The following are seen as the main risks: – the leverage is too high; in the case of the LTCM hedge fund, which got into trouble in 1998, the leverage was 25: the portfolio exceeded the fund’s equity by this factor. A lot of leverage allows a hedge fund to greatly increase returns. As long as the interest on the leverage is below the fund’s return, there is a strong incentive to raise more and more leverage. – Funds are moved from regulated markets to unregulated offshore financial centers, which easily leads to more careless risk management. – High performance pressure forces hedge fund managers to act in the same way: their risk appetite increases; at the same time, the risk of fund insolvency increases. – In the event of losses, high leverage forces hedge fund managers to rapidly reduce the exposures that caused them: this can very easily lead to a rush to the exit, as was demonstrated in the financial crisis that followed the subprime crisis in 2007.- Activity in relatively illiquid markets can trigger sudden price jumps with far-reaching consequences or – as in the case of the subprime crisis – exacerbate existing market disruptions. This is particularly true when hedge funds receive high margin calls from their prime brokers and, at the same time, investors withdraw their deposits from the hedge fund because they themselves are often in a liquidity squeeze. As a result, in the slipstream of the turmoil surrounding the subprime crisis, volatility in the financial market increased markedly; at the same time, the rate of hedge fund exits more than doubled from the normal twelve percent per year worldwide. – On the other hand, however, there is no evidence that hedge funds played a significant role in causing the financial crisis that followed the subprime crisis, although this has often been claimed. – See cannibalization, over-the-counter, cash settlement, supervision, indirect, Counterparty Risk Management Policy Group, loan-versus-paper business, domino effect, leverage (effect), hedge fund strategies, capital tapping, rush to the exit, zombie bank. – See BaFin Annual Report 2004, pp. 18 ff., p. 89 (problems with risk measurement of funds of hedge funds) pp. 182 ff. (recent regulatory developments), BaFin Annual Report 2009, p. 211 (international efforts to tighten regulation), and the respective BaFin Annual Report, chapter “Supervision of Securities Trading and Investment Business,” Financial Stability Report 2012, pp. 67 ff. (shadow banking sector as a whole and its risks).
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University Professor Dr. Gerhard Merk, Dipl.rer.pol., Dipl.rer.oec.
Professor Dr. Eckehard Krah, Dipl.rer.pol.
E-mail address: info@ekrah.com
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https://www.jung-stilling-gesellschaft.de/merk/
https://www.gerhardmerk.de/