Throughout the globe, today's landscape of international financial market and institutions has continued to experience several changes that require practitioners to examine new models. The need for practitioners to examine new models that are relevant to the state of these markets and institutions has also been necessitated by the recent events that contribute to financial crises, which have been very dramatic. Actually, the recent financial crisis has had significant impacts on the financial institutions and markets resulting in the need for changes. International financial markets and institutions have become an important aspect of economies because they affect daily life. This is primarily because they involve the huge flow of different types of funds in the entire economy that in turn impact the profits of businesses, production of goods and services, and economic well-being of countries. In some cases, the events in these institutions and markets become a subject of huge concern to politicians and can have a significant impact on elections (Mishkin & Eakins, 2011).
Role of Financial Markets and Institutions:
As previously mentioned, financial markets and institutions have a critical role in almost every economy that result in huge impact in the financial system within an economy. Due to their various functions and intermediary roles they play, financial markets and institutions have become crucial to the achievement of a sustainable economic process. Generally, financial markets have six major functions i.e. borrowing and lending, risk sharing, price determination, information aggregation and coordination, efficiency, and liquidity. The operations of financial markets are determined through the consideration of the various kinds of financial institutions that participate in the markets and the various ways with which the financial markets are structured (Tesfatsion, 2012).
The main intermediary role played by financial institutions is promoting and facilitating the interactions between customers and the financial markets. As financial intermediaries, the institutions help in improving the efficiency of the economy through facilitating financial transactions, portfolio creation, spreading risks over time, easing constraints associated with household liquidity, and lessening the problem of asymmetric information.
Capital markets are regarded as the driving force of the economy since they are places where the money is availed to boost the creation of wealth. These markets consist of supply agents with positive capacity for savings such as businesses and households ("The Function of Financial Markets," 2009). As a result, capital markets play a critical role in the financial market because they are places that drive the economy. On the other hand, financial institutions act as vital economic agents that establish the link between the various stakeholders in the capital and financial markets. Generally, these institutions facilitate the process of transforming short-term resources into both medium and long-term resources. As intermediaries that facilitate various functions in the financial market, these institutions play a critical role in the financing of the economy through providing the link between various stakeholders in the financial market.
With the ever-changing state of financial markets across the globe, there is increased development of these markets and the development of new financial instruments. Some of the major reasons associated with these developments include the need to improve the efficiency of the markets due to several financial crises brought by globalization. Secondly, these developments also originate from attempts to promote and maintain a sustainable economic development process because of the signs of serious instabilities emanating from the international financial markets. Some of these factors contributing to the developments can be attributed to globalization and the ongoing technological advancements.
Flow of Funds in Financial Markets and Institutions:
The impact of financial markets and institution originate from the role the play in the flow of various types of funds in an economy. Some of the most common types of investment funds in financial markets and institutions include mutual funds, pension funds, and hedge funds. While the term hedge fund is not a legal term, it's an industry term that currently applies to international private financial institutions that seek to maximize profits from shareholders in high-risk speculative ventures in the short-term. As the name suggests, hedge funds are used to ensure the enclosure of one's property and invest mainly in the new financial derivatives.
Hedge funds can basically be described as pools of capital for accredited investors only and are arranged through the use of limited partnership legal structures. In most cases, the general partner tends to be the money manager and has the likelihood of having a great percentage his/her own net worth in the fund (Chriss, 1998). The descriptions of hedge funds incorporate various aspects of investment companies as legal structure, investment strategy, and investor pool. Notably, these funds are designed to lessen an investment risk that is commonly known as hedging while maintaining a good return on investment.
One of the most evident characteristics of these funds is that they are highly specialized i.e. they depend on the specific expertise of the fund managers to generate profit. As a result the managers of these funds follow various investment strategies like leverage and derivatives and conservative strategies. In order to meet their risk and return goals, hedge fund managers normally use a broad range of strategies since these funds are small and involve private partnerships. It's important to note that are various types, categories, and strategies of hedge funds that are currently in use. As a result of these differences, a single strategy or category may not be appropriate for certain types of investments.
Categories of Hedge Funds:
There are various categories of hedge funds that are currently used in the financial markets including & #8230;
Absolute-return Hedge Funds:
This category of hedge funds is sometimes referred to as non-directional funds and it's devised to produce a steady return despite of what the market is doing. Generally, absolute-return funds seek to generate returns in both growing and failing financial markets. The non-directional hedge funds are the most suitable categories for a traditional investor looking for low risk and willing to ready to give up some return in exchange. The fund manager investors may obtain returns in various forms such as income, capital appreciation, or a combination of them based on the utilized investment strategy. These funds sometimes range from very conservative to aggressive depending on the investment strategy used by the manager and the underlying investments ("Absolute Return Funds," n.d.).
Directional Hedge Funds:
This category of hedge funds doesn't hedge completely as their managers maintain some exposure to the market while they try to obtain returns that are higher than expected for the amount of the risk that they take. Since they involve taking huge bets on the direction of the financial market, this category of hedge funds are regarded as the most risky. In certain cases, the directional funds are known as beta funds as they contain some exposure to the stock market.
Event-driven Hedge Funds:
These hedge funds take advantage of opportunities provided by organizational and corporate events like initial public offerings, legal cases, mergers, spin-offs, bankruptcies, and regulatory decisions. Event-driven funds normally use long exposures in one security together with other derivatives to counteract the others sources of risks in the market.
Relative Value Strategies:
The main aim of relative value strategies is to seize the profit potential of securities that are mispriced while counteracting the impact of other market risks like fixed-income duration risk and equity market risk. They achieve this by seeking for mispriced securities relative to each other and generate money by lessening the overpriced security while maintaining the underpriced one ("What are Hedge Fund Strategies?" 2012).
Multi-strategy Hedge Funds:
They are single funds that use a combination of several strategies such as attempting to choose the best-performing strategy for the present environment and assigning assets in programs that are managed internally in order to generate profits from the connection across various strategies.
Similarities and Differences between these Categories of Hedge Funds:
There are certain similarities in these various categories of hedge funds including the fact that they are permitted to use a broad range of trading tools due to their lightly regulated status. Due to their status, these hedge funds facilitate a larger number of investment strategies unlike the conventional mutual funds and other investment companies. Secondly, relative value strategies, event-driven, and directional hedge funds are considered as single-strategy hedge funds or individual hedge fund strategies. Third, the boundaries between strategies in these categories of hedge funds are not clear in practice and necessitate substantial due diligence before and during the investing process because these funds try to mix various strategies. Fourth, these categories of hedge funds are usually less efficient because of lack of investor interest and flow information as they focus on emerging markets.
However, there are several differences between these categories of hedge funds including the fact that multi-strategy hedge funds have more appealing net fee structure than other funds. While event-driven funds have some similarities to relative-value funds in their implementation, their main features originate from the ability of fund managers to evaluate the behavior of…