Executive summary - Udo Bullmann

A majority of hedge funds have limited choices for boosting returns - and extensiveleverage is one of those. Think LTCM!1.8. Asset valuation - in complexities and derivativesRecently studies by the World Bank and several national authorities have highlighted someproblems of market integrity, i.e. mis-evaluation of complex instruments. This is of specificimportance for investor protection, not least for pension funds.Even if some of the considerations are general and not specific to hedge funds, there is anincreasing risk of inadequate evaluations of illiquid and complex assets, careless evaluationand even miscalculations due to:• The growth of hedge funds and their importance to the market• The strong increase of complex instruments like derivatives.• The extreme rewards offered to hedge fund managers• Lack of clarity and/or independence of internal control and evaluation• Total lack of transparency and disclosure. All trading is outside public exchanges.All this is creating increased risk of miscalculations or even potential dishonesty ofevaluations of assets. These new instruments, derivatives - including credit default swaps(DSS) and collateralised debt obligations (CDOS) - are as complex as their names suggestand some of their most important innovations are causing new challenges for regulators aswell as the market.Credit derivatives allow investors to buy or sell cover against default by borrowers. Theyare being pooled into collateralised debt obligations (CDOS) - this form of investment inparticular is growing extremely fast. It is easy to see that these profits encourage liquidity andmake it possible for banks to sell on the risk of loans turning bad - thereby enabling them toincrease their lending capacity.A derivative which has become very much used among hedge funds recently is the socalledvariant swap. By using these instruments, hedge funds can place bets on the directionof stock markets’ volatility in a leveraged way.Recently (September 2006), the international swaps and directives association has made anestimate of the nominal amount of outstanding credit derivatives - rising in the first half of2006 by more than 52 percent, indicating a rise in derivatives totaling 26 trillion US dollars.The increasing use of complex instruments - typically derivatives, such as the onesdescribed above - there seems to be a double problem:• One dimension of a lack of competence. New “instruments” are developed so rapidlythat there is an increasing risk of lack of competence. Who can validate the models? i.e. itmust, of course, be an evaluation independent of financial engineering, using as well ascreating the new instrument.• Furthermore - where are the objective data for volatility in these complex derivatives?22