Newspapers report that Long-Term Capital Management–the high-profile hedge fund run by a hotshot bond trader and two Nobel laureates–nearly plunged the world into financial ruin last week. And it’s not just journalists who say so. Intent on forestalling global financial disaster, a group of big-money Wall Street banks convened by the Fed ponied up almost $3.5 billion to bail out the fund. (For more on the Nobel laureates, click here.)
What are hedge funds? Why are their meltdowns so spectacular?
A hedge fund is nothing more than a pool of money which a manager invests for a group of wealthy investors (minimum buy-in is often $10 million). Hedge funds promise an investment strategy that makes money when the market rises and when it falls. The hedge fund manager takes 15 to 20 percent of profits, the rest goes to investors. Sounds grand, but how does it work?
Long-Term’s manager, backed by a star-studded research division, dealt in so-called derivatives. Derivatives are financial creations whose value is based upon, or derived from, the price of some underlying item, like stocks, bonds, commodities, or currencies. For example: stock options are a wager on the future price of, say, AT&T stock; commodity futures are a wager on the future price of, say, pork bellies. Both count as derivatives, as do more exotic creations like swaptions and quantos (don’t ask).
Derivatives permit a fund manager to reduce certain kinds of risk. Suppose the manager is holding a portfolio whose value rises when interest rates rise but falls when interest rates fall. Adding an appropriate derivative–one which bets for an interest rate fall–to the portfolio mitigates losses if, in fact, interest rates fall. (Hence the name “hedge funds”–one investment position offsets, or hedges, another investment position.)
Of course hedge fund managers do more than just bet both for and against some outcome. At the end of the day, they must bet on something, right? It seems that Long-Term was betting on the yields of bonds from G-7 countries (no one is sure since Long-Term won’t disclose details of its dealings). By analyzing historical data, Long-Term developed predictions about the relative rates of return on different countries’ bonds. The firm used a series of hedges–which means buying derivatives–to make sure that they were insulated from general rises and falls in interest rates, stock exchanges etc… That’s the beauty of hedging with derivatives–they let you bet on precisely what you want to. In theory, other perturbations are not supposed to affect your assets.
But something happened that the financial “rocket scientists”–so named because many have doctorates in math or physics–either didn’t expect or couldn’t conceive of. An article by MIT economist Paul Krugman considers just what might have gone wrong. (He thinks the rocket scientists were smart but naïve. In other words, their computer models didn’t sufficiently account for extremely unlikely but extremely serious developments, like economic crisis in Russia and political gridlock in Japan.)
Krugman also thinks that investors were naïve to believe that Long-Term offered return without risk. The chance of things going wrong may have been slim, but when things went wrong, they went spectacularly wrong. One key feature of derivatives is they can get you in a pot of trouble very quickly. If you buy stock, and its price falls by 10 percent, you’ve simply lost 10 percent of your money. But if, for instance, you buy a so-called call option (which is a bet that the stock will rise) and the stock falls by 10 percent, you may lose all your money. (A call option allows you to buy the stock at a specified price, known as the strike price. If the market price falls and stays below the strike price, then the option is worthless.) There are even derivatives–such as futures contracts–with which you can lose more than your original investment if you bet on the wrong horse. No one but Long-Term really knows what Long-Term held, but the fund’s asset pool has reportedly shrunk to one-tenth the size it was in January.