Both returns and losses can get amplified, so maintain back-up liquidity to meet margin requirements.
Most people use some form of leverage. Simply put, leveraging is borrowing to invest. If one can borrow funds and invest this in high-yielding assets and earn super-normal returns, he can make a profit after taking into account both the interest and the principal payments. So the use of leverage can greatly magnify returns.
But just as gains are amplified, so are losses. Returns could be impacted if there is a fluctuation in the price of the underlying asset. Any hike in the interest rates would add to the cost of funds and thus impact profits or add to the losses. It is important to enter into any leveraging strategy with these risks in mind.
Hedge funds, typically, use a very high degree of leverage to generate superior returns. Hedge fund failures have been fairly common on account of investment bets gone wrong.Some of the major hedge fund failures include the likes of Amaranth Advisors, Aman Capital and Tiger Fund. The most common strategies employed by hedge funds include currency carry trades and fixed income arbitrage. The former strategy is based on the principle of interest rate differential and currency differentials globally. The strategy entails borrowing money in a currency with low domestic interest rates and investing in high-yielding currencies or assets. Fixed income arbitrage entails going long and short on bonds with varying credit qualities. Using a high degree of leverage also helps improve returns. It would entail purchase of very high quality corporate or asset-backed securities, using borrowed money. As long as the cost of leverage is less than the returns earned, the strategy generates a profit. To hedge away part of the interest rate risks, bonds of lower credit quality may be shorted, assuming they would fall in value faster if the credit market deteriorates.
ROOM FOR ERROR
Most leveraged strategies fail because of the underlying assumption that past behavior patterns will be repeated within a reasonable degree of error. However, markets may not behave in line with historical patterns at all points of time. The history of most hedge fund blowouts show,that these happened largely on account of the failure to meet margin requirements and being forced out of positions at an inopportune time. Because hedge funds often tend to be highly leveraged, it is rare that they have substantial amounts of cash on the sidelines. This is also true for individual investors with highly leveraged positions.
Highly leveraged positions in the futures market led to the January 2008 crash in the Indian equity markets. Thus, when markets corrected sharply, additional margin requirements were triggered. Failure to meet the margin requirements resulted in forced unwinding of leveraged long positions. This resulted in a free fall of 19.4 per cent within two trading sessions, as the benchmark BSE Sensex touched an intra-day low of 15,332 on January 21 of 2008, after closing at 19,013 on Janaury 18.
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Another example is the collapse of the US sub-prime market, which triggered a collapse of the US housing market and resulted in a global financial crisis.
LESSONS FROM CRASH
- Avoid over-leveraging as markets can be unpredictable.
- Accept that predicting the future is fraught with risk and appropriately model the trades. This will diminish potential returns.
- Some back-up liquidity should always be maintained, to meet margin requirements if need be.
- Monitor investments as any sharp short-term market fluctuations can prove to be fatal in case of leveraged positions.
- Clear stop-loss levels should be defined for any trades based on individual risk tolerance.
The writer is research analyst, Fullerton Securities and Wealth Advisors
