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Introduction
A hedge fund is basically a fancy name for an investment partnership. It's the marriage of a fund manager,
which can often be known as the general partner, and the investors in the hedge fund, sometimes known as
the limited partners. The limited partners contribute the money and the general partner manages it according
to the fund's strategy. A hedge fund's purpose is to maximize investor returns and eliminate risk, hence the
word "hedge." If these objectives sound a lot like the objectives of mutual funds, they are, but that is
basically where the similarities end.

The name "hedge fund" came into being because the aim of these vehicles was to make money regardless of
whether the market climbed higher or declined. This was made possible because the managers could "hedge"
themselves by going long or short stocks (shorting is a way to make money when a stock drops).

Key Characteristics

1. Only open to "accredited" or qualified investors: Investors in hedge funds have to meet certain net
worth requirements to invest in them - net worth exceeding $1 million excluding their primary residence.
2. Wider investment latitude: A hedge fund's investment universe is only limited by its mandate. A hedge
fund can basically invest in anything - land, real estate, stocks, derivatives, currencies. Mutual funds, by
contrast, have to basically stick to stocks or bonds.
3. Often employ leverage: Hedge funds will often use borrowed money to amplify their returns. As we saw
during the financial crisis of 2008, leverage can also wipe out hedge funds.
4. Fee structure: Instead of charging an expense ratio only, hedge funds charge both an expense ratio and a
performance fee. The common fee structure is known as "Two and Twenty" - a 2% asset management fee
and then a 20% cut of any gains generated.

There are more specific characteristics that define a hedge fund, but basically because they are private
investment vehicles that only allow wealthy individuals to invest, hedge funds can pretty much do what they
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want as long as they disclose the strategy upfront to investors. This wide latitude may sound very risky, and
at times it can be. Some of the most spectacular financial blow-ups have involved hedge funds. That said,
this flexibility afforded to hedge funds has led to some of the most talented money managers producing
some amazing long-term returns.

BREAKING DOWN 'Hedge Fund'


Each hedge fund strategy is constructed to take advantage of certain identifiable market opportunities. Hedge
funds use different investment strategies and thus are often classified according to investment style. There is
substantial diversity in risk attributes and investment opportunities among styles, which reflects the
flexibility of the hedge fund format. In general, this diversity benefits investors by increasing the range of
choices among investment attributes.

Legally, hedge funds are most often set up as private investment limited partnerships that are open to a
limited number of accredited investors and require a large initial minimum investment. Investments in hedge
funds are illiquid as they often require investors keep their money in the fund for at least one year, a time
known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or biannually.

The first hedge fund was established in the late 1940s as a longshort hedged equity vehicle. More recently,
institutional investors corporate and public pension funds, endowments and trusts, and bank trust
departments have included hedge funds as one segment of a well-diversified portfolio.

It is important to note that "hedging" is actually the practice of attempting to reduce risk, but the goal of
most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge
funds tried to hedge against the downside risk of a bear market by shorting the market. (Mutual funds
generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens
of different strategies, so it isn't accurate to say that hedge funds just "hedge risk." In fact, because hedge
fund managers make speculative investments, these funds can carry more risk than the overall market.
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A Hedge Fund at Work - A Fictional Example

To better understand hedge funds and why they have become so popular with both investors and money
managers, let's set one up and watch it work for one year. I will call my hedge fund "Value Opportunities
Fund, LLC." My operating agreement - the legal document that says how my fund works - states that I will
receive 25% of any profits over 5% per year, and that I can invest in anything anywhere in the world.

Ten investors sign up, each putting in $10 million, so my fund starts with $100 million. Each investor fills
out his investment agreement - similar to an account application form - and sends his check directly to my
broker or to a fund administrator, who will record his or her investment on the books and then wire the funds
to the broker. A fund administrator is an accounting firm that provides all the administration work for an
investment fund. Value Opportunities Fund is now open, and I begin managing the money. Once I find
attractive opportunities, I call my broker and tell him what to buy with the $100 million.
A year goes by and my fund is up 40%, so it is now worth $140 million. Now, according to the fund's
operating agreement, the first 5% belongs to the investors with anything above that being split 25% to me
and 75% to my investors. So the capital gain of $40 million would first be reduced by $2 million, or 5% of
$40 million, and that goes to the investors. That 5% is known as a hurdle rate, because you have to first
achieve that 5% hurdle rate return before earning any performance compensation. The remaining $38
million is split 25% to me and 75% to my investors.

Based on my first-year performance and the terms of my fund, I have earned $9.5 million in compensation in
a single year. The investors get the remaining $28.5 million along with the $2 million hurdle rate cut for a
capital gain of $30.5 million. As you can see, the hedge fund business can be very lucrative. If I were
managing $1 billion instead, my take would have been $95 million and my investors, $305 million. Of
course, many hedge fund managers get vilified for earning such exuberant sums of money. But that's
because those doing the finger pointing - often the newspapers - fail to mention that my investors made $305
million.

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Hedge Fund Strategies


Many hedge fund styles exist; the following classification of hedge fund styles is a general overview.

Equity market neutral: These funds attempt to identify overvalued and undervalued equity securities
while neutralizing the portfolios exposure to market risk by combining long and short positions. Portfolios
are typically structured to be market, industry, sector, and dollar neutral, with a portfolio beta around zero.
This is accomplished by holding long and short equity positions with roughly equal exposure to the related
market or sector factors. Because many investors face constraints relative to shorting stocks, situations of
overvaluation may be slower to correct than those of undervaluation. Because this style seeks an absolute
return, the benchmark is typically the risk-free rate. (For more, see: Getting Positive Results With MarketNeutral Funds.)

Convertible arbitrage: These strategies attempt to exploit mis-pricings in corporate convertible


securities, such as convertible bonds, warrants, and convertible preferred stock. Managers in this category
buy or sell these securities and then hedge part or all of the associated risks. The simplest example is buying
convertible bonds and hedging the equity component of the bonds risk by shorting the associated stock. In
addition to collecting the coupon on the underlying convertible bond, convertible arbitrage strategies can
make money if the expected volatility of the underlying asset increases due the embedded option, or if the
price of the underlying asset increases rapidly. Depending on the hedge strategy, the strategy will also make
money if the credit quality of the issuer improves. (See also: Convertible Bonds: An Introduction.)

Fixed-income arbitrage: These funds attempt to identify overvalued and undervalued fixed-income
securities (bonds) primarily on the basis of expectations of changes in the term structure or the credit quality
of various related issues or market sectors. Fixed-income portfolios are generally neutralized against
directional market movements because the portfolios combine long and short positions, therefore the
portfolio duration is close to zero.

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Distressed securities: Portfolios of distressed securities are invested in both the debt and equity of
companies that are in or near bankruptcy. Most investors are not prepared for the legal difficulties and
negotiations with creditors and other claimants that are common with distressed companies. Traditional
investors prefer to transfer those risks to others when a company is in danger of default. Furthermore, many
investors are prevented from holding securities that are in default or at risk of default. Because of the relative
illiquidity of distressed debt and equity, short sales are difficult, so most funds are long. (For more, see:
Activist Hedge Funds: Follow The Trail To Profit and Why Hedge Funds Love Distressed Debt.)

Merger arbitrage: Merger arbitrage, also called deal arbitrage, seeks to capture the price spread
between current market prices of corporate securities and their value upon successful completion of a
takeover, merger, spin-off, or similar transaction involving more than one company. In merger arbitrage, the
opportunity typically involves buying the stock of a target company after a merger announcement and
shorting an appropriate amount of the acquiring companys stock. (See also: Trade Takeover Stocks With
Merger Arbitrage.)

Hedged equity: Hedged equity strategies attempt to identify overvalued and undervalued equity
securities. Portfolios are typically not structured to be market, industry, sector, and dollar neutral, and they
may be highly concentrated. For example, the value of short positions may be only a fraction of the value of
long positions and the portfolio may have a net long exposure to the equity market. Hedged equity is the
largest of the various hedge fund strategies in terms of assets under management. It is also know as the
long/short equity strategy.

Global macro: Global macro strategies primarily attempt to take advantage of systematic moves in major
financial and non-financial markets through trading in currencies, futures, and option contracts, although
they may also take major positions in traditional equity and bond markets. For the most part, they differ from
traditional hedge fund strategies in that they concentrate on major market trends rather than on individual
security opportunities. Many global macro managers use derivatives, such as futures and options, in their
strategies. Managed futures are sometimes classified under global macro as a result.

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Emerging markets: These funds focus on the emerging and less mature markets. Because short selling is
not permitted in most emerging markets and because futures and options may not available, these funds tend
to be long.

Fund of funds: A fund of funds (FOF) is a fund that invests in a number of underlying hedge funds. A
typical FOF invests in 1030 hedge funds, and some FOFs are even more diversified. Although FOF
investors can achieve diversification among hedge fund managers and strategies, they have to pay two layers
of fees: one to the hedge fund manager, and the other to the manager of the FOF. FOF are typically more
accessible to individual investors and are more liquid. (For more, see: Fund of Funds: High Society for the
Little Guy.)

Hedge Funds Today

By most estimates, thousands of hedge funds are operating today, collectively managing over $1 trillion.
Hedge funds can pursue a varying degree of strategies including macro, equity, relative value, distressed
securities and activism. A macro hedge fund invests in stocks, bonds and currencies in hopes of profiting
from changes in macroeconomic variables such as global interest rates and countries economic policies. An
equity hedge fund may be global or country specific, investing in attractive stocks while hedging against
downturns in equity markets by shorting overvalued stocks or stock indices. A relative-value hedge fund
takes advantage of price or spread inefficiencies. Other hedge fund strategies include aggressive growth,
income, emerging markets, value and short selling.
Another popular strategy is the "fund of funds" approach in which a hedge fund mixes and matches other
hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes
aims to provide a more stable long-term investment return than any of the individual funds. Returns, risk and
volatility can be controlled by the mix of underlying strategies and funds.

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New Regulations for Hedge Funds

One aspect that has set the hedge fund industry apart for so long is the fact that hedge funds face little
money-management regulation. Compared to mutual funds, pension funds and other investment vehicles,
hedge funds are the least regulated. That's because hedge funds are only allowed to take money from
"qualified" investors - individuals with an annual income that exceeds $200,000 for the past two years or a
net worth exceeding $1 million excluding their primary residence. As such, the Securities and Exchange
Commission deems qualified investors suitable enough to handle the potential risks that come from a wider
investment mandate.

But make no mistake, hedge funds are regulated, and recently they are coming under the microscope more
and more. Hedge funds are so big and powerful that the SEC is starting to pay closer attention. And breaches
such as insider trading seem to be occurring much more frequently, an activity regulators come down hard
on.

In September 2013, the hedge fund industry experienced one of the most significant regulatory changes to
come along in years. In March 2012, the Jumpstart Our Business Startups Act (JOBS Act) was signed into
law. The basic premise of the JOBS Act was to encourage funding of small businesses in the U.S by easing
securities regulation. The JOBS Act also had a major impact on hedge funds: In September 2013, the ban on
hedge fund advertising was lifted. In a 4-to-1 vote, the SEC approved a motion to allow hedge funds and
other firms that create private offerings to advertise to whomever they want, but they can only accept
investments from accredited investors. While hedge funds may not look like small businesses, because of
their wide investment latitude they are often key suppliers of capital to startups and small businesses. Giving
hedge funds the opportunity to solicit capital would in effect help the growth of small businesses by
increasing the pool of available investment capital.

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Hedge fund advertising deals with offering the fund's investment products to accredited investors or
financial intermediaries through print, television and the internet. A hedge fund that wants to solicit
(advertise to) investors must file a Form D with the SEC at least 15 days before it starts advertising.
Because hedge fund advertising was strictly prohibited prior to lifting this ban, the SEC is very interested in
how advertising is being used by private issuers, so it has made changes to Form D filings. Funds that make
public solicitations will also need to file an amended Form D within 30 days of the offerings termination.
Failure to follow these rules will likely result in a ban from creating additional securities for a year or more.

Not For Everyone


It should be obvious that hedge funds offer some worthwhile benefits over traditional investment funds.
Some notable benefits of hedge funds include:
1. Investment strategies that have the ability to generate positive returns in both rising and falling equity and
bond markets.
2. Hedge funds in a balanced portfolio can reduce overall portfolio risk and volatility and increase returns.
3. A huge variety of hedge fund investment styles many uncorrelated with each other provide investors
the ability to precisely customize investment strategy.
4. Access to some of the world's most talented investment managers. Of course, hedge funds are not without
risk as well:
1. Concentrated investment strategy exposes hedge funds to potentially huge losses.
2. Hedge funds typically require investors to lock up money for a period of years.
3. Use of leverage, or borrowed money, can turn what would have been a minor loss into a significant loss.

Size of the Hedge Fund Market:

Since hedge funds do not register with SEC their actual data cannot be independently followed; therefore
hedge fund data is self-reported. Despite the ambivalent image, hedge funds have attracted significant capital
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over the last decade, triggered by successful track records. The global hedge funds volume has increased
from US $ 50 billion in 1988 to US $ 750 billion in 2003 yielding an astonishing cumulative average growth
rate (CAGR) of 24 %. The global hedge fund volume accounts for about 1% of the combined global equity
and bond market. The number of hedge funds increased from 1500 to about 8000 between 1998 and 2003.
Estimates of new assets flowing into hedge funds exceed US $25 billion on average for the last few years. In
the next five to ten years, hedge fund assets have been predicted to exceed US $ 1 trillion.
In Europe the overall hedge fund volume is still small with about US $ 80 billion in 2003 which accounts for
about 11% of the global hedge fund volume. The number of hedge funds in Europe is about 600. Within
Europe, hedge funds become particularly popular in France and Switzerland where already 35% and 30% of
all institutional investors have allocated funds into hedge funds. In 2003, Italys hedge fund industry nearly
tripled in size as assets grew from Euro 2.2 billion to Euro 6.2 billion. Germany is at the lower end with only
7% of the institutional investors using hedge funds. But the Investment Modernization Act may well trigger
rising interest from German investors. Overall, hedge fund assets are estimated to increase tenfold in Europe
over the next 10 years. The acceptance of hedge funds seems to be growing throughout Europe, as investors
have sought alternatives that are perceived as less risky during the last three years equity bear market.

This trend is also evident in Asia, where hedge funds are starting to take off. According to Asia Hedge
magazine, some 150 hedge funds operate in Asia, till year 2002 which together managed assets estimated at
around US $ 15 billion. In Japan, too hedge funds are becoming the focus of more attention. Recently,
Japans Government Pension Fund one of the worlds largest pension fund with US $ 300 billion has
announced plans to start allocating money to hedge funds. Industry participants believe that Asia could be
the next region of growth for the hedge fund industry. The potential of Asian hedge funds is well supported
by fundamentals. From an investment perspective, the volatility in the Asian markets in recent years has
allowed long-short and other strategic players to outperform regional indices. The relative inefficiency of the
regional markets also presents arbitrage opportunities from a demand stand point US and European investors
are expected to turn to alternatives in Asia as capacity in their home markets diminish. Further, the
improving economic climate in South East Asia should help foreign fund managers and investors to refocus
their attention on the region. Overall, hedge funds look set to play a larger role in Asia.

Reasons for Rapid Growth of Hedge Fund Industry

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While high net worth individuals remain the main source of capital, hedge funds are becoming more popular
among institutional and retail investors. Funds of funds (hedge funds) and other hedge fund-Linked products
are increasingly being marketed to the retail investors in some jurisdictions. There are a number of factors
behind the rising demand for hedge funds. The unprecedented bull run in the US equity markets during the
1990s swelled investment portfolios this lead both fund managers and investors to become more keenly
aware of the need for diversification. Hedge funds are seen as a natural hedge for controlling downside
risk because they employ exotic investments strategies believed to generate returns that are uncorrelated to
asset classes.
Until recently, the bursting of the technology and telecommunications bubbles, the wave of scandals that hit
corporate America and the uncertainties in the US economy have lead to a general decline in the stock
markets worldwide. This in turn provided fresh impetus for hedge funds as investors searched for absolute
returns.

The growing demand for hedge fund products has brought changes on the supply side of the market. The
prospect of untold riches has spurred on many former fund managers and proprietary trades to strike out on
their own and set up new hedge funds. With hedge funds entering the main stream and becoming
respectable, an increasing number of banks, insurance companies, pension funds, are investing in them.

Market Benefits of Hedge Funds

Hedge funds can provide benefits to financial markets by contributing to market efficiency and enhance
liquidity. Many hedge fund advisors take speculative trading positions on behalf of their managed hedge
funds based extensive research about the true value or future value of a security. They may also use short
term trading strategies to exploit perceived mis-pricings of securities. Because securities markets are
dynamic, the result of such trading is that market prices of securities will move toward their true value.
Trading on behalf of hedge funds can thus bring price information to the securities markets, which can
translate into market price efficiency. Hedge funds also provide liquidity to the capital markets by
participating in the market.

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Hedge funds play an important role in a financial system where various risks are distributed across a variety
of innovative financial instruments. They often assume risks by serving as ready counter parties to entities
that wish to hedge risks. For example, hedge funds are buyers and sellers of certain derivatives, such as
securitised financial instruments, that provide a mechanism for banks and other creditors to un -bundle the
risks involved in real economic activity. By actively participating in the secondary market for these
instruments, hedge funds can help such entities to reduce or manage their own risks because a portion of the
financial risks are shifted to investors in the form of these tradable financial instruments. By reallocating
financial risks, this market activity provides the added benefit of lowering the financing costs shouldered by
other sectors of the economy. The absence of hedge funds from these markets could lead to fewer risk
management choices and a higher cost of capital.

Hedge fund can also serve as an important risk management tool for investors by providing valuable
portfolio diversification. Hedge fund strategies are typically designed to protect investment principal. Hedge
funds frequently use investment instruments (e.g. derivatives) and techniques (e.g. short selling) to hedge
against market risk and construct a conservative investment portfolio one designed to preserve wealth.

In addition, hedge funds investment performance can exhibit low correlation to that of traditional
investments in the equity and fixed income markets. Institutional investors have used hedge funds to
diversify their investments based on this historic low correlation with overall market activity.

From time to time, allegations are made by market participants about collusion among hedge funds to
manipulate markets. Like all other market participants, hedge funds are covered by both criminal and civil
regimes that outlaw various forms of market manipulation and abuse.

FINANCIAL CRISIS AND HEDGE FUNDS


In spite of difference of views, the role played by some of the large hedge funds has often been associated
with major financial crisis that took place in the 90s.

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East Asian Crisis

The impact of the East Asian crisis which materialized in the middle of 1997, and the subsequent turbulence
that swept the worlds financial markets over the next 12 -18 months, has been significant not only in terms
of the financial, economic and social consequences that these events wrought on emerging market
economies, but also in terms of drawing the worlds attention to outstanding issues concerning the structure,
operation and regulation of the international financial system.
Causes of the crisis remain among the most contentious issues and continue to be debated at the academic as
well as policy level. The Emerging Markets Committee of IOSCO identified multiple causes of the East
Asian crisis. The Committee also made a reference to the role played by some hedge funds: complex
trading strategies involving futures were thought by some authorities to have exerted a destabilizing
influence on market performance in their jurisdictions. Currency speculators pursued a so - called double
play aimed at playing off the Hong Kong currency board system against the administrations stock and
futures markets. However, subsequent research could not produce robust evidence implicating the hedge
funds for precipitating the crisis. Researchers have, however, attributed the negative public perception of the
role of hedge fund managers in crisis partly to the limited information available about what they actually do.

Long Term Capital Management (LTCM)

Another major financial crisis involving a large hedge fund was that of the huge loss (US $ 4 billion)
suffered by LTCM in 1998. LTCM built its positions on sophisticated arbitrage trading strategies. In
addition, it used a significant degree of leverage to increase its expected return. In August, and September of
1998, as the global financial crisis worsened, it became clear to LTCM that many of the assumptions
inherent in the arbitrage positions it held were incorrect. Due to LTCMs leverage (which at one point has
exceeded 50 to 1), those incorrect assumptions resulted in substantial losses for the firm and eroded its
capital base. Liquidation of LTCMs positions could have potentially disrupted the financial markets,
resulting in losses for other participants in those markets. Finally, a consortium of banks worked out a rescue
plan facilitated by the Federal Reserve Bank of New York, acknowledged that LTCMs potential impact on
the worlds financial markets raises legitimate questions about the activities of hedge funds in general, as
well as the proper role that regulators should play with respect to those activities. However, he also asserted
that it was too soon to tell whether LTCMs investment strategies represent the norm in the hedge funds
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industry or, whether LTCM was an overly aggressive player among otherwise responsible market
participants.

In response to the near collapse of Long -Term Capital Management, LP (LTCM), the Technical Committee
of the IOSCO formed a special Task Force on Hedge Funds and Other Highly Leveraged Institutions to
address regulatory issues relating to the activities of highly leveraged institutions (HLIs) or hedge funds. The
Committee in its report underlined that HLIs, like other institutional investors, can provide benefits to global
financial markets. It also highlighted the combination of characteristics typically associated with HLIs such
as significant leverage, and the legal and other uncertainties arising out of the extensive operations in
offshore centers posing particular challenges which need to be managed carefully in order to avoid risks to
the financial system. The committee, as a defense against systemic risk in the market , recommended strong
and prudent risk management processes at the regulated firms with which the HLIs trade. The Committee
also highlighted the importance of transparent disclosure by the regulated entities dealing with HLIs and
HLIs themselves on a voluntary basis, as a means to maintain market integrity.
In spite of occasional negative perception about the role of hedge funds, such perceived misdemeanours by
certain hedge funds have been considered more as occasional aberrations than general industry wide
behaviour. This is also corroborated by the fact that many jurisdictions are gradually opening up their
markets for hedge funds to establish and market their products
Further, for the purpose of this paper it must be emphasized here that allowing access to offshore hedge
funds to invest in India through FII route will not provide any opportunity to them to build up leveraged
position onshore as borrowing by FIIs are not allowed under the terms of RBIs general permission.

COUNTRY EXPERIENCES
MALAYSIA

An example of the problematic effects of hedge funds was provided by the experience of Malaysia during
the East Asian crisis (for a good summary of the debate on hedge funds role, see de Brower, 2001; for a
more detailed analysis see Rodrik and Kaplan 2001). The Malaysian experience also provides a good
example of how capital controls can - in certain circumstances - be effective in curbing speculative attacks
and their negative effects.
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Malaysia entered the Asian financial crisis with relatively strong fundamentals, and a much smaller share of
short-term external debt in the total than neighbouring countries; short-term debt was also well below its
foreign exchange reserves, which made it less prone to a run by foreign creditors.
Nevertheless as a country with a very high level of indebtedness overall, it was quite vulnerable to
turnarounds in general market sentiment that would be reflected in an increase in interest rates or reduction
in credit availability. This was particularly serious in the context of intense contagion as the East Asian crisis
spread.

In addition, Malaysia had the world's highest stock market capitalization ratio (310 percent of GDP). The
rise in equity prices had in turn contributed to a domestic lending boom, leaving Malaysia in mid-1997 with
a domestic debt-GDP ratio (170 percent) that was among the highest in the world (Perkins and Woo
2000,237).

Since June 1997 Malaysia experienced significant amounts of outflows. These outflows comprised mainly
portfolio investments by non-residents in the Malaysian stock market. Consequently, stock prices declined
by 65%, reducing the market capitalisation to a quarter of its prevailing levels prior to the crisis.
Initially Malaysia also voluntarily took on IMF-type policies. But this did not work, as the high interest
rates added to the corporate and banking crisis; the flexible exchange policy enabled the ringgit to
depreciate; the freedom of capital mobility allowed funds to flow out; and the cutbacks in government
expenditure added to recessionary pressures.

At the end of June, 1998, alternative policies were formulated. They attempted to reflate the economy
through cuts in interest rates and credit expansion, but the attempt to reduce domestic interest rates was
undercut by growing speculation against the ringgit in offshore markets.

Those offshore centres provided easy access to ringgit funds for speculative activities. At its peak, offshore
ringgit deposits were attracting interest rates in excess of 30%. Such high interest rates demonstrated just
how profitable ringgit speculation had become. It also revealed the constraints imposed by external
developments on the conduct of monetary policy. Offshore institutions (mainly in Singapore) borrowed
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ringgit at premium rates to purchase dollars and bet in favour of the ringgit's collapse. The economy's
decline continued.

The controls that were established by Malaysias economic authorities in September were aimed at finishing
this speculation. They were the following:

To shut down offshore trading, the government mandated that all sales of ringgit assets had to go

through authorized domestic intermediaries, effectively making offshore trading illegal.

All ringgit assets held abroad had to be repatriated. Worried that these measures would lead to an

outflow of capital and further depreciation of the currency, the Malaysian government also banned for a
period of one year all repatriation of investment held by foreigners.

Simultaneously, in an attempt to revive aggregate demand, Malaysia lowered the 3-month Bank

Negara Intervention Rate from 9.5% to 8%. On February 15th 1999, the Central Bank of Malaysia changed
the regulations on capital restrictions, shifting from an outright ban to a graduated levy and replacing the
levy on capital with a profits levy on future inflows.

In order to not affect FDI or current account transactions, repatriation of profits and dividends from

(documented) FDI activities were freely allowed. Foreign currency transactions for current-account purposes
(including the provision of up to 6 months of trade credit for foreigners buying Malaysian goods) were also
not restricted.

The ringgit was fixed to 3.8 to the US$.

Regarding the advantages of this policy Rodrik and Kaplan, op cit rightly argue that the results of Malaysian
controls have to be evaluated from two different perspectives - financial and economic; from the financial
viewpoint, a significant question was whether the financial segmentation was put to good use? On this
aspect, it is important to highlight that the government had no difficulty in sharply lowering domestic
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interest rates, and making the fixed exchange rate stick without the appearance of a black-market premium
for foreign currency. As an IMF paper states, "there [were] only a few reports of efforts to evade controls,
and no indications of circumvention through under invoicing or over invoicing of imports (Kochhar 1999,
p. 8). Another IMF staff report concludes that the controls were effective in eliminating the offshore ringgit
market and choking off speculative activity, including that by hedge funds against the ringgit despite the
easing of monetary and fiscal policies (Ariyoshi et al. 1999). More systematic, comparative evidence is
presented by Kaminsky and Schmukler (2000) and Edison and Reinhart (1999). These papers finds that the
September 1998 controls were successful in lowering interest rates, stabilizing the exchange rate, and
reducing the co-movement of Malaysian overnight interest rates with regional interest rates.

Furthermore, as Stiglitz (1999) argues, the Malaysian experience showed that one can intervene in shortterm flows, and still provide a hospitable environment for foreign direct investment.

Indeed, there is now consensus that though fairly drastic, the Malaysian capital controls did not deter future
FDI, and that they contributed to curb potentially very disruptive speculation by actors, such as hedge funds.
From a broader economic aspect, they were one of several factors that contributed to fairly rapid recovery of
the Malaysian economy.

HONG KONG

In the summer of 2008, East Asia was in the midst of a major crisis and Hong Kong had a recession. There
were concerns among investors about the Hong Kong stock market, which had been falling rapidly, and
doubts about the survival of the Hong Kong currency peg, in spite of the commitment by the authorities to
maintain the currency board (see Goodhart and Dai, 2003, for an excellent discussion of the background,
speculative attack and intervention).

Several factors made Hong Kongs currency vulnerable to speculative attack. These included: the
commitment to a fixed exchange rate, the initial small size of the monetary base, the unrestricted ease of
short-selling, in stock spot and index futures markets, and the laxity in the enforcement of settlement. To this

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was added the ease with which speculators could borrow Hong Kong dollars, either in the interbank market
or via swaps with multilateral institutions that had issued a large volume of Hong Kong dollar debt.

Indeed, the hedge funds reportedly launched their attack on Hong Kong after careful planning. The hedge
funds had pre-funded themselves by borrowing and sitting on large amounts of Hong Kong dollars. From the
beginning of 1997 to the middle of August 1998, over HK$30 billion of one and two-year money was raised
through the issue of debt paper in Hong Kong. According to Yam (1999) this pre-funding by hedge funds
insulated them from the sharp increase in the HK dollar interest rates when the short-selling of HK dollars
began.

In this context, a few large hedge funds (HFs) moved to attack both the currency and the stock market. In the
view of the Hong Kong authorities, the double play proceeded as follows. First, HFs shorted the Hong
Kong (spot) stock market as well as the Hang Seng Index futures. Next, by using forward purchases of US
dollars and spot sales of Hong Kong dollars, they tried to induce a devaluation. Apparently, the size of the
short positions of these HFs in the forex and stock markets were very large. Indeed, the Hong Kong
government estimated that speculators sold short Hong Kong stocks for US$6 billion in the first two weeks
of August (NBER).
On 14th August 1998, the HKMA entered the equity market, drawing on official reserves to purchase stocks
with the aim of ensuring that the speculators (who were mainly hedge funds) did not profit from their short
positions. Prior to the intervention the stock market had fallen by 40% from 1st May 1998 to 13th August
1998. As a result of the intervention the stock market was successfully pushed up. The government stock
purchases lasted ten working days. As disclosed by the government the HKMA spent HK $118 billion
overall in the process of acquiring shares, representing about 7.3% of such stocks.

Indeed the Double Market Play of hedge funds implied the following: (Goodhart and Li, op cit). The
speculators simultaneously sold short Hong Kong dollars, both spot and forward, on the foreign exchange
market and shorted Hong Kong stocks on both the spot and futures markets. Such massive selling of Hong
Kong dollars squeezed the liquidity of the Hong Kong banking system, leading to a sharp increase in interest
rates. The stock and futures markets were then under great pressure to fall. Moreover, if under such pressures
the HKMA were to give up the Hong Kong dollar peg, the speculators could reap enormous profits from the
foreign exchange and, potentially, also the securities markets. The Hong Kong residents, on the other hand,

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would have to suffer the collapse of their asset markets, and with banks facing serious difficulties, there was
a risk of a banking crisis, like what had happened in other Asian countries.

As a result of this massive intervention by the authorities in the stock markets, the HK peg was maintained.
Furthermore, the risk premium on the HK$ fell from a high of 1250 basis points in August to 45 basis points
in December 1998, comparable to the pre-crisis level. The speculators were defeated. Furthermore, the
HKMA actually made a large profit from its intervention when they sold the shares later at higher prices.

The Hong Kong experience is unique for several reasons. Firstly, though risky at the time, it provides a fairly
rare example of a very successful government intervention against large speculation by hedge funds.
Secondly, it was carried out by a government deeply committed to free markets. Thirdly, the intervention
was done through the stock market, which is also quite rate.
From the perspective of this study, it is important to stress the following points. One of the crucial preconditions of the successful intervention in Hong Kong was the availability of large foreign exchange
reserves; a second pre-condition was quite detailed knowledge by the economic authorities of what the
hedge funds were doing. This emphasizes the importance of transparency of information, and its availability
to authorities.

Finally, as Goodhart and Li stress the intervention was worthwhile, as the HK economy with intervention
was in a far better condition than it would have been without the intervention. Nevertheless, it seems better
to try to prevent such speculative attacks as the risks and potential costs of intervention can be very large.
(See below discussion of Brazilian experience)

The HK Government later created a vehicle to divest the acquired shares, the Tracker Fund of Hong Kong,
which was listed in 1999. As mentioned, the Government sold the shares at a large profit.

It is interesting to stress that in addition the government brought in a 30-Point package tightening the
regulation of the securities and futures markets, including of course aspects relating to hedge funds. They
introduced measures covering short selling, system improvement, risk management, and intermarket
surveillance.
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The Government introduced a major three-pronged market reform in March 1999.The three prongs were
the modernisation of the securities legislation, demutualisation and listing of the stock and futures
exchanges, and the enhancement of financial infrastructure

Some of the measures in the package include the strict enforcement of the settlement process, imposing a
super margin on brokers with highly concentrated positions, introducing the client identity rule, increasing
the penalty for naked short selling, creating a new offence for unreported short sales, and introducing new
requirements for stock lenders to keep proper records of their lending activities.

In parallel, the stock market re-introduced the up-tick rule (no short selling below the current best ask price)
for covered short selling and HKFE tightened the large open position reporting requirements and imposed
position limits for HSI Futures and Options Contracts.

In the period 1999-2003 further modernisation of the regulatory regime and market facilitation took place.

The most significant regulatory development was the enactment of the Securities and Futures Ordinance.
Some of the key features were the following:
(a) a new dual filing arrangement that ensures timely and accurate disclosure of information by listed
companies and listing applicants. False or misleading disclosure made knowingly or recklessly is liable to
prosecution; (b) insider dealing, market manipulation, dissemination of false and misleading information can
be pursued either by prosecution or through a new Market Misconduct Tribunal. The Tribunal may impose a
range of deterrent sanctions; (c) a single licensing system that brings improved cost effectiveness to licensed
market practitioners; (d) the SFC has greater flexibility in determining disciplinary sanctions against licensed
practitioners misconduct.

The SFC is now considering relaxation of the regulations relating to short selling and derivatives activity.
Relaxation measures applicable to certain market neutral transactions have been introduced. The short
selling exemption is expected to enhance the liquidity of both the cash and futures markets.
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Furthermore Hong Kong is reportedly poised to relax an important licensing requirement for international
hedge fund managers in a move that could help the territory fend off competitive challenges from Singapore
and other lightly regulated financial centres.

The move could allow a hedge fund manager to become a responsible officer without taking the regulatory
exam. Analysts said the change should help streamline a licensing process that can take 18-20 weeks.
Reportedly, however, Hong Kong has so far ruled out following Singapore, where hedge funds can set up
shop in less than a week.

It may be a cause of concern that HK, having been so threatened by major disruptions to its economy caused
by hedge funds and derivatives is now considering relaxing its regulations, reportedly due to competitive
pressures.

BRAZIL
Brazil had a rather different experience, especially as compared with Hong Kong. In the wake of the Asian
crisis, during 1998 and 1999, there emerged speculative pressures on the Brazilian real. These were partly
caused by a somewhat overvalued exchange rate and a fairly important fiscal deficit.
However, a big role was played by contagion from the Asian and Russian crisis, as well as LTCM, and the
actions of financial actors, including HLIs. One of the main mechanisms for this contagion was through the
Brady bonds (Franco, 2000; Dodd and Griffith-Jones, forthcoming). Indeed, hedging strategies for long
positions in Russian instruments had been constructed against a short position of the EMBI, (the Emerging
Market Bond Index), in which Brazilian paper was very important or against Brazilian paper, which was the
most liquid in the market. Franco, op cit argues that there was no question that the way the short selling was
done was meant to drive the price of the Brazilian bonds downwards, to reduce losses in Russia. It has been
reported (interview material) that a number of dubious practices were used by market actors, including HLIs,
such as short selling a larger amount of bonds that were available in the market. According to Franco, op cit,
(then Governor of the Brazilian Central Bank), these transactions carried out offshore violated International
Securities Market Association rules, to which trading houses subscribe on a voluntary basis .Reportedly a
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challenge to these practices by Brazilian banks produced threats of retaliation on the part of the market
makers. This implied a regulatory asymmetry that did not allow Brazilian banks to challenge short sales that
were detrimental to market integrity

More generally, pressure on the real was exerted both on the spot and the large foreign exchange derivatives
markets by a number of actors including HLIs. The Central Bank tried to resist this pressure and defended
the exchange rate by intervention in both the spot, and especially, the derivatives market. The justification
for the latter was that in this way the Central Bank would have a better chance to defeat the speculators, that
were highly leveraged. Though the Central Bank was successful in 1997, by 1998 the level of pressure had
increased, and by early 1999 the Brazilian authorities were forced to abandon their exchange rate regime and
float, as capital outflows became massive and there were large short positions against the Brazilian real in
the derivatives markets. The intervention was costly for the Central Bank, and eventually not successful.
However, the fact that the Central Bank had intervened in the derivatives market provided hedges for
corporates and banks, which helped soften somewhat the impact of the devaluation on the real economy.
Unlike in East Asia, GDP did not fall during the year of the crisis, 1999, though growth was very anaemic
for several years, as a result largely of the crisis.

It can be concluded that the Brazilian experience was more problematic than that of Hong Kong. This may
have many reasons, but the fact that Brazil had a relatively lower level of foreign exchange reserves, by the
end of 1998, may have been an important factor.

Further research seems necessary to understand what determines whether intervention by economic
authorities is successful or not in their defence against speculative pressures, by HLIs as well as by other
market actors, in different circumstances and countries.

Finally, it is important to note that since 2003, there has been a tendency for excessive appreciation of the
Brazilian real. This was partly determined by fundamentals, such as an increasing current account surplus.
However, there is strong evidence, that part of the appreciation is due to carry trade between the high interest
Brazilian real and low interest currencies like the yen or the Chilean peso, carried out to an important extent
by HLIs. (See UNCTAD, 2007). Again efforts of the Central Bank, this time to resist appreciation, has not
been very successful.
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THE SUBPRIME CRISIS AND ITS EFFECTS ON EMERGING MARKETS


The subprime crisis
Financial markets have been experiencing important transformations during the last decade through the
emergence of new innovations (hedge funds and private equity ) and new instruments (derivatives and
structured products).

Regarding hedge funds, it is worth mentioning Quants. These make their decisions based on sophisticated
computerized models. Because of their high returns (over the last twenty years Renaissance Technologies
flagship fund had an average annual return of 30 percent ) Quants grew very rapidily and now they are
thought to represent about one quarter of all US equity hedge funds.

Among the new instruments, innovations have included financial instruments for securitising debt into
assets. Many of these debts were high-risk loans made to home buyers with poor credit or little income the
so-called subprime borrowers. Such loans do not conform to the criteria for prime mortgages, and so have
a lower expected probability of full repayment.

In order to make these assets more appealing to risk averse investors like banks, the asset structurers have
been combining them with supposedly safer loans instruments called collateralised debt obligations (CDOs).
Those CDOs, in the absence of a liquid market in papers, were valued on the basis of models and ratings,
mainly AAA ratings.

Many of the subprime loans had introductory teaser rates that reset after two or three years. With the US
economy slowing, interest rates rising and house prices falling, subprime mortgage defaults climbed. As this
market was hit hard, those securities were repriced downward. This, in turn, infected the CDOs because
following the losses on the underlying subprime mortgages nobody any longer trusted either the models or
the ratings. (See EIU,2007)
After some investment managers realized losses in the subprime mortgage markets, investment banks asked
hedge funds to reduce their leverage. In order to obtain the necessary cash, hedge funds had to sell assets,
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but since mortgage-linked CDOs are not liquid, they decided to sell liquid high-quality equities. As the
prices of quality liquid assets started falling other Quants funds - which in a crunch scenario were
programmed to go long on this type of assets and short on illiquid high beta stocks - started making losses as
market prices were not confirming their assumptions. Hence the margin calls and the need to sell high
quality assets forced the market to do exactly the opposite of what models predicted. Losses were amplified
by their initial leverage and by the fact that most Quants worked with similar models.
Goldman Sachs annouced that its Quants hedge funds lost approximately 30 percent of their value in a week.
In its letter to investors the company announced that the losses were due to a 25 standard deviation event.
The probability of a 25 standard deviation event can happen with a 5% probability and such an occurrence
should happen once every 100,000 years. The problem is that these black swans seem to be happening
more often than they should. It was such an event that caused the LTCM collapse in 1998. Goldman Sachs
injected US$ 4 billion into its global equity fund and external investors injected US$ 1 billion.
Another of the main hedge funds to suffer were a couple run by the investment bank Bear Stearns. One of
these funds invested in cash and derivative instruments tied to CDOs backed by subprime residential
mortgages. As this market was hit hard those securities were repriced downward. To increase returns the
Bear Stearns fund had high leverage. This added to declining security values as it meant margin calls by the
Wall Street investment banks that did the lending. When one bank, Merrill Lynch, found it difficult to find
buyers for their loans collateral the result was severe downward pressure on those and similar CDOs
tranches. In addition other hedge funds faced margin calls from lenders forcing them to sell good assets to
raise cash. Sometimes certain funds had to implement other measures. BNP for example froze withdrawals
by investors in three of its hedge funds.
All of this was occurring parallel to corporate borrowing costs soaring, mergers and acquisitions drying up,
and stock prices falling. Most seriously, the biggest institutions became reluctant to lend to each other in the
interbank market since it was difficult for lenders to assess other financial institutions exposure to subprime
losses.
As a consequence the supply of funds in money markets was squeezed restricting the supply of short-term
financing for financial institutions and threatening a systemic liquidity crisis.
Several German, UK, US, and Chinese banks were affected linked to the repricing of risky assets and
deleveraging by investors. The UK suffered the first bank run in almost 150 years. Though this was mainly
caused by the inappropiate business model of Northern Rock, as well as regulatory failures, reportedly
hedge funds played a role in accentuating the problem, by shorting the banks shares, which they had
borrowed from institutional investors. According to some estimates, at one point, as much as 50% of

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Northern Rock shares were being shorted by HLIs; the resulting declines in the price of shares contributed to
increasing panic, untill the Bank of England provided its lender of last resort facility.

Monetary policy has played a key role in determining the consequences of the crisis. Central banks liquidity
injections were followed by interest rate cuts. The first intervention was by ECB followed by central banks
in the US, Japan, Australia, and Canada that injected funds into their economies to keep them functioning.
Also on the 18th September the US Federal Reserve cut its target rate for the first time in three years from
5.25% to 4.75%.s

As investors and financial institutions reappraise the risks associated with different assets, prices of all sorts
of instruments - equities, corporate and government bonds, commodities - have been adjusted to new and
generally lower levels. For any given level of risk, financing is likely to be more expensive.

The effects in emerging markets


i. According to the IMF (2007), emerging market risk had broadly declined in recent years, supported by the
then benign global economic outlook, improved macroeconomic performance, improving sovereign debt
profiles, and commodity prices. External positions generally remain very strong, and robust growth led to
an improvement in fiscal positions in many countries.

The concern about the consequences of the subprime crisis on EMs can be explained in terms of risk
models. These models determine that certain funds, including HFs, which orient their investment in certain
countries financial instruments, take decisions that affect those instruments themselves. This decision - from
the point of view of an individual fund - is a rational response to a particular expectation. However, this
situation when undertaken by various funds could lead to systemic risks.

Also there are several vulnerable points where EMs can be affected by additional volatility in mature
markets. These weaknesses are related to the growing market of privately placed syndicated loans in
emerging markets that share similar evidence of credit indiscipline as in the leveraged loan segment;
emerging market banks in some regions are relying increasingly on international borrowing to finance rapid
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domestic credit growth; emerging market corporates appear increasingly engaged in the carry trade; and
some emerging market financial institutions in several countries are increasingly using structured and
synthetic instruments to increase returns, potentially exposing them to losses as volatility rises. Many of
these points, as we will see later, are related to the HF investment strategies.
ii. As a product of this recent turmoil and the associated reappraisal of risk, new issues from emerging
markets increased in price. Nevertheless, the increase in spreads has so far been relatively moderate for most
developing countries.
iii. Another consequence of the subprime crisis can be seen through the greater difficulties for launching new
issues in international markets. During the recent credit squeeze international markets were closed to new
issues and reopened only after the US Federal Reserve cut interest rates. A number of sovereign borrowers
used that thaw to come to market, including Mexico and Ghana which made its international debut with a
$750 million 10-year offering. Nevertheless, the answer to this question is not unique. Some EM countries
have reduced their need for funds because of record-high commodity prices, increases in manufactured
exports and rising forex reserves. Others, however, did not: Europe and Central Asia now absorb nearly half
of all international bank and bond financing. These economies are, accordingly, vulnerable to shifts in
external credit.
iv. A fourth consequence is related to the impact of the crisis on the US economy. Regarding this, global
growth will be slower in the next quarters and this will negatively influence the economy of most developing
countries, unless the rest of the world compensates for slower US growth.

HEDGE FUNDS IN INDIA


India focused hedge funds have posted spectacular returns in 2014 against the backdrop of rising domestic
equity markets, and a renewed sense of confidence in the Indian economy which is being led by Narendra
Modi. Hedge funds investing with an Indian mandate have topped the performance tables in 2014 and in this
special section of The Eurekahedge Report, we ask some of the top performing Indian hedge fund managers

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about their winning themes during the year, in addition to investor allocation activity and the key
macroeconomic themes which they will be watching out for in 2015.

In 2014, the average Indian hedge fund was up 39.36%, outperforming underlying markets by almost 10%.
Managers running long/short equity strategies emerged as the clear winner posting gains of 54.83% -their
best performance in the last eight years. Figure 1 below details the historical performance of Indian
managers relative to the BSE Sensex Index and shows how managers focused on the country have
rebounded after a relative lull over the preceding four years.

In terms of asset growth, Indian hedge fund assets under management (AUM) are currently at a seven year
high of US$3.45 billion, though roughly 36% below their 2007 peak of US$5.36 billion. The average Indian
hedge fund was down 50.66% during the 2008 financial crisis, witnessing steep performance - based losses
and investor redemptions from which the Indian hedge fund industry is yet to recover.

Since 2009, Indian managers have posted an eight year annualised return of 10.89%, and barring 2011, their
AUM continues to trend upwards albeit at slower pace compared to the broader Asian hedge fund space.
Managers have raked in roughly US$700 million in performance - based gains in 2014 while seeing net
inflows of US$215 million during the year. While investor flows have not kept pace with manager
performance in 2014, going forward one should expect an uptick in investor allocation towards India as the
country remains a much better value proposition for investors compared to some of its emerging market
peers and a clear beneficiary of the lower oil prices. Structural weaknesses within the economy and the risk
of capital flight following a rise in US rates could potentially upset the prospects of the Indian markets in
2015.

CONCLUSION
Hedge Funds as a whole are becoming a prominent segment of the asset management industry
and gaining popularity from investors particularly from high net worth investors, universities, charitable
funds, endowments, pension funds, insurance and other institutional investors. Most hedge fund
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managers are embracing the new sources of capital from institutional investors, who are, by their very
nature, highly regulated and their investments scrutinized. They encourage the hedge funds to improve
their internal controls to meet the Alpha requirements.

The assets under management of the hedge funds are growing on a double digit rate and it is estimated
that worldwide the Hedge Fund industry is nearly $3 trillion dollars. This has created a lot of disquietude for
financial regulators as Hedge funds are able to influence markets in a more radical manner than they would
do so when they first started.

In India the issues are intended to widen the FII inflow and to allow these alternatives
investment pools to our securities market in a transparent and orderly manner. In addition, the suggestions
also provide for adequate safety measures to address legitimate concerns associated with these funds. Most
industry people are of the view that regulation is welcome and good but only if it does not impinge on
innovation, competitiveness and the industry's ability to evolve. It's all about educating the investors and
ensuring they know what they are getting into.

Hedge Funds bring liquidity to capital markets, and also make capital markets more efficient because
they scour the financial landscape for inefficiencies, and then use expertise to structure the optimal
investment to take advantage of the opportunity. They have been instrumental in transforming the
investment landscape, making it much broader than equities, bonds and property. Hedge funds have
acted as a beachhead in new investment strategies, including middle market lending, asset- backed
lending, credit derivatives, reinsurance, and carbon credits.The greater challenge for the regulators is
as to how to increase compliance and protect investors without making hedge fund managers relocate to
unregulated jurisdictions.

REFERENCES
Alternative Investment Management Association (2002), Guide to Sound Practices for European Hedge
Fund Managers, August.
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Alternative Investment Management Association (2007), Guide to Sound Practices for European Hedge
Fund Managers, May.

An overview of the Major Events and Regulations of The Securities and Futures Markets Between 1997
and 2007,Securities and Futures Commission, June 2007.

WEBLINKS
(Hedge Funds in India)
http://www.hedgefund-index.com/Legal%20Framework%20for%20Hedge%20Fund%20Regulation.pdf
(Hedge Funds Definition)
http://www.sebi.gov.in/cms/sebi_data/attachdocs/1293006463914.pdf

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