedge fund, Amaranth, in 2006; and the huge losses of French bank Société Générale in 2008. It was legendary investor Warren Buffet who called derivatives “financial weapons of mass destruction.”
Depending on the purpose — hedging or speculation — the use of derivatives may be associated with lower or higher fund risk, Chen said. “Although it cannot be ruled out that some hedge funds use derivatives to speculate on asset prices,” he says, “the overall evidence is more consistent with risk-management-motivated use of derivatives.”
Chen’s study found that “derivatives users engage less in risk shifting,” the practice in which funds performing poorly in the first half of a given year tend to increase portfolio risk in hopes of catching up in the second half, while funds performing well try to lock in their returns by lowering risk. Derivatives users, he adds, are also less likely to liquidate during market downturns.
Virginia Tech’s nationally ranked Pamplin College of Business offers undergraduate and graduate programs in accounting and information systems, business information technology, economics, finance, hospitality and tourism management, management, and marketing. The college emphasizes the development of ethical values and leadership, technology, and international business skills. Its centers focus on business leadership, business diversity, electronic commerce, forest industries, organizational performance, and services innovation. The college is committed to serving business and society through the expertise of its faculty, alumni, and students. It is named in honor of alumnus Robert B. Pamplin, who died in June 2009 at age 97 and was the retired CEO of Georgia-Pacific, and businessman, philanthropist, and alumnus Robert B. Pamplin Jr.
Sookhan Ho | Newswise Science News
Frugal Innovations: when less is more
19.04.2017 | Fraunhofer-Institut für Arbeitswirtschaft und Organisation IAO
Europe's microtechnology industry is attuned to growth
10.03.2017 | IVAM Fachverband für Mikrotechnik
The nearby, giant radio galaxy M87 hosts a supermassive black hole (BH) and is well-known for its bright jet dominating the spectrum over ten orders of magnitude in frequency. Due to its proximity, jet prominence, and the large black hole mass, M87 is the best laboratory for investigating the formation, acceleration, and collimation of relativistic jets. A research team led by Silke Britzen from the Max Planck Institute for Radio Astronomy in Bonn, Germany, has found strong indication for turbulent processes connecting the accretion disk and the jet of that galaxy providing insights into the longstanding problem of the origin of astrophysical jets.
Supermassive black holes form some of the most enigmatic phenomena in astrophysics. Their enormous energy output is supposed to be generated by the...
The probability to find a certain number of photons inside a laser pulse usually corresponds to a classical distribution of independent events, the so-called...
Microprocessors based on atomically thin materials hold the promise of the evolution of traditional processors as well as new applications in the field of flexible electronics. Now, a TU Wien research team led by Thomas Müller has made a breakthrough in this field as part of an ongoing research project.
Two-dimensional materials, or 2D materials for short, are extremely versatile, although – or often more precisely because – they are made up of just one or a...
Two researchers at Heidelberg University have developed a model system that enables a better understanding of the processes in a quantum-physical experiment...
Glaciers might seem rather inhospitable environments. However, they are home to a diverse and vibrant microbial community. It’s becoming increasingly clear that they play a bigger role in the carbon cycle than previously thought.
A new study, now published in the journal Nature Geoscience, shows how microbial communities in melting glaciers contribute to the Earth’s carbon cycle, a...
20.04.2017 | Event News
18.04.2017 | Event News
03.04.2017 | Event News
21.04.2017 | Physics and Astronomy
21.04.2017 | Health and Medicine
21.04.2017 | Physics and Astronomy