What Are Hedge Fund Derivatives?
Thousands of hedge funds use derivatives as part of trading strategies. Hedge fund managers are among the most intelligent traders, and derivatives are among the most complex trading instruments. Derivatives are used to offset risk from a trade.
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Identification
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Derivatives are contracts between two parties betting on whether a security will rise or drop in price. The market is dominated by hedge funds and is estimated to be valued in the tens of trillions of dollars, according to the Washington Post.
Expert Insight
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The creation of risky financial derivatives led to the financial crisis that rocked the U.S. economy in 2008 and 2009, according to Richard Bookstaber, author of "A Demon of Our Own Design." He said derivatives made investments "more risky," and hedge funds were growing too fast, largely due to returns that were being generated because of trading derivatives.
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Features
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A derivative's value is not independent and is derived from an underlying security, index or financial instrument. Derivatives can be linked to such securities as options and futures contracts, in addition to credit default swaps, which are a way to bet on the credit-worthiness of a company.
Regulation
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For decades, derivatives traded as privately negotiated contracts, and hedge funds similarly flew under the radar screen of regulators by not having to register with the Securities and Exchange Commission. The U.S. Congress debated legislation for oversight in both markets in 2009.
Gold Derivatives
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Legendary investor John Paulson, who made billions in 2007 by betting on the decline in financial stocks, launched a hedge fund to trade gold-related derivatives in November 2009. Investors may trade gold derivatives to hedge against fluctuations in the U.S. dollar, according to HedgeCo.net.
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- Photo Credit Image by Flickr.com, courtesy of Alan Cleaver
