Introduction
Hedge funds are a form of unregulated mutual funds– often located offshore for tax and regulatory reasons - catering exclusively to high net worth individuals and cash-rich institutions and making profits through highly leveraged speculative short-term investments. These mammoth funds have existed in financial markets since the 1970s. However, it was not until 1992 that they made their presence felt.
Hedge funds were implicated in the 1992 crisis that led to major exchange rate realignments in the European Monetary System, and again in 1994 after a period of turbulence in international bond markets. Concerns mounted in 1997 in the wake of the financial upheavals in Asia and they were amplified in 1998, with allegations of large hedge fund transactions in various Asian currency markets (Eichengreen & Mathieson, 1999).
These concerns are growing along with the increasing asset size of hedge funds and their share of turnover in various markets. There are now almost 10,000 hedge funds around the world managing about US$1.6 trillion of assets, with increasing retail and institutional interests (Yam). Even if a single prominent fund out of these having large exposures to other financial institutions fails, it could trigger a series of panic sell-offs potentially causing a sharp decline in asset prices and liquidity crunch in the market.
Despite such risks, hedge funds do bring significant benefits to financial markets as well. Their prime contribution has been in providing additional liquidity and improving market efficiency by exploiting arbitrage opportunities. They also facilitate financial innovation through developing and trading complex and innovative financial products while their "contrarian" investment style tends to stabilise financial ...