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Hedge funds, financial intermediation, and systemic risk

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Author Info

  • John Kambhu
  • Til Schuermann
  • Kevin J. Stiroh

Abstract

Hedge funds, with assets under management approaching an estimated $1.5 trillion in 2006, have become important players in the U.S. and global capital markets. These largely unregulated funds differ from other market participants in their use of a variety of complex trading strategies and instruments, in their liberal use of leverage, in their opacity to outsiders, and in their convex compensation structure. These differences can exacerbate potential market failures stemming from agency problems, externalities, and moral hazard. Counterparty credit risk management (CCRM) practices, used by financial institutions to assess credit risk and limit counterparty exposure, are the first line of defense against market disruptions with potential systemic consequences. This article examines how the unique nature of hedge funds may generate market failures that make counterparty credit risk for exposures to the funds intrinsically more difficult to manage, both for regulated institutions and for policymakers concerned with systemic risk. The authors acknowledge that various market failures, such as the events surrounding the 1998 collapse of hedge fund Long-Term Capital Management, may make CCRM imperfect. However, CCRM has improved significantly since then, and it remains the appropriate starting point for limiting the potential for hedge funds to generate systemic disruptions.

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Bibliographic Info

Article provided by Federal Reserve Bank of New York in its journal Economic Policy Review.

Volume (Year): (2007)
Issue (Month): Dec ()
Pages: 1-18

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Handle: RePEc:fip:fednep:y:2007:i:dec:p:1-18:n:v.13no.3

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Related research

Keywords: Hedge funds ; Capital market ; Risk management;

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References

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Citations

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Cited by:
  1. Ang, Andrew & Gorovyy, Sergiy & van Inwegen, Gregory B., 2011. "Hedge fund leverage," Journal of Financial Economics, Elsevier, vol. 102(1), pages 102-126, October.
  2. Michel Aglietta & Sandra Rigot, 2008. "The regulation of hedge funds under the prism of the financial crisis," EconomiX Working Papers 2008-20, University of Paris West - Nanterre la Défense, EconomiX.
  3. Patrick M McGuire & Kostas Tsatsaronis, 2008. "Estimating hedge fund leverage," BIS Working Papers 260, Bank for International Settlements.

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