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Yen exchange rate and hedge funds

Date: Tuesday, March 20, 2007
Author: A V Rajwade, Business Standard (New Delhi)

The yen and hedge funds are at centre stage, but what will happen if China diversifies into holding the yen.
In an earlier article, I had referred to the large bets of hedge funds in the “carry trade”, estimated at around $ 100 billion. The last few weeks seem to have witnessed hedge funds unwinding carry trades by buying the yen, even as Japanese investors continue to sell the domestic currency to invest abroad. Perhaps the most profitable investments have been in the New Zealand dollar: not only was/is there a huge “carry” to be earned in interest differential, but the dollar has appreciated from JPY 55 to JPY 80 over the last five years!
Carry trade is, however, only a small proportion of the hedge fund industry which now commands investment capital of the order of $ 1.5 trillion — with leveraging, the total investment in risky strategies, could be of the order of perhaps $ 4 trillion, a massive sum of money by any standards. With growing size, the industry is attracting more regulatory attention. In the US, new guidelines for the industry were issued in the last week of February but, overall, regulators prefer a light touch believing that hedge funds “are good for the markets” (EU internal market commissioner) and “have contributed of the financial system” (G7).
But the industry continues to attract adverse comments and publicity. For example, the German vice chancellor recently compared hedge and private equity funds to “locusts who act without sparing a thought for the consequences, for workers, for the people, …. to make even more money”. Critics have found more ammunition recently in a court case involving Zambian debt, justifying the name “vulture fund”. Historically, most international bonds have not carried covenants prescribing that, in the event of default, debt resolution voted for by, say, 75 per cent of the bond holders, would be binding on all. In the absence of such clauses, some hedge funds have sued the issuer/debtor for full repayment, after most of the creditors had settled. There have been cases where courts have ruled in favour of the bondholder. A few years back, a case involving Peru had attracted a lot of notoriety. The latest involved the purchase by a hedge fund of Zambian debt of $ 42 million to Romania, for $ 4 million. The debt had been agreed to be settled at 12 cents to the dollar but the actual settlement never took place, giving the fund the opportunity to buy the debt and sue Zambia in a UK court, for full satisfaction. Many NGOs like Oxfam, for example, have criticised such actions, at a time when many western governments are writing off the debt owed by “heavily indebted poor countries”, as part of the IMF’s HIPC initiative.
As the scale of their activities has grown, the hedge fund industry is being forced to innovate its investment strategies. The latest comes from the plight of pension funds, faced with the “risk” of pensioners living longer than the mortality rates factored in the calculations! Pension funds are trying to lay off the risk through issuance of so-called “mortality bonds” whose pay-offs depend on the longevity of the population as measured by a benchmark: longer the life, lower the pay off. Any market is inefficient in its early stages — so is the longevity (or mortality) bond market. And, investors who can forecast future life expectancy accurately stand to make handsome gains. In a way, such longevity bonds are similar to “catastrophe bonds” issued by reinsurance companies where the pay-off depends on whether a catastrophe like a Tsunami occurs or not. Hedge funds are active investors in catastrophe bonds as well. Lately, they have also indulged in shareholder activism forcing even large companies like ABN AMRO, Japan Power and Deutsche Borse to adopt more shareholder-friendly policies. And, they went to join MTS, the European government bond-trading platform. One threat to the hedge fund industry comes from an unlikely quarter — the academic world. Research seems to suggest that returns to the investor, after the hefty 20 per cent plus fees of the fund manager, are not all that higher than, say, investment in the S&P 500 Index. Since 2000, the average hedge fund has given a return of only 8.4 per cent — and this despite the “survivor bias” in the numbers calculated from only the surviving funds. Academics argue that hedge fund strategies can be mimicked at a much lower cost than the fund manager’s fees. Recently several such funds have been floated. Their success remains to be proven, but this has prompted some hedge funds to focus on even riskier, and potentially more rewarding, strategies like concentrating investments in only a few bets. But to come back to the yen, what will make a big impact is diversification of China’s reserves into yen, arguably the world’s most undervalued currency.