Hedge Funds background information

From CUP resources:

What is it?

A hedge fund is an investment fund which uses high-risk investment techniques. Many other investment funds are regulated in order to protect investors from severe risks, but because hedge funds have only a small number of large investors, they are not subject to the usual restrictions. High-risk techniques such as short-selling (i.e. selling assets before you’ve actually bought them, in expectation of a lower price later) and leverage (i.e. using the money put into the fund by investors to borrow much larger sums of money) allow hedge funds to generate excellent profits during good times, but may have disastrous consequences during a crisis.

Ironically, the verb ‘to hedge’ means to reduce or manage risks by focusing on several alternative options, as in the idiom “to hedge one’s bets”. Many hedge funds do in fact hedge their risks by making several diverse investments, although such diversity may not be enough to protect them when the whole economy is struggling.

Why was the term in the news?

A prominent Wall Street hedge fund run was at the centre of a huge fraud scandal. Prosecutors allege that the fund made fraudulent losses of $50 billion, and was merely a Ponzi scheme, which pays earlier investors out of money invested by later clients. Many of the scheme’s alleged victims are themselves hedge funds.

More generally, hedge funds have been particularly badly hit by the current economic crisis, with many making huge losses which their investors never thought possible.

How can I use it in class?

Discussion:

Elicit from the class if any students have experience of hedge funds, and what they know about them. Discuss whether high-risk, high-profit investment is something to encourage or to fear.

Research and presentation:

If students are unfamiliar with the expression, they could research aspects of hedge funds (e.g. short selling, leverage, hedging one’s investments, regulation of investment funds, etc.) as a homework task (e.g. on Wikipedia and newspaper articles), followed by mini-presentations of their findings in class.

Class debate:

Divide the class into two teams. One should argue in favour of unregulated hedge funds; the other should argue that the disadvantages outweigh the advantages.

Role play:

Members of the class play the roles of members of a wealthy family planning how to invest their billions during the current financial crisis. Options include property (real estate), regulated investment funds, hedge funds, shares in banks or other companies, etc. If they decide to invest in a hedge fund, by what criteria should they choose the best fund?

Where can I read about it?

• Top investors 'hit by $50bn con', BBC, 13th December 2008. 
• Private equity must self-regulate or suffer from 'indiscriminate' rethink, EU commissioner warns, Guardian, 11th December 2008.
• Hedge funds 'facing credit storm', BBC, 28th October 2008.
• Hedge fund (excellent introduction to Hedge Funds), Wikipedia.

Mark to market

From CUP Resources: (n. mark to market; adj. mark-to-market; v. to mark sth to market) What is it? Mark-to-market accounting is a way of assigning a value to financial instruments, based on their current market value (i.e. their price if they were to be sold today rather than held as assets). Mark-to-market contrasts with cost-based accounting, where financial assets are carried at the price that was originally paid for them. As a simple example, imagine shares that were bought for £100 that are now worth £150. The two different accounting methods would carry them differently, and two companies holding exactly the same assets could have radically different values for them in their accounts. In theory, marking-to-market should provide a more accurate picture of a company’s assets, which is useful for investors. One problem is that the market value of financial instruments is not always easy to assess, which creates the possibility for some companies to manipulate the value of their assets, as famously happened in the Enron scandal (see article below). Another problem is that a company using mark to market can be pushed close to bankruptcy suddenly if the market price of its assets collapses – even if it has no intention of selling those assets in the short term – as has happened to many banks in the recent financial turmoil. Why is it in the news? The International Accounting Standards Board (IASB), which sets accounting rules for most of Europe and Asia, has drafted a new set of rules to sort out the current messy situation where different companies use different systems. Under the proposals, very simple financial assets such as loans (and similar instruments) are to be valued at cost. More complex securities, such as derivatives, equities and other financial instruments, are to be carried at market prices. These new rules should simplify the current situation, and allow much easier financial comparisons between companies in different countries. The draft is likely to be approved later this year. Discussion: Students discuss the pros and cons of the two accounting methods (mark to market and cost-based). Reading/speaking/writing: The original IASB draft proposals, linked below, should make interesting reading for accountants and others involved in finance. The purpose of the draft is to elicit feedback from interested parties around the world on various aspects of the draft before it is implemented. Although the document is 37 pages long, the draft proposal itself takes up only 6 pages – much of the rest of the document consists of discussion questions and explanations. Where can I read about it? Coming clean on bank rules, Times, July 15th 2009. Financial Instruments: Classification and Measurement, IASB Exposure Draft ED/2009/7 Mark-to-market accounting, Wikipedia. Mark-to-market accounting in the Enron scandal, Wikipedia.