Forum for Science, Industry and Business

Sponsored by:     3M 
Search our Site:

 

Research Counters Risky Image of Popular Financial Investments

05.03.2010
They have been called “financial weapons of mass destruction” and blamed for a number of catastrophic losses and bankruptcies. New research by a finance professor at Virginia Tech’s Pamplin College of Business, however, counters the popular perception of derivatives as dangerous tools and investments.

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
Further information:
http://www.vt.edu

Further reports about: Financial Planner Risky driving mutual funds

More articles from Business and Finance:

nachricht Microtechnology industry is hiring – positive developments of past years continue
09.04.2018 | IVAM Fachverband für Mikrotechnik

nachricht RWI/ISL-Container Throughput Index with minor decline on a high overall level
20.03.2018 | RWI – Leibniz-Institut für Wirtschaftsforschung

All articles from Business and Finance >>>

The most recent press releases about innovation >>>

Die letzten 5 Focus-News des innovations-reports im Überblick:

Im Focus: Hygiene at your fingertips with the new CleanHand Network

The Fraunhofer FEP has been involved in developing processes and equipment for cleaning, sterilization, and surface modification for decades. The CleanHand Network for development of systems and technologies to clean surfaces, materials, and objects was established in May 2018 to bundle the expertise of many partnering organizations. As a partner in the CleanHand Network, Fraunhofer FEP will present the Network and current research topics of the Institute in the field of hygiene and cleaning at the parts2clean trade fair, October 23-25, 2018 in Stuttgart, at the booth of the Fraunhofer Cleaning Technology Alliance (Hall 5, Booth C31).

Test reports and studies on the cleanliness of European motorway rest areas, hotel beds, and outdoor pools increasingly appear in the press, especially during...

Im Focus: Scientists present new observations to understand the phase transition in quantum chromodynamics

The building blocks of matter in our universe were formed in the first 10 microseconds of its existence, according to the currently accepted scientific picture. After the Big Bang about 13.7 billion years ago, matter consisted mainly of quarks and gluons, two types of elementary particles whose interactions are governed by quantum chromodynamics (QCD), the theory of strong interaction. In the early universe, these particles moved (nearly) freely in a quark-gluon plasma.

This is a joint press release of University Muenster and Heidelberg as well as the GSI Helmholtzzentrum für Schwerionenforschung in Darmstadt.

Then, in a phase transition, they combined and formed hadrons, among them the building blocks of atomic nuclei, protons and neutrons. In the current issue of...

Im Focus: Patented nanostructure for solar cells: Rough optics, smooth surface

Thin-film solar cells made of crystalline silicon are inexpensive and achieve efficiencies of a good 14 percent. However, they could do even better if their shiny surfaces reflected less light. A team led by Prof. Christiane Becker from the Helmholtz-Zentrum Berlin (HZB) has now patented a sophisticated new solution to this problem.

"It is not enough simply to bring more light into the cell," says Christiane Becker. Such surface structures can even ultimately reduce the efficiency by...

Im Focus: New soft coral species discovered in Panama

A study in the journal Bulletin of Marine Science describes a new, blood-red species of octocoral found in Panama. The species in the genus Thesea was discovered in the threatened low-light reef environment on Hannibal Bank, 60 kilometers off mainland Pacific Panama, by researchers at the Smithsonian Tropical Research Institute in Panama (STRI) and the Centro de Investigación en Ciencias del Mar y Limnología (CIMAR) at the University of Costa Rica.

Scientists established the new species, Thesea dalioi, by comparing its physical traits, such as branch thickness and the bright red colony color, with the...

Im Focus: New devices based on rust could reduce excess heat in computers

Physicists explore long-distance information transmission in antiferromagnetic iron oxide

Scientists have succeeded in observing the first long-distance transfer of information in a magnetic group of materials known as antiferromagnets.

All Focus news of the innovation-report >>>

Anzeige

Anzeige

VideoLinks
Industry & Economy
Event News

"Boston calling": TU Berlin and the Weizenbaum Institute organize a conference in USA

21.09.2018 | Event News

One of the world’s most prominent strategic forums for global health held in Berlin in October 2018

03.09.2018 | Event News

4th Intelligent Materials - European Symposium on Intelligent Materials

27.08.2018 | Event News

 
Latest News

Small modulator for big data

25.09.2018 | Information Technology

NASA's Terra Satellite glares at the 37-mile wide eye of Super Typhoon Trami

25.09.2018 | Earth Sciences

Rice U. study sheds light on -- and through -- 2D materials

25.09.2018 | Materials Sciences

VideoLinks
Science & Research
Overview of more VideoLinks >>>