Financial derivatives and hedge funds have played an increasingly important and often interrelated role in American business history. Hedge funds in particular have exploded in size, number, and relevance since the beginning of the twenty-first century. The funds have been leaders in financial innovation and have helped reduce overall risks in the economy.
Financial derivatives have enabled the growth of businesses by allowing companies to make specific investments that reduce the risks to which they are exposed and by making available more information about the value of assets to be transmitted throughout the economy. A common type of derivative is an employee stock option, which gives employees the right to purchase stock in their own company at a predetermined price. Another type of derivative is a futures contract, which obligates one party to deliver an asset to another on a specified date. Two other types of derivatives are swaps and forwards. Derivatives may be traded on an organized exchange or bilaterally negotiated over-the-counter (OTC) between purchasers and sellers.
Derivatives facilitate production and investment activities by allowing companies and investors to reduce and manage risk exposure. Derivatives trading also benefits the economy by revealing information about the value of derivatives contracts’ underlying assets, thereby allowing market participants to make more informed decisions.
On March 13, 1851, the Chicago Board of Trade became the first American exchange on which a derivatives contract was traded. Until the 1970’s, futures were based mostly on agricultural commodities and livestock. Since the 1970’s, the derivatives markets have witnessed a rapid proliferation of new products, including derivatives of foreign currencies, common stocks, interest rates, and stock indices. The stock market crash of October 19, 1987, commonly called Black Monday, was widely blamed on derivatives serving as portfolio insurance.
By 1991, the notational amount of OTC derivatives became greater than exchange-traded derivatives. At the turn of the century, difficulties in valuing energy derivatives in part contributed to Enron becoming a symbol of deficiencies in American corporate governance. On March 16, 2008, the Federal Reserve arranged a fire sale of Bear Stearns, one of Wall Street’s oldest and most prominent securities firms, to J. P. Morgan Chase in part because of Bear Stearns’ involvement with a type of derivative known as a credit default swap.
Hedge funds are active traders of derivatives. Hedge funds compensate management in part with annual performance fees and typically engage in the active trading of financial instruments. By law, they may accept capital only from wealthy individuals and institutions. Although Alfred Winslow Jones is widely regarded has having established the first hedge fund in 1951 by purchasing stocks he believed were undervalued and short-selling those he thought were overvalued, Jones was preceded by at least two decades when, on December 17, 1930, Karl Karsten established a private fund in Connecticut employing an early form of a trading strategy known as statistical arbitrage.
The hedge fund industry received notoriety in 1998, when the Federal Reserve of New York coordinated a $3.5 billion private bailout of the hedge fund Long-Term Capital Management. In part because hedge funds preserved their investors’ wealth through the recession of 2000 to 2002, institutional investors increasingly sought them out as tools to preserve wealth in downmarkets, and they began to grow rapidly in size and number. Hedge funds approximately tripled in size from 2002 to 2007, when they managed an estimated $2 trillion in assets spread across about ten thousand funds. In September of 2006, the hedge fund Amaranth Advisors experienced $6.6 billion in losses stemming from its investments in natural gas derivatives, the largest losses ever for a U.S. hedge fund. Despite notable hedge fund losses, the hedge fund industry has primarily helped contribute to the stability and growth of the U.S. economy by ferreting out inefficiencies and taking risks other institutions are incapable of taking.
Hull, John C. Options, Futures, and Other Derivatives. 6th ed. Englewood Cliffs, N.J.: Prentice Hall, 2006. Lhabitant, Francois-Serge. Handbook of Hedge Funds. Hoboken, N.J.: Wiley Finance, 2006.
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