Hedge funds and Private Equity - PES

gies, size and age. For instance, it is worth noting that the hedge funds with the largest amount of
assets under management also seem to operate with relatively high levels of leverage.
Contrary to the FSA and ECB, the German Bundesbank has warned against a growing use of
leverage 76 . The latter view is supported by several observers of the financial markets. In a cautionary
essay from April 2006 the renowned hedge fund manager Jonathan Bailey wrote that “hedge funds
have rarely been longer, more levered and less hedged than they are today.” 77 In a comment from
January 2007 Financial Times, editor Gillian Tett made a similar point. In addition, she suggested
that much of the rising leverage and leverage risk remains undisclosed because hedge funds obtain
leverage in ways that are difficult for outsiders to monitor and comprehend (see box 3).
Why is there such a significant difference in the assessments of the current levels of leverage and
leverage risk in the hedge fund industry? Indeed, it might be – as Gillian Tett suggests – that we
experience an unnoticed boom in leverage and risk without knowing it, because the boom is
occurring in an area where there is little available information. In addition, there are a number of
possible measures of, and methodological problems with the measurement of leverage. 78 To
understand this argument it seems helpful to take a closer look at the concept and sources of
leverage. Leverage (or gearing) can be defined as the use of given resources in such a way that
the potential positive outcome of the use is magnified. Thus, leverage allows greater potential
return to the investor than otherwise would have been available. However, the potential for loss
is also greater because loans and other sources of leverage need to be repaid.
The classic source of leverage is loans. Yet, there are also a number of other ways to obtain
leverage. According to the ECB hedge funds tend to prefer, a) arrangements where positions are
established by posting margins rather than the full value of a position, or b) derivatives. By
contrast, direct credit in the form of loans is rather uncommon, although credit lines for liquidity
purposes are widely used. 79 Generally, margin buying and derivatives offer the greatest possibility
to capitalise on leverage. Yet, margin buying and derivatives are also likely to be associated
with much greater risks. Moreover, the risks inherent in these activities may not be fully recognized.
A look at derivatives and the market for credit derivatives can serve to illustrate this point.
Derivatives allow leverage without borrowing explicitly. However the risk of borrowing is implicit
in the price of the derivative. Derivatives such as futures, options and swaps are financial instruments
derived from some other asset. Rather than trading or exchanging an asset itself, market
participants enter into an agreement to exchange or to have the possibility to exchange money,
assets or some other value at some future date. A simple example is a futures contract, i.e. an
agreement to exchange the underlying asset at a future date.
The markets for derivatives are generally growing at an extraordinary pace. This is not least the
case with the market for credit derivatives. Credit derivatives allow default risk to be transferred
without modifying the legal ownership of the underlying assets and without having to refinance
the loan. As a result, this market is booming and notional amounts outstanding rose from less
than $ 1,000 billion in 2001 to $ 26,000 billion at the end of June 2006. 80 Hedge funds are
increasingly active in the markets for credit derivatives. Fitch Ratings estimates their share of
derivatives trading at 25%. In addition, it is assumed that hedge funds trade mainly in the riskiest
segments of the market. 81
76 Deutsche Bundesbank (2006): Risiken im Finanzsystem. Herausforderungen für die Bankenaufsicht, in Festvortrag von Dr. h. c . Edgar
Meister (Mitglied des Vorstandes der Deutschen Bundesbank) anlässlich der ordentlichen Generalversammlung der Österreichischen
Bankwissenschaftlichen Gesellschaft in Wien am Montag, 16. Oktober 2006,
http://www.bundesbank.de/download/presse/reden/2006/20061016_meister.pdf (05.01.2007).
77 Bailey, J. (2006): Hedgehog, Wealth Management Survey (Spear Media), April Edition.
78 ECB (2005): ibid., p. 30f.
79 ECB (2005): ibid., p. 28f.
80 Banque de France, Financial Stability Review, No. 9, December 2006, p. 18.
81 Fitch Ratings (2006): Global Credit Derivatives Survey: Risk Dispersion Accelerates, http://www.fitchratings.com/corporate/search/results.cfm
(15.01.2007, subject to fee).
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