Wednesday, September 21, 2011

Hedge funds. What are they? [Note to self]

Here is another post inspired by the book "Ascent of Money" written by Niall Ferguson. You will probably get better information on hedge funds and hedging from Wikipedia, but here is my take on the subject and what I saw as important in Ferguson's presentation of the matter.

Hedging and hedge funds have their roots in agriculture. For a farmer there are two things that affect his income: first one is the amount of crop and second one is price of the crop. The amount of crop depends on the weather and there is not much you can do about it. The price the farmer gets paid depends on the market price. The farmer pretty much knows what his expenses will be when sows his seeds. What he does not know is how much he will be paid at harvest. The farmer could protect himself against price fluctuations by making a deal with, for example, bakery that it will by all of his wheat with certain price. At harvest the market price may be lower than the price the farmer and agreed upon, in this case the farmer wins. It also could be that the market price is higher than agreed in which case the bakery wins, because it gets it wheat at a cheaper price than if it would by the same amount of raw material with market prices.

The first standardised future contracts that were traded in after markets were created in Chicago. The Chicago Produce Exchange was the first permanent place for trading futures.

Since this type of elimination of risk requires a speculator as a counter part trading in futures has been viewed as nothing more than a casino. Partly because of that only 1970s trading of interest and currency futures was permitted. In 1982 the future contracts were allowed to stock trade.

Since all futures contracts are derived from the value of the property the contract is based on all futures contracts are so called derivatives. Here are some derivatives that Ferguson presents in his books. There is a good list of derivatives on Wikipedia.

Options are form of derivative financial instrument closely related to futures contracts. There basically are two types of options selling and buying options. The option grants the owner of the contract the option (not an obligation) to buy/sell a certain amount of goods at a price agreed in the contract.

Swaps are a form of derivative where two parties basically bet on, for example, the development of interest rates. Someone who receives income from loan where interest is fixed can swap the interest rate to floating rate. 

Credit default swap is a contract where the buyer of the CDS makes a payment to the seller and receives a pay off if a instrument goes default.

There are also weather derivatives which enable you to insure against natural catastrophes and extreme weather patterns. In 2006 the nominal value of weather derivative was 46 billion dollars.

Nowadays most of the derivatives are no longer standardized but tailor made and sold in so called over the counter (OTC) trade outside the stock exchanges. Banks are the usual seller of OTC derivatives and majority are temporarily arranged between two parties.

The problem with derivatives and future contracts is that it has divided world into those that have money to protect themselves to those that don't. It usually takes a seven-figure-sum of money to protect against unexpected fluctuations in interest rates or in commodity prices etc.

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