Hedging history: rice to swaps

Traditional investments have made room for alternative products, but hedge fund methodology can be traced back to 17th century rice farming in Japan. Historically, there has always been much discussion about hedge funds. Depending on the market cycle and investor experience, they have been presented at different times as both a menace to markets and as the perfect answer to all return requirements. The purpose of this article is to discuss some of the market implications of hedge funds and address some of the issues that have arisen over the last few years. A discussion on hedge funds would be incomplete without some understanding of hedging. The origins of hedging lie in the now seemingly esoteric world of agricultural commodities such as lean hogs, pork bellies and feed wheat. Yet hedging arose from a need to transact year-round seasonal products such as these. As early as the 17th century, Japanese rice merchants were selling future receipts against stored or expected rice crops. These receipts known as “rice tickets” guaranteed a future sale price and were the first form of futures trading. Like all good financial products, these became standardised and were eventually accepted as a form of currency. In the United States, futures trading started in the grain markets in the middle of the 19th century. However, the biggest increase in tradable hedges occurred in the 1970s when futures on financial instruments such as bonds and currencies started trading in Chicago. Expansion In the 1980s, futures began trading on stock market indices and in the 1990s hedges and derivatives on virtually every form of financial security emerged from credit default swaps to options on the weather. For the individual hedger, the result of this expansion in hedging instruments was not that different to that early Japanese rice farmer, namely the transfer of risk on a time or price basis. Hedgers in general own the commodity and look to sell it forward. To do this, the hedger needs the price of the future to be at a level that is preferably rich relative to his utility function – the cost of production, storage and level of risk he is willing to take. The hedger is thus looking to implement a form of “arbitrage” but in one direction only. In parallel, for the professional market participant, the explosion of hedging instruments changed markets for all time with the new ability to engineer virtually any outcome for a price. Enter hedge funds. Karl Marx is credited with saying “Give me the windmill and I will give you the Middle Ages.” Given large equity and bond markets combined with the valuation and portfolio methodologies of luminaries such as Harry Markowitz, Robert Merton, and William Sharpe, and you get traditional funds searching for absolute value against these metrics. Given the same asset markets, the multitude of hedging instruments and the absence of directional bias and hedge funds become a reality of the modern marketplace seeking relative value opportunities utilising many of the same metrics. It is precisely this lack of bias that makes hedge funds attractive in a variety of market conditions. Implications Hedge funds can in many ways be considered a natural complement to traditional funds. The impact of traditional managers is the transfer of capital to the best opportunities in world markets. The market implications of hedge funds can be similarly defined. Identifying arbitrage in general involves a sophisticated view on the relative valuation of securities. The execution of such a view improves the informational and valuation efficiencies of markets and provides liquidity when a systematic market bias or panic distorts valuation. Richard Bookstaber, in a 1999 treatise on risk management, summarised it neatly: “To avoid crises, markets must have liquidity suppliers who react quickly, who take contrarian positions when doing so seems imprudent, who search out unoccupied habitats and populate those to provide the diversity that is necessary, and who focus on risk taking and risk management”. It is in this function that hedge funds can be seen as adding stability to markets. It is also this continued expansion of markets to meet the multitude of hedging and capital needs that ultimately is a huge mitigant to the issue of capacity in hedge fund strategies. As markets continue to evolve and sophistication continues to increase, hedge fund strategies will evolve apace creating new arbitrage and capacity opportunities. Why then the cry of “hubris”, the accusations of being “the highway men of modern markets” or the spectacular market volatility sparked by the LTCM debacle? The danger here is generalising from the few to the many, as well as a shortsighted perspective of market volatility. For example, the ability of hedge funds to manipulate markets or trigger crises, measured as a function of assets, is minimal compared with the institutional market. It is more probable, for example, that institutional capital fleeing emerging markets was responsible for the currency crises of the late 1990s than were hedge funds. On the question of leverage, a recent IMF study found very few hedge funds to be leveraged more than twice time’s capital. The systemic risk raised by LTCM should be considered as much an issue of poor counterparty risk measures at banking institutions as that of hedge funds being unduly leveraged. The truth is that despite the unfortunate press hedge funds have received, most hedge funds “truths” have yet to be substantiated. From an industry perspective, witness George Soros’ comment that “speculators ought to keep quiet and speculate”. On the other hand, are hedge funds the paragons of modern markets? The answer is of course not. Hedge funds require the same measures of prudence and risk control that should have been required of traditional institutions of the ilk of Barings, Kidder Peabody and Orange County. There is no doubt that hedge funds will occasionally stray, which is precisely why the role of a fund of hedge funds in the expanded manager universe continues to increase in difficulty. An ex-employer and mentor, on being shown an arbitrage between a cheap bond and a related rich one, defined for me the “Texas Hedge”. Liking the sector, he bought both bonds. Clifford De Souza is senior investment officer at Citigroup’s fund of hedge funds unit