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Hedge funds
The term “hedge fund” refers to a fund that uses debt or so-called short positions in certain assets to raise funds to purchase others. A short position means that the fund receives securities to borrow from others and then sell them to raise money. They often use different policy and it can be a big difference for instance in how they invest in assets and how they raise money. Some trade mostly in equities, others in bonds or derivatives, currencies, precious metals or commodities. Many of them have diversified business with different properties in the markets. These funds are normally used to some extent to hedge; that is, they buy certain assets and take the same position in other assets that are expected to be unstable in the same way due to certain risk factors. Usually hedge funds are closed to the public and only certain investors have opportunities to buy into them. One explanation is the rich requirements for disclosures; they want to keep their cards close to their chests. Another explanation is that these funds often take a lot of risks and most people are not willing to do that. The third explanation is that the investment and operation of these funds are often very complicated and therefore only suitable for financial experts to take part. Hedge funds are often criticized considerably. Sometimes they are criticized for high fees and not delivering results that justify them but more often they are criticized for lack of transparency and the risk they take, which can cause problems for the financial system. Therefore some hedge funds have lost a fortune or even collapsed. It can cause their contracting parties great losses. The most famous example of a hedge fund that has gone into trouble is the U.S. fund; Long Term Capital Management, LTCM. In 1998.

LTCM case
LTCM was a hedge fund, founded in 1994. It was founded by Jon Meriwether, a Salomon Brothers trader. The principal shareholders were the economists Myron Scholes as well as Robert Merton. Both have been winners in the economic Nobel-prize in 1997. It had 126 billion US Dollar in assets. If you wanted to become an investor in the LTCM you had to pay $ 10 Million. The money had to be in the fond for a minimum of three years. While the investing time it was hardly possible to get any information about the businesses done by the fond. Due to the high investitions of the investors after the year 1995 no new investors have been adopted anymore. LTCM had spectacular annual returns of 42,8% in 1995 and 40,8% in 1996, even after the management had taken 27% off the top in fees before. Also in 1997 the return rate was quite high. It was 17,1%, also there was the Asian currency crisis. The financing was mainly due to borrowed capital. They speculated for example to a common interest rate that should appear caused by the monetary reform in the EU. That meant that the interest rate of fixed-interest securities had to be adopted. The speculation was based on the thinking that the rate of low-rated government bonds, e.g. Italy would rise after the monetary reform. Consequently they invested in this kind of bonds.

LTCM crisis
In the beginning of 1998 the fund held huge positions in the market, totaling roughly 5% of the total global fixed-income market. But in September 1998 Russia announced it was devaluing its currency and defaulting on its bonds. And that´s why LTCM’s highly leveraged investments crumbled. This financial crisis in Russia led to a flight to quality, the fund sustained massive losses and was in danger of defaulting on its loans. This made it difficult for the fund to cut its losses in its positions. As a global reaction on the financial market the U.S. stock market dropped 20%, while European markets fell 35%. Actually the company's risky trades brought it close to bankruptcy. LTCM had borrowed massive amounts of money to finance its leveraged trades. Had LTCM gone into default, it would have triggered a global financial crisis, caused by the massive write-offs its creditors would have had to make.

LTCM rescue and the FED
The LTCM rescue was carried out by the Federal Reserve of the United States. The alternative to the rescue would had been to liquidate LTCM, but the Federal Reserve was somehow afaid of the possible consequences of the wind up. The officials from the Federal Reserve believed that it could destabilize the financial market. One of the main reasons why the liquidation would have had a bad effect on the market was basically that the market was already in a fragile situation. Also, LTCM was involved in a lot of derivative contracts, and in case of liquidation, that would mean that the counterparties of LTCM would have had to end the contract and liquidate their assets. It is also important to consider that when LTCM started the business, most of its financing came from banks and securities firms, and these firms were also the main derivative counterparties mentioned before. Therefore, these lenders would have had big potential losses. More importantly, all of this situation would have had a direct effect on the financial market: prices would have collapsed.

Controversy of the rescue
The role of the FED in the LTCM created some controversy. Why would the Federal Reserve be interested in rescuing LTCM? The critic to the LTCM rescue is based on the fact that this kind of intervention can lead or encourage other companies to excessive risk taking. Therefore this would mean that more protection and intervention would be needed and this would obviously entail huge costs. Therefore, this would make the financial market more fragile in the long term. The critic also focuses on the paper that LTCM played on all the story. That is, how could LTCM reach that situation? How was it possible that it got so much money from banks and securities firms? Also, it seems clear that LTCM, whose main activity was primarily speculation, did not provide its investors with enough information. They did not know what LTCM was doing with their money. And this is not an isolated example. The lack of disclosure of information seems to be something very common in hedge funds. All of this suggests that a better regulation was needed at that time, and that a more effective regulation will avoid situations like in the future. The regulation should take control of the involved parties, such as the banks and securities firms, and it should also make sure that there is discipline in the market and the parties do not take unnecessary imprudent risks. Evidence also shows that the mathematical models used to predict future losses were not very effective, so that is also another factor to consider in order to avoid future problems.

List of references
Hedge Funds and the Collapse of Long-Term Capital Management. Franklin R. Edwards. Journal of Economic Perspectives—Volume 13, Number 2—spring 1999—Pages 189–210

http://www.applet-magic.com/ltcm.htm http://useconomy.about.com/od/themarkets/f/LTCM.htm http://www.investopedia.com/terms/l/longtermcapital.asp#axzz2Mfr9AV89