Kein Folientitel

1
Due To Deregulation, Liberalization and
Globaliza-tion The Traditional Bank Business Has
Changed Dramatically. Banks can enter a business
that had been off limits before Deepening of
Capital markets connected corporates directly to
the market. Corporate Finance business has
suffered from highly specialized securities
firms and institutional asset managers. Tradition
al Sources Of Bank Profits Have Shifted Bank
Deposits are decreasing. Liabilities as bank
loans are also decreasing on the assets side
(Table 1,2). On the other side negotiable
liabilities have increased (tradable securities
on the asset side) (Table 3,4).
2
In Most G7-Countries Bank Deposits in Percent of
Total Liabilities were Decreasing During the Last
Twenty Years
Table 1. Bank Deposits in percent of total bank
liabilities
3
In Some G7-Countries also Bank Loans as in
Percent of Total Bank Assets Decreased
Table 2. Bank Loans in percent of total Bank
Assets
4
Banks are Using More and More Capital Market
Instruments to Refinance Their Businesses
Table 3. Negotiable Liabilities in percent of
total Bank Liabilities
5
Banks Have Also Entered resp. Enlarged Their
Asset Management Businesses
Table 4. Tradable Securities Holding in percent
of Total Bank Assets
6
Three Major Changes In The Composition Of Banks
Balance SheetsDisplacement of lending by other
activities.Growth of off-balance-sheet assets in
percent of total assets.Displacement of deposit
loan-income by other operating income. Changes
Are Reflected By Desegementation And
RestructuringExpanding into other markets
(Securities) to face competition to the Asset
Management Industry.Entering the insurance
marketsEntering Asset Management business
providing investment management services and a
wider range of financial services to their
customers.All this changes are reflected by
heavily increasing M A activities.
7
Source of Bank Profits Have Shifted From Interest
Related Income to Other Income
Table 5. Balance Sheet Information of Top 50
Banks in percent as noted
8
The Traditional View of Financial Intermediation
Has Eroded

• Traditionally banks intermediate between
  borrowers and savers by using deposits,
  securities firms were providing the distribution
  of new issues of equity and debt to public.
• On the supply side, Nonbank financial
  institutions have entered the traditional bank
  business. Insurance Comp., Investment banks, even
  telcos and food companies are providing
  bank-services.
• On the demand side, households were bypassing
  banks by investing directly to those investment
  firms which could cause of theire specializtion
  more effective handle the savings.
• As a result from this, the nonbank-sector became
  larger and larger.(Table 6,7). In the United
  States the nonbank-sector is managing (1995)11,5
  trillion US compared to 5 Trillion in the
  banking sector.

9
Institutional Investors Were Steadily Growing at
High Average Rates
Table 6. Assets of Institutional Investors
10
Institutional Investors Were Steadily Growing at
High Average Rates
Table 7. Assets of all Institutional Investors
in of GDP
11

• Globalization
• Financial Markets Are Facing Closer Integration
• Liberalization and Development of Information
  Technologies prepared the way to globalization
  and integration
• Securities Portfolios became far more
  internationally diversified (Table 8). The growth
  in gross portfolio flows increased by almost more
  than 200 times.
• Cross border transactions in Bonds and Equities
  reached up to between seven and one times GDP. In
  the US those transactions between US and foreign
  investors totaled 17 Trillion US. (see Table 9)
  or 213 of the US - GDP.
• Although investment portfolios are fare away from
  beeing adequately internationally diversified,
  i.e. portfolios still do not reflect the the
  structure of the world market capitalization
  (USA 42, Japan 15, UK 9, other industrial
  countries 23, emerging markets 11)

12
Globalization Financial Markets are Facing Closer
Integration

• Mirroring this expansion firms also turned to
  international markets to raise funds (see Table
  10).
• Even the volume of outstanding issues of
  international debt securities reached to 3,7
  Trillion US , sixfold larger than in 1985.
• Financial Globalization has been a counterpart to
  international trade. The foreign exchange market
  has far outpaced the growth of trade. In 1995 an
  annual worldwide trade volume of 6,1 Trillion
  US was faced by a daily market turnover of 1,2
  Trillion US . (see T.11.)
• Nonresidents holdings of public debt also
  increased substantially (see Table 12)

13
Foreign Net and Portfolio Investments (in bn )
Table 8. Gross and Net Flows of Foreign Direct
and Portfolio Investment (G7)
14
Cross Border Transactions of Bonds and Equities
Table 9. Cross Border Transactions in Bonds and
Equities
15
Foreign Exchange Trading (Turnover in bn per
day)
Table 11. Foreign Exchange Trading
16
Nonresidents Holdings of Public Debt (in of
Total Debt)
Table 12. Nonresidents Holdings of Public
Debt(in percent of total public debt)
17

• Accompanying all this, we can observe extending
  linkages between international Exchanges (Eurex,
  CBOT and Eurex)
• OTC- and Exchange traded markets will merge
• New Markets for unbundling and trade of risks
  will emerge
• Actually the risk market volume is estimated to
  reach up to a volume of more than 130 Bio US
  /year (notional amount outstanding per end of
  year). This would be more than the total volume
  of all traded bonds, equities and bank
  assets Outlook to new market propositions
• In future we will face an ongoing increase of
  methods and products concerning risk markets,
  also dealing new kinds of risks like
• Catastrophe Risks (ART) will change insurance
  marketsCredit Risks will change the business
  potential of credit business.Private Income
  Risks

18
New Trends New Markets New Chances New Risks
19
New Markets and Products for Unbundling, Pricing,
Trading and Managing Risks
Example U.S. bank has given a floating rate
Yen denominated loan to a Japanese bank.
Credit-risk loaded floating-rate, Yen-denominated
loan
Riskless, fixed rate dollar denominated security
20
How Risk Management Works
Japanese Bank
US Bank
100 Bio Y at LIBOR
Floating Rate YenLoan
Floating Rate YenCredit
LIBOR Payed in Y
Payback in Yen
LIBOR in Yen
InterestRateSwap
Fixed rate in Yen
Fixed Rate Dollar Loan
Yen - Payer
OTC - Market
CurrencySwap
US Receiver
Credit Default Swap
21
Growth in Global Security Issues,1990-2003
Bn
Global debt equity
U.S. Issuers worldwide
22
Derivatives - Notional Amount Outstanding per
12/1987 to 12/2005
23
MarketsareInterlinked ExampleSpot and
Futures Market
24
Spot Future - Parity
Spot Future ParityIndex Arbitrage (Example)
Today, one (theoretical) Index-Future is sold at
5,500 (1 per Index-point). Long and
Short-positions can be described by a profit and
loss diagram
If you are Long-Future, then you may claim for
delivery of one index at a price of 5,500 at
the maturity of the index-future. That means, if
the index at delivery is quoted at more than
5,500, you will win from your futures position.
25
Spot Future - Parity
Spot Future ParityIndex Arbitrage (Example)
You hold an Index-Portfolio, currently valued at
5,500 (1 Index-point 1 ). If the annual risk
free rate rf is at 3.5 and the expected
dividends on your Index portfolio are at 100 (d
100/5,500) , an Index Future with one year to
maturity has a fair price of
To prevent our Index-Portfolio from losses, we
could hedge the price risk by taking a short
future position (selling a future at 5,592.40).
26
Spot Future - Parity
Spot Future ParityIndex Arbitrage (Example)
The total expected payoffs from your portfolio
will depend on the fu-ture state of the
environment (see below payoffs 1-5). A decreasing
stock market will be compensated by profits from
the short future po-sition, increasing stock
prices will be outbalanced by losses due to
pay-ment obligations from the future.
Assets Payoff1 Payoff2 Payoff3 Payoff4 Payoff5
Stock Portfolio 4500,00 5000,00 5500,00 6000,00 6500,00
Dividends 100,00 100,00 100,00 100,00 100,00
Short Future 1092,40 592,40 92,40 -407,60 -907,60
Total 5692,40 5692,40 5692,40 5692,40 5692,40
27
Spot Future - Parity
Spot Future ParityIndex Arbitrage (Example)
Assets Payoff1 Payoff2 Payoff3 Payoff4 Payoff5
Stock Portfolio 4500,00 5000,00 5500,00 6000,00 6500,00
Dividends 100,00 100,00 100,00 100,00 100,00
Short Future 1092,40 592,40 92,40 -407,60 -907,60
Total 5692,40 5692,40 5692,40 5692,40 5692,40
Initially you have paid 5,500 for your stock
portfolio. Taking the short future position, the
final outcome of your portfolio will be 5,692,40
, whatever the stock price will be, i.e. you
will earn 192,40 which equals 3.5. Obviously,
this profit is riskless
Spot-Future- Parity
28
Spot Future - Parity
Spot Future ParityIndex Arbitrage (Example)
Rising future prices will due to arbitrage
trading - induce rising spot prices. For example,
a future traded at 6,000 is (relative to a spot
market price of 5,500) clearly overpriced, if the
stock price remains unchanged at 5,500 . In this
case, smart traders will make arbitrage profits
of 407,50 per contract and bring back the
market to equilibrium
Action t0 t1
Borrow money at rF (3,5) 5,500.00 - 5,692.50
Buy/Sell Stock Portfolio - 5,500.00 Stock
Sell/Buy Future at 6,000 0 6,000.00 - Stock
Total 0 307,50
Note, that the arbitrage profit equals the
difference between a fair- and mispriced future
(6,000 5,592,40) plus Dividends. Higher Future
prices will lead to massivly increased demand at
spot markets until spot prices and futures are
back to equilibrium.
29
Spot Future ParityFinancial Market Stability
Spot Future ParityIndex Arbitrage (Example)

• Spot Markets and Future (Forward) Markets are
  interlinked.
• Mispriced spot or future market instruments will
  affect both markets.
• Future market speculations that drive futures
  prices will also drive spot market prices due to
  arbitrage trading (et vice versa).
• Speculation on futures markets, resulting in
  higher future prices will induce higher spot
  market prices due to arbitrage trading. Finally
  this may result in spot market bubbles that
  jeopardizes the allocation mechanism of real
  goods markets.

30
Management of Operational Risks Weather Derivativ
es
31
Weather DerivativesHistory

• Weather Derivatives occured in 1997 in the USA
  after the El Niño effects. (Aquila Energy, Kansas
  City/Missouri).
• At the end of 1998 first Weather Derivatives
  were issued in Germany
• Since 1998 Weather Futures and Weather -
  Options are traded at the Chicago Mercantile
  Exchange .
• In August 2001 London International Financial
  Futures Exchange (LIFFE) started trading Weather
  Futures.
• Eurex planned to launch weather related
  derivatives in 2004.

32
Weather Derivatives German Temperature Index
Xelsius
33
Weather Derivatives German Temperature Index
Xelsius
34
Weather Derivatives German Temperature Index
Xelsius
HDDInterval Max 0, 18C - ? Temp
CDDInterval Max 0, ? Temp - 18C
Example On December, 12th 2001 the average
temperature in Berlin has been - 6 C. This day
the Index shows 24 HDD.
35
Weather Derivatives In many cases operational
income is directly weather related
36
Weather Derivatives In many cases operational
income is directly weather related
The annual turnover (Business Unit Heating
Energy) of the former Berlin Energy - Supplier
BEWAG (now VATTEN-FALL) 1999 / 2000 mounted to
771 Mio DM. The winter season 1999/2000 showed
2.425 HDD. This equals an average turnover per
HDD of 320 TDM. If the winter would have been
warmer (for example at only 2000 HDD) this would
have caused a lower turnover of approx. 425 HDD x
320 TDM 136 Mio DM.Insofar BEWAGs
operational income is directly related to the
average temperature in winter season.
37
Weather DerivativesThe
Payoff-Profile from Heating Business remembers to
the payoff profile of a financial future.
Example If 2500 HDD would represent an average
cold winter, then a higher number of HDD would
create additional turnovers, whereas a lower
number would lead to a smaller turnover.
38
Weather DerivativesIn this example the risk of
warmer winters (i.e. lt 2500 HDD) could be hedged
by weather futures.
At a Standard of 100 per HDD, a weather future
on the basis of 2500 HDD has a contract value of
2500 x 100 250 T. Given a profit-margin of
approx. 20 (turnover at 2500 HDD 2500 x 320
TDM 800 Mio DM (400 Mio ) i.e. a total average
profit of 160 Mio DM or 80 Mio resp. an average
profit per HDD of 32 T) BEWAG could hedge the
weather risk selling 320 weather futures at an
Index of 2500 HDD.
39
Weather DerivativesIf BEWAG takes the
short-position this could result in the following
scenarios


Income from
Operational

Income


Short Future
HDD

Turnover

Profit


Total Profit




(Mio )
(Mio )

(Mio )
(Mio )
2000

320

64

16

80

2100

336

67

12,8

80

2200

352

70

9,6

80

2800

448

90

-
9,6

80

2900

464

93

-
12,8

80

3000

480

96

-
16

80


40
Weather Derivatives Payoff-profiles of a
hedged (operational) business are similiar to the
payoff-profiles of a future hedged trade.
41
Weather Derivatives OptionsPut - Options
Hedging with weather futures means not only to
eliminate operational risks but also to eliminate
the chance of having a better result than hedged.
To avoid this, one could lmake use of weather
options (as traded at LIFFE). To minimize option
premiums, options frequentlly contain caps or
floors.
42
Weather Derivatives Options Call - Options
To buy a put at a strike of 2500 HDD leads to
compensations when the average number of HDD is
below 2500 HDD. To buy a call wouold mean, that
the buyer can claim fo compensation-payments if
the number of HDD is above 2.500 HDD.
Short Call at a Strike of2500 HDD
2500 HDD
Long Call at a Strikeof 2500 HDD
Floor at 2700 HDD
43
Weather Collar Short Call 2700 HDD and Long Put
at 2300 HDD
Max. Chance
Max. Risk
44
Weather Collar (Short Call 2700 HDD and Long
Put at 2300 HDD)
A Zero Cost Weather Collar (Short Collar)
can be designed to restrict the volatility of
weather related profits wo to the boundaries of
an upper and lower limit.
45
Management of Operational Risks Non Performing
LoansandCredit Risk Marktes
46
Topics Covered

• NPLs in China and Germany
• Origin and Dynamics of NPLs
• Centralized Problem Solving Approaches
• Decentralized Problem Solving Approaches
• Outlook

47
Germany At a Total Volume of 3,500 bn. Loans
Outstanding approx. 300 bn. are Non Performing
(estimated in 2004)
48
Referring to Fundamental Data (Profits) German
Stock Markets Were Overvalued From 1997-2001
49
Although Investments (Plant, Machinery) Were
Decreasing Loans to Enterprises Remained High
50
After the Bubble Bad Debt and Bad Debt Losses
Increased
51
Solving the Problem
StockProblem
FlowProblem
52
China In 2002 Total NPL Amounted to 770 bn.
Which Corresponded to 61 of GDP or 37 of Total
Loans
168 bn
Approx. 2,508 bn
602 bn
Total Outstanding Loans
Total Non Performing Loans
53
Origin and Characteristics of NPL
54
Stock and Flow Problems Need Different
Approaches
NPL
Stock
Solve the Flow Problem
Credit Ceilings Efficient Legal Framework
Operational Restructuring Centralized Bad
BankHard Budget Constraints
Flow
55
Market for Credit DerivativesSource British
Bankers Association(in Bio. US)
56
Basics of Credit Derivatives Asset Swaps
pays fixed Swap-rate (Coupon Rate)
receives LIBOR var. Premium (spread)
Receivesfixedrate
The Investor protects his portfolio against
credit quality degradations by a simple swap
construction using a interest swap the investor
swaps fixed income from his portfolio into
variable premium payments from the risk buyer.
57
Credit Default Swap (C.D.S.)
Premium bps x Notional Value
Credit Event ?
NoNo Com-pensation
YesCompen-sation
58
Total Rate of Return Swap(Synthetic Sales or
Short Sales of Loans)
negativeMarket price changes
LIBOR /-Spread
Fixed Interest Rates
positive Market price changes
Reference Value(e.g. Bondes, IndicesAsset
baskets, Loans)
59
Credit Linked Notes (CLN)
Notional Value of CLN
Fixed Rate CLN
Repayment of C.L.N. possibly minus compensation
if Credit Event
60
Credit Spread PutConstruction of strike-spreads
Example5-y. Corp.Bond 5,955-y.
Swap-rate(fix against 6-M-EURIBOR)
5,50 Credit Spread 0,45 45
basepointsAt an agreed strike-spread of 45
bps, the short side will pay a compensation, if
the spread increases.
61
Credit Spread PutMechanism
62
What is A Credit Event ?
The ideal case would be a reference value (e.g. a
bond) that is highly correlated with the secured
loan.
63
Credit Default Swap / OptionSettlement Versions
64
Extension of Risk Management by Credit
Derivatives
Market Risks
Risk of Default
InsolvencyRisk
SpreadRisk
Credit DefaultSwap
Credit SpreadPut
Total Rate of Return Swap
65
Alternative I ABS Transactions(True Sale)
66
Market Securitisation of Credit Risks(Europe
2002 in Mrd. )
67
Alternative II Synthetic Sales by
Collateralized Debt Obligations (C.D.S.)
68
Fazit

• Die Problemkreditbearbeitung wird zukünftig
  deutlich stärker von risikopräventiven und/oder
  risikokurativen Managementaufgaben geprägt sein.
• Im risikopräventiven Bereich erwarte ich
  einerseits eine intensive Auseinandersetzung mit
  portfolio-orientierten Risikostrategien,
  andererseits eine spürbare Zunahme des Transfers
  von Adressen-risiken
• Im risikokurativen Bereich erwarte ich eine
  stärkere Akzentuierung eines fundamentalen
  (Kredit-)Sa-nierungsmanagements auch unter
  Einbeziehung bankexterner Funktionen

69
Management of Operational Risks Capital Markets
and Refinancing ofInsurance Industry
70
Alternativer Risiko Transfer (A.R.T.)

• Katastrophen - Derivate
• Katastrophen Anleihen (Cat Bonds)
• Act of God - Bonds

71
A.lternativer R.isiko T.ransferGrößte
versicherte Schäden 1989 - 2001
72
Alternativer Risiko TransferVersicherbarkeit von
Risiken
Max. Schaden schätzbar
Ausr. Anzahl gleichartiger Risiken
Risiken
Zufälligkeit
nein
Ausfall Olympische Spiele
X
X
Produkthaftpflichtfür Arzneimittel
nein
?
?
Attentat mit nuklearen Waffen
?
X
nein
73
Klassischer vs. Alternativer Risiko Transfer
Klassischer versicherungstechnischer
Risiko-transfer
Alternativer versicherungstechnischer
Risiko-transfer
74
Produktentwicklung im Risikogeschäft
75
A.R.T. - Produkte
Finanztitel
originär
derivativ
Bonds
Options
Futures
Verknüpfung mit versicherungstechnischem Risiko
Underlying
Principal
Coupon
GCCI , PCS (Property Claims Services) - Indices
Principal und / oder Coupon at Risk
76
A.R.T. - ProdukteStruktur eines CAT - Bonds mit
S.P.V.
Schadens-ausgleich
Versicherungs-nehmer
Kapitalmärkte
Wert-papiere
Prämien
SpecialPurposeVehicle
Kapital
Prämien
TilgungZinsen
Versicherer
Investoren
Refinanzierung des Schadenausgleichs
Tilgung, Zinsen
77
A.R.T. - ProdukteAusstattungsmerkmale Cat-Bonds
Pionierprodukt war der Cat-Bond (Hagelbond) der
Winterthur Versicherung (WinCat). Der erste
WinCat Bond enthielt folgende Formulierung
Die Zahlungen auf den Zinscoupon entfallen, wenn
die Winterthur während der Beobachtungs-periode,
die jeweils vom 1. November bis zum 31. Oktober
des Folgejahres dauert, als Folge min-destens
eines großen Hagel- oder Sturmereignisses für
mehr als 6,000 Motorfahrzeuge ihrer
Motorfahrzeug-Kasko-versicherung Leistungen
erbringt. Dabei werden Schäden, die innerhalb
eines Kalendertages auftre-ten, dem gleichen
Schadensereignis zugeordnet.
78
A.R.T. - ProdukteBeispiel Cat-Bonds
1997 plazierte ein SPV (United Services
Automobile Association und Residential
Reiunsurance Limited) einen Cat-Bond über 477 Mio
USD in zwei Tranchen mit jeweils einjähriger
Laufzeit Die erste Tranche war
nominalwert-geschützt (Class A-1, LIBOR 273
bps) und umfaßte 164 Mio USD, die zweite Tranche
(Class A-2, LIBOR 576 bps) über 333 Mio USD
unterlag Tilgungsrisiken. Die Zahlungsströme der
Tranchen waren auf Hurricane Katastrophenschäden
bedingt, soweit diese in ausgewählten Regionen
einen Gesamtbetrag von 1 Mrd. USD übersteigen.
Erreichen die Hurricane - Schäden ein Volumen von
1,5 Mrd. USD, verlieren die Class-A-2 Investoren
ihr gesamtes Kapital.
79
A.R.T. - ProdukteOptionsprodukte/ Beispiel
An der Chicago Board of Trade werden seit 1992
indexbasierte Optionsprodukte, Puts und Calls,
gehandelt. Der zugrunde-liegende Index ist der
PCS - Property Claims Services - Schadensindex.
Jeder Indexpunkt repräsentiert einen Marktschaden
von 10 Mio USD.
Beispiel Ein Erstversicherer möchte sein
Sturmrisiko / Florida reduzieren. Er nutzt hierzu
den an der CBOT gehandelten Florida PCS - Call
Spread 100 / 150, d.h. er kauft Call Optionen auf
einen PCS - Indexstand 100 und verkauft
gleichzeitig Call Optionen auf einen PCS -
Indexstand von 150.
80
A.R.T. - ProdukteWirkung eines 100/150 Call
Spreads auf den PCS-Index
81
A.R.T. - ProdukteOptionsprodukte/ Beispiel
Szenario A Liegt der PCS -Index aufgrund der in
Florida aggregierten Marktschäden bei weniger als
1 Mrd. USD, verfallen beide Optionen. Per saldo
sind Prämien von 5 Mio USD verloren. Szenario
B Marktschäden übersteigen 1 Mrd. USD, bleiben
jedoch niedriger als 1,4 Mrd. USD Die Long Call
Position bei einem Strike-Index von 100 gerät ins
Geld, die Short-Position verfällt wertlos.
Schadensausgleich wird im Idealfall kompensiert
durch A.R.T. Gewinne.Szenario C Die
Marktschäden liegen bei mehr als 1,4 Mrd. USD.
Der Wertzuwachs der Long-Position wird
kompensiert durch Verluste aus der 140er
Short-Position.
82
Alternativer Risiko Transfer

• A.R.T. - Refinanzierung der Versicherer /
  Rückversicherer über die Kapitalmärkte eröffnet
  Chancen zur Kapazitätser-weiterung und
  Versicherung bislang unversicherbarer Risiken.
• A.R.T. bietet Instrumente, die aufgrund ihrer
  Kovarianzpro-file gut in viele Anlageportfolios
  passen würden.
• A.R.T. bieten sich an zur kapitalschonenden
  Risikodiver-sifkation der Versicherer bzw. zur
  Ergänzung von klassischen Investor - Portfolios
  aus traditionellen Finanzmarktprodukten.
• A.R.T. Produkte sind schwierig zu bewerten. Es
  exisitiert kein allgemein anerkanntes
  Preisbildungsmodell, Investoren verhalten sich
  deshalb abwartend.
• A.R.T. Markt ist klein und entwickelt sich
  zögerlich.

83
Financial Markets Imbalances are Accompanied By
Increasing Size and Activity of Alternative
Investments
84
Alternative Investment Strategies And Financial
MarketStability Southwestern University
ofFinance and Economics Chengdu September
2006 The only hope to produce a superior
record is to do something different. If you buy
the same securities as other people, you will
have the same results as other people John
Templeton Prof. Dr. Rainer Stachuletz Berlin
School of Economics
85
Contents

• Business models of hedge fund investors and their
  current role in financial markets
• Typical designs, mechanisms and conditions of
  hedge funds investment strategies
• Do alternative investments jeopardize the
  stability of financial markets
• Summary / Conclusions / What to do ?

86
The Universe of Alternative Investments
87
General Characteristics of Alternative
Investment Strategies
88
Hedge Funds Business Model
Mostly unregulated, offshore residing eclectic
investment pools with aggressively managed short
term portfolios. Hedge Funds employ investment
techniques like short selling, leverage, and are
allowed to create a variety of synthetic
positions by unlimited usage of
derivatives. Often hedge funds are set up as
private partnerships, open to a limited number of
investors and require a very large initial
minimum investment. Typically hedge Funds are
illiquid as they often require investors keep
their money in the fund for a minimum number of
years. Hedge funds managers typically charge a
management fee (1-2 of asset value) and a
performance fee of about 20 of the capital gains
and capital appreciation.
89
Development of Hedge FundsNumber and Portfolio
(in Bio US)
90
Hedge Funds Investment Strategies
Risk and Return
91
Relative Value StrategyLong / Short Equity
Hedge
92
Relative Value StrategyLong / Short Equity
Hedge
93
Directional StrategiesNon Hedge Long-/Short
Directional Strategies represent unhedged,
directional speculations on growing (long) or
declining (short selling) markets. By additional
usage of debt (leverage) respectively completing
short or long-positions synthetically, the total
risk and return positions can be amplified.
94
Event Driven Strategies(Merger Arbitrage)
95
Event Driven StrategiesLongShortEquity and
Merger Arbitrage
96
Event Driven Strategies(Merger Arbitrage)
97
Three Popular Arguments on Hedge Fund Investments
and Financial Market Stability ?

1. Hedge Funds operate high leveraged portfolios of
   mostly risky assets. As a result, market
   processes tend to be more volatile and more
   uncertain. Thus syestemic market risk will
   increase !
2. Hedge Fund investments tend because of their
   sheer size to manipulate asset prices. This
   will directly compromise the pricing mechanism
   and thus lead to inefficient factor allocations !
3. As Hedge Funds often do not have to follow any
   regu-lations that are used to be applied to
   onshore finan-cial institutions (transparancy of
   investment styles, accounting, disclosure and
   auditing, taxes etc.) investors are not
   sufficiently protected.

98
1. Do Hedge Funds Increase Market Volatility ?
99
1. Are Hedge Fund StrategiesRisky Investments ?
100
1. Do Hedge Funds Increase Systematic Risk ?
(Theoretical Portfolios of Traditional Assets
(MSCI 50, JP Morgan Global 50) and the
CSFB-Hedge Fund Index based on monthly figures
between 1994-2004)
101
2. Hedge Funds and Market Manipulation
Hedge Funds do not rely on momentum investments
and often take contrary positions. Thus, their
engagement will support the pricing mechanism
while providing liquidity and keeping the market
process running. By this, Hedge Funds help
substantially to rebalance the markets and smooth
volatility.
Hedge Funds, that operate in smaller markets
generally have the potential of market
manipulation. In the case of arbitrage trading or
related relative value strategies, hedge funds
activities target directly to change market
prices. A manipulation of prices back to the
equilibrium is desired. This may be seen
different concerning other investment strategies.
102
2. Hedge Funds and Market Manipulation
In fact, only 20 of the total investment is
arbitrage tra-ding. The rest is more or less
directional. The major part of directional
investments is represented by directional
equity-investments (long-/short-only).
103
3. Need Investors to be Protected ?
The Hedge Funds market is dominated by well
experienced, well informed and educated powerful
investors (average entry investment at 630 T !)
like banks, pension funds, endowments and wealthy
individuals (HNI). As they are strong enough to
take care of their specific information needs, no
regulation is required.
104
3. Need Investors to be Protected ?

• Investor protection seems to be a week argument,
  if it is focused on the typical hedge fund
  investor as shown above.
• As hedge funds have started to copy the
  profitable investment model of private equity
  funds in a short term version, there are not the
  hedge fund investors that need to be protected,
  but those long term investors, who are affected
  by short term hedge fund investment activities.
• Therefore, to focus investor protection on the
  hedge fund investor is misleading. Investors
  should be protected against hedge fund investors.
  

105
Summary and Conclusions

1. Currently Hedge Funds control an investment
   volume of about 1.2 Trillion USD, which means a
   proportion of 12 of the total global fund
   investments.
2. Although they are powerful, Hedge Funds are
   widely un-regulated, e.g. they do not report
   their acitivities like other financial
   institutions, mostly they dont have to fol-low
   minimum capital requirements, minimum disclosure
   standards or minimum audit standards. In a strong
   sense they do not contribute to rational decision
   making.
3. Due to their characteristics non regulated
   offshore residents, excessive leverage, short
   sales and unlimited incorporation of derivatives
   (synthetic assets) their investment styles and
   their sheer size, hedge funds affect or have the
   potential to affect market processes.

106
Summary and Conclusions

1. The total business model including investors who
   provide equity, hedge fund corporations that
   select investments and investment styles and
   investment banks which provide the loan is highly
   concentrated and interlinked. That high
   integrated and concen-trated business modell
   increases the probability of extensively
   widespread cascading effects in case of a failure
   (see the LTCM Case in 1998).
2. As Hedge Funds have started to copy typically
   Private-Equity-Engagements even those parts of
   the real economy that have not been direktly
   linked to capital markets, have become the target
   of short term financial investments and will be
   exposed to intensified leverage risks.

107
Does The Market Need Hedge Fonds ?

• Hedge Funds are in general non transparent,
  offshore located and tax avoiding investment
  strategies beyond any national jurisdiction.

• Hedge Funds have not only the potential but also
  strong incentives to manipulate market processes
  e.g. to generate price movements that enhance the
  profitability of their underlying positions.

• With the today known market strategies that
  includes desireable arbitrage trading only to a
  proportion of approxi-mately 20 and the
  observable move to directional strategies
  concerning long equity positions Hedge Funds need
  to be regulated to support long term oriented
  micro- and macro-policy approaches.

108
Private Equity Investmentsand Regulatory (Tax)
Arbitrage
Private Equity means to invest in non-listed,
frequently undervalued corporations and any other
(undervalued) assets. Mostly returns result
simply from tax arbitrage.