Hedge Funds 

Hedge Funds its working requirement & its

impact on Indian Capital Market

A Project Report

Under the guidance of

Prof. M.S. Rana

Submitted By

Manoj Kr. Dey & Sumanta Mondal

In partial fulfillment of the requirement

For the award of the degree

Of

MBA

In

Finance

March 2011

 
 
Hedge Funds 

Acknowledgement

We are very much Thankful to our Prof. M.S. Rana ( Project guide)
for giving opportunity and his guidance help us out through preparing this
report. He has provided us a valuable suggestions and excellence guidance
about this project which proved very helpful to us to utilize Theoretical
knowledge in Practical knowledge.

At last Iam also thankful to Prof. Poonam Arora who has help me
out for implementing the Two test in these project. I am also thankful to
my friends, to all known & unknown individuals who has given me their
consecutive advice, educative suggestion, encouragement, co-operation &
motivation to prepare these report.

I am highly obliged to my friends who helped and encouraged me in

my study. They have played a vital role in making this Masters degree a
very enjoyable experience.

Last but not the least I would like to thank God- The Almighty for
rendering all his blessings on me, which has helped me to achieve success
in whatever I have pursued in life and wish to continue doing so in the
future.

Manoj Kr. Dey:520952833

Sumanta Mondal:520952843

 
 
Hedge Funds 

Certified that this project report titled “Hedge funds,

its working requirement & its impact on Indian

Capital Market is the bonafide work of Manoj Kr. Dey

& Sumanta Mondal who carried out the project work

under my supervision.

Signature: Signature:

Prof. B.N. Mehta Prof. M.S.Rana

HEAD OF THE DEPARTMENT FACULTY-IN- CHARGE
IBMR Business School IBMR Business School
Near Asia school Near Asia School
Drive-in-road Drive-in-road
Ahmedabad-380054 Ahmedbad-380054

   

 
 
Hedge Funds 

Examiner Certificate

The Project report of

“Hedge Funds its working requirement & its impact on Indian

Capital Market”

By

Manoj Kr. Dey (520952833)

Sumanta Mondal (520952843)

Accepted in Quality

Internal Examiner External Examiner

Signature: Signature:

 
 
Hedge Funds 

Executive summary

Hedge funds are an investment structure that manages a “private

unregistered investment pool”. They use several strategies like leveraging,
long, short and derivative positions to generate high returns and hedge
probable market risks. Hedge funds restrict their investment base to high
net worth individuals rather than allowing the general public to invest in
them.

By 2025 the Indian economy is projected to be about 60 per cent the

size of the US economy. This is due to major initiatives undertaken by the
Indian Government. One such effort was taken in 1993 when with the
notification of SEBI (Mutual Fund) Regulations; the asset management
business under private sector took its root in India. India today has much of
the necessary institutional framework for hedging, including a regulatory
regime and good information disclosure standards.

This study is written with an aim of providing a deeper insight into

hedge funds and their possible impacts on the Indian Capital Market.
Analysis has been done by using a Quantitative Research and using
Statistical techniques like chi-square and coefficient of correlation.

The main advantages or impact of Hedge funds in India are that they
bring in the much welcome volumes, and thus, liquidity in the market.
Moreover, as all market experts will concede, market liquidity leads to
better price discovery in the market.
 

 
 
Hedge Funds 

Table of Contents
1  INTRODUCTION : ................................................................................................. 9 
1.1  Objective of the study: ............................................................................... 12 
1.2  SCOPE OF THE STUDY: ................................................................................ 12 
1.3  Rationale of the study: ............................................................................... 13 
1.4  List of Hedge Fund in India: ........................................................................ 14 
1.5  Investing of hedge funds in India: .............................................................. 15 
2  MAIN BODY OF THE PROJECT: ............................................................................... 17 
2.1  THE ORIGIN OF HEDGE FUNDS: .................................................................. 18 
2.2  CHARACTERISTICS OF HEDGE FUNDS: ........................................................ 19 
2.3  Hedge Funds vs. Mutual Funds: ................................................................. 21 
2.4  HOW THEY WORK:...................................................................................... 22 
2.5  STRATEGIES OF HEDGE FUNDS: .................................................................. 23 
2.5.1  Market Trend (Directional/Tactical) Strategies: ............................ 24 
2.5.2  Event‐Driven Strategies: ................................................................ 25 
2.5.3  Arbitrage Strategies: ..................................................................... 25 
2.5.4  Fixed Income Arbitrage: ............................................................... 26 
2.5.5  Statistical Arbitrage: ...................................................................... 26 
2.6  HEDGE FUND INVESTMENT ACTIVITIES COMPARED TO THOSE OF 
REGISTERED INVESTMENT COMPANIES: ............................................................... 26 
2.7  LEVERAGE ................................................................................................... 28 
2.7.1  Background ................................................................................... 28 
2.7.2  Use of Leverage by Hedge Funds: ................................................ 29 
2.7.3  Use of Leverage by Registered Investment Companies: ............... 30 
2.7.4  SHORT SELLING: ....................................................................... 31 
2.8  PERFORMANCE IN A PORTFOLIO CONTEXT: .................................. 33 
2.9  Literature Review of the Indian Capital Market: ....................................... 34 
2.9.1  INTRODUCTION: ........................................................................ 34 
2.9.2  ISSUES AND PRIORTIES FOR INDIA: ..................................... 35 
2.9.3  SOME HIGHLIGHTS: ................................................................. 38 
2.10  HISTORY OF INDIAN CAPITAL MARKETS: ...................................... 40 

 
 
Hedge Funds 

2.11  DIFFERENT PLAYERS IN INDIAN CAPITAL MARKETS: ................ 45 

2.11.1  MUTUAL FUNDS ........................................................................ 45 
2.11.2  History: - ....................................................................................... 46 
2.11.3  FOREIGN INSTITUTIONAL INVESTOR: ................................ 47 
2.11.4  RETAIL INVESTORS: ................................................................. 49 
2.12  HEDGE FUNDS IN ASIA: ........................................................................ 50 
2.13  MARKET BENEFITS OF HEDGE FUNDS: ............................................ 51 
2.14  HEDGE FUNDS IN INDIA: ...................................................................... 53 
2.15  PARTICIPATORY NOTES: ..................................................................... 56 
2.16  WHY HEDGE FUNDS ARE LOOKING AT INDIA: .............................. 57 
2.17  ADVANTAGE INDIA: ............................................................................ 58 
2.18  THE RISKS ASSOCIATED WITH HEDGE FUNDS: ............................. 58 
2.18.1  MARKET RISK: COMPONENTS: .............................................. 60 
2.18.2  EQUITY RISK: ............................................................................. 61 
2.18.3  Volatility risk: ............................................................................... 62 
2.18.4  CORRELATION RISK: ............................................................... 63 
2.18.5  COMMODITY RISK: ................................................................... 63 
2.18.6  CURRENCY RISK: ...................................................................... 64 
2.18.7  CREDIT RISK: ............................................................................. 65 
2.18.8  LIQUIDITY RISK: ....................................................................... 66 
2.18.9  OPERATIONAL RISK: ................................................................ 68 
2.18.10 MODEL RISK: ............................................................................. 68 
2.18.11 HUMAN RISK: ............................................................................ 69 
2.19  RESEARCH DESIGN: .............................................................................. 70 
2.19.1  INTRODUCTION:........................................................................ 70 
2.19.2  RESEARCH METHODS: ............................................................. 70 
2.19.3  RESEARCH DESIGN: ................................................................. 71 
2.19.4  STATEMENT OF THE PROBLEM: ........................................... 71 
2.19.5  LIMITATIONS OF THE STUDY: ............................................... 72 
3  ANALYSIS & INTERPRETATION ............................................................................... 73 
3.1  CORRELATION BETWEEN HEDGE FUND INFLOWS AND SENSEX RETURNS:75 

 
 
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3.2  ESTABLISHING A RELATIONSHIP BETWEEN THE FINANCIAL

CRISIS AND HEDGE FUND PERFORMANCE: ............................................... 89 
3.3  SUMMARY OF FINDINGS: ........................................................................... 95 
3.4  SUGGESTIONS: ..................................................................................... 101 
3.5  CONCLUSION: ....................................................................................... 103 
4  BIBLIOGRAPHY: .............................................................................................. 104 
5  INDEX ................................................................................................................... 105 
 

List of Figures:
Figure 1: How they Work ............................................................................................................ 22 
Figure 2: Working of Mutual  Fund ............................................................................................. 45 
Figure 3 : Risk Galaxy .................................................................................................................. 59 
Figure 4: market risk ................................................................................................................... 60 
Figure 5: Internal Rate return ..................................................................................................... 60 
Figure 6: Equity risk ..................................................................................................................... 61 
Figure 7: Commodity risk ............................................................................................................ 63 
Figure 7: Operational Risk ........................................................................................................... 68 
Figure 8: Bar Daigram 2003 ........................................................................................................ 77 
Figure 9: Bar Daigram 2004 ........................................................................................................ 80 
Figure 10: Bar Daigram 2005 ...................................................................................................... 82 
Figure 11; Bar daigram 2006 ....................................................................................................... 85 

List of Tables:

Table 1: Hedge fund vs Mutual fund........................................................................................... 21 
Table 2 : Flow of Hedge Funds from 2003 and SENSEX return for the corresponding year .... 76 
Table 3: Hedge funds inflow & sensex return for the year Apr 03 to Apr 04 ............................. 78 
Table 4: Hedge funds inflow & sensex return for the year 2004 ................................................ 79 
Table 5: Hedge funds inflow & sensex return for the financial year Apr 04 to Mar 05 .............. 80 
Table 6: Hedge fund inflow & sensex return for the year 2005 ................................................. 81 
Table 7: Hedge fund inflow & sensex return for the financial year Apr 05 to Mar 06 ............... 83 
Table 8: Hedge fund & sensex return for the year 2006 ............................................................ 84 
Table 9: Hedge fund & sensex return for the financial year Apr06 to Mar07 ............................ 85 

 
 
Hedge Funds 

1 INTRODUCTION :

A hedge fund can be defined as an investment structure that manages

a “private unregistered investment pool” and compensates the fund
manager with an incentive-based fee based on a percentage of the profits
earned by the fund (Nicolas J.G).

Hedge fund is an aggressively managed portfolio of investments that

uses advanced investment strategies such as leverage, long, short and
derivative positions in both domestic and international markets with the
goal of generating high returns.

Legally, hedge funds are most often set up as private investment

partnerships that are open to a limited number of investors and require a
very large initial minimum investment. Investments in hedge funds are
illiquid as they often require investors to keep their money in the fund for a
minimum period of at least one year.

They are typically organized as private partnerships and often

located offshore, thus, saving on tax and regulatory issues. Also, the initial
high investments and illiquid nature of funds keeps a check on the
investment in hedge funds.

Hedge funds, in general, are not registered. They have avoided

registration by limiting the number of investors and requiring that their
investors meet an income or a net worth standard. Furthermore, hedge
funds are also prohibited from soliciting or advertising to the general

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audience. The primary aim of most hedge funds is to reduce volatility and
risk while attempting to preserve capital, and deliver positive returns under
all market conditions.

For present purposes, 3 main classes of hedge funds can be identified: -

Macro Funds, which take large unhedged positions in national markets

based on top-down analysis of macroeconomic and financial conditions.
These funds take position in either mature or key emerging markets. They
spread their holdings across equities, bonds and currencies.
Some long-established macro funds find it Cheaper to use
conventional forwards and futures to take positions ahead of the market
moves they foresee. Some newer macro funds pursue more specialized
trading strategies using complex derivative securities.

“A fund of this type might take a long position in a currency that is

undervalued and an equal, short position in another currency that is
overvalued”.

Global Funds:Which also take positions worldwide, but employ bottom-

up analysis, picking stocks on the basis of individual companies' prospects.

Relative Value Funds:Which take bets on the relative prices of

closely related securities (treasury bills and bonds, for example). They limit
their holdings to the mature markets, because their expertise is limited to
those markets. Relative value funds are also inclined to use derivatives.

10 
 
Hedge Funds 

Hedge funds are investment pools employing sophisticated trading

and arbitrage techniques including leverage and short selling, wide usage
of derivative securities etc.
Generally, hedge funds restrict share ownership to high net worth
individuals and institutions, and do not offer their securities to the general
public. Some hedge funds are limited to 100 investors.
This private nature of hedge funds has resulted in few regulations
and disclosure requirements, compared for example, with mutual funds.
Also, the hedge funds may take advantage of specialized, risk-seeking
investment and trading strategies, which other investment vehicles are not
allowed to use.

Hedge funds are subject to far fewer regulations than other pooled
investment vehicles, especially to regulations designed to protect investors.

This applies to such regulations as regulations on liquidity,

requirements that fund’s shares must be redeemable at any time,Protecting
conflicts of interests, assuring fairness of pricing of fund shares, disclosure
requirements, limiting usage of leverage, short selling etc. This is a
consequence of the fact that hedge funds’ investors qualify as sophisticated
high-income individuals and institutions.
Hedge funds offer their securities as private placements, on
individual basis, rather than through public advertisement, which allows
them to avoid disclosing publicly their financial performance or asset
positions.

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Hedge Funds 

However, hedge funds must provide to investors some information

about their activity, and of course, they are subject to statutes governing
fraud and other criminal activities.

For e.g. “controversies and frauds surrounding hedge funds seem to

deal with the issue of transparency, today such controversy has run into a
cul de sac, or dead end, because transparency of hedge funds have
increased to the point that one can log into hedge fund information portals
and examine up to date information on hedge fund data”.

1.1 Objective of the study:

¾ Comparision between Hedge funds & Mutual funds.

¾ To study Hedge fund investment Strategies.

¾ Impact on Hedge Funds investments in Indian Capital Market.

¾ How Hedge funds work in Indian Capital Market.

 

1.2 SCOPE OF THE STUDY: 

Though there is a large number of players who are active in the Indian
Capital markets and many Indices which can be taken as benchmark for
comparison, only one index SENSEX is taken into consideration, to reduce
the complexity of analysis.

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Though there are many financial crisis that has resulted in financial
world only four main crisis has been taken into consideration because of
not availability of enough data.
Study has been limited to only Indian Capital markets, though Hedge
Funds has a direct impact on the whole financial system of the country.

1.3 Rationale of the study:

These project is based on fundamental analysis, technical analysis &

efficient market hypothesis.

¾ It helps pool assets with those of other investors in managing their

portfolio to give good return

¾ It help with prudent fund hedging.

¾ It is a method to access the alternative statement investment

strategies used by the manager.

¾ It helps in liquidity management. 

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1.4 List of Hedge Fund in India: 

™ Hudson Fairfax Group (HFG) Private Equity.

™ Avatar Investment Management (AIM) Private Equity.

™ India Deep Value Fund Long Term Investments in Capital Markets

and Real Estate.

™ Heritage Capital India Long-short Equity.

™ Fair Value Capital Traditional Investment Approach, Event-based

investments.

™ India Capital Fund Multi-strategy.

™ Monsoon Capital Indian Equities Investments

™ Karma Capital Indian Equities Investments.

™ Atlanta Capital Investment in Indian Equities and Precious Metals.

™ Baer Capital Partners Private Equity, Equity Investments.

™ Brahma Capital Board Asset Management.

™ Eight Capital Alternative Investments.

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™ EM Capital Management Emerging Markets.

™ Evolvence Capital Alternative Investments.

™ Jina Ventures Private Equity, M&A.

™ Och-Ziff Alternative Investments.

™ Sandstone Capital Equity Investments.

™ Fulcrum Investment Group, LLC Alternative Investments.

™ Greenwich Advisors Diversified Indian markets.

1.5 Investing of hedge funds in India:

™ Prior to finalizing investment, take couple of months to know about
the hedge fund industry in India. The age of hedge fund industry, the
key players, their worth, the operational risks, the pros and cons of
investing in hedge funds etc.

™ Identify potential hedge funds, refer commercial directories or

databases. Account for your investment goals, risk tolerance level,
amount allocated for investment.

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Hedge Funds 

™ Get to understand the ground realities of regulatory factors, its

implications, how business is run in India all helps.

™ Read blogs, financial magazines, websites, news articles, white

papers on hedge funds in India. Talk to personnel; preferably interact
with hedge fund managers involved with hedge fund investments
and those who have already invested in hedge funds.

™ Notice annual events like Hedge funds world India to gain an

assessment of the burgeoning Indian hedge fund industry.

™ Approach wealth manager in wealth management companies,

securities broker or licensed investment consultant for advice on
hedge fund investments in India.

™ Understand terms related to hedge funds, remittance, management

fee and performance fee, withdrawal and redemption fees.

™ Check the pros and cons of long-term hedge funds vs. short-term
hedge funds.

™ Ensure your activities are that of an accredited investor (with a net

worth of more than $1 million).

™ Involve financial advisor in the process of investing in hedge funds

in India.

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Chapter: -

2 MAIN BODY OF THE PROJECT: 

17 
 
Hedge Funds 

2.1 THE ORIGIN OF HEDGE FUNDS:

The year was 1949, WWII just ended, and the world was in a unified
celebration. Alfred Winslow Jones, a sociologist, was working on
assignment for Fortune magazine investigating fundamental and technical
research on forecasting the stock market. The article reported on a new
class of stock market timers, in addition to unorthodox methods of
investing, all to achieve positive returns and call the market. Jones was
very intrigued by these trading methods and became absolutely consumed
with his own concept of an investment fund.

Prior to the release of his Fortune article, Jones setup an investment

fund with himself as general partner. The fund was designed as a market-
neutral strategy, whereby the long positions in undervalued equities would
be offset by short positions in others.

This “hedged” position would allow capital to be leveraged, while

also enabling large wagers to be made with limited resources. Another
genius feature was having an incentive fee amounting to 20% of any
realized profits or gains with no fixed fees.

However, Jones’ greatest notoriety stems from his innovation that

specific limited partnerships, if structured correctly, are exempt from
regulatory control under the Investment Company Act of 1940.

This exemption allows managers to utilize techniques, such as

leverage and short-selling which typically binds other mutual funds and

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investment companies. Consequently, many copy -cats mimicked the fee

structure, but not the “hedge” mentality and philosophy that Jones inspired.
It was not until another Fortune magazine article, in 1966, which branded
the market-neutral strategy that Jones’ designed as a “hedge fund”.

2.2 CHARACTERISTICS OF HEDGE FUNDS:

Although financial service providers, regulators and the media
commonly refer to “hedge funds,” the term has no precise legal or
universally accepted definition. The term generally identifies an entity that
holds a pool of securities and perhaps other assets that does not register its
securities offerings under the Securities Act and which is not registered as
an investment company under the Investment Company Act.

Hedge funds are also characterized by their fee structure, which

compensates the adviser based upon a percentage of the hedge fund’s
capital gains and capital appreciation. Hedge fund advisory personnel often
invest significant amounts of their own money into the hedge funds that
they manage.

Schneeweis, Spurgin and Karavas (2001) suggest that an allocation

of 10 to 20% to hedge funds optimally improves traditional portfolio
performance. The investment goals of hedge funds vary among funds, but
many hedge funds seek to achieve a positive, absolute return rather than
measuring their performance against a securities index or other benchmark.
“This does not mean however that all hedge funds have comparable
risk and return characteristics. In reality, there exists a variety of trading

19 
 
Hedge Funds 

strategies that determine the funds’ risk and return profiles. Improperly
included, an allocation to hedge funds can have disastrous consequences”
(Soueissy, M. & Sidani, R).
Hedge funds utilize a number of different investment styles and
strategies and invest in a wide variety of financial instruments. Hedge
funds invest in equity and fixed income securities, currencies, over-the-
counter derivatives, futures contracts and other assets.
Some hedge funds may take on substantial leverage, sell securities
short and employ certain hedging and arbitrage strategies. Hedge funds
typically engage one or more broker-dealers to provide a variety of
services, including trade clearance and settlement, financing and custody
services.
Hedge funds often provide markets and investors with substantial
benefits. For example, based on our observations, many hedge funds take
speculative, value-driven trading positions based on extensive research
about the value of a security. These positions can enhance liquidity and
contribute to market efficiency.
In addition, hedge funds offer investors an important risk
management tool by providing valuable portfolio diversification because
hedge fund returns in many cases are not correlated to the broader debt and
equity markets. On the other hand as Jeremy Siegel at Wharton Business
School(2005) pointed out that “there is a risk that many hedge funds
making similar bets could suffer bigger losses all at once ,damaging other
investors”.
 

20 
 
Hedge Funds 

2.3 Hedge Funds vs. Mutual Funds:

Hedge funds are institutional investors, just like mutual funds.
However, this is where the similarity ends. Typically, only high net worth
individuals and institutions invest in hedge funds, while mutual funds are
the main investment vehicle of the small and retail investors. Additionally,
mutual funds are highly regulated institutions that file a lot of information
like inflows and outflows, breakup of investments and other statutory
details with the regulatory authority.

Table 1: Hedge fund vs Mutual fund

Feature Mutual Fund Hedge Fund

Number of Few high net worth

Very large (in thousands)
owners individuals or institutions

Regulated strictly by the

Regulation Minimum regulation
capital markets regulator

Publishes annual reports

Information given only to
and monthly information
Transparency investors. Not accountable
sheets that show
to any other body
investment and profits

Invests in equity, debt and Follows many investment

Investment
derivatives, but follows a strategies, including going
Style
long strategy short on some securities
Fee not linked to
Fee linked to performance-
Management performance. Usually a
managers charge a high
Fees percentage of assets
percentage of profits made
managed

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Hedge Funds 

2.4 HOW THEY WORK: 

To achieve pre-set returns target, these funds do not restrict themselves to
their country of origin and operate on a global scale. Hedge fund managers
typically seek absolute positive investment performance. This means that,
the hedge funds target a specific range of performance, and attempt to
produce targeted returns irrespective of the stock market trends.

This is in contrast to investments by mutual funds, where success or

failure is often measured in terms of performance in relation to a stock
index, like the Sensex or Nifty in India.

Figure 1: How they Work

22 
 
Hedge Funds 

For investors, this structure-

1. Helps pool assets with those of other investors.

2. Is a way to access talented hedge fund managers

3. Is a method to access the alternative investment strategies used by the

manager.
To achieve this "absolute return", hedge fund managers have the
flexibility to incorporate different strategies and techniques that may
include:

Short-selling: Sale of a security that you do not own, with the anticipation
of purchasing it in the future, at a reduced cost.

Arbitrage: Simultaneous buying and selling of a financial instrument in

different markets to profit from the difference between the prices

Hedging: Buying/selling a security to offset a potential loss on an

investment.

Leverage: Borrowing money for investment purposes.

2.5 STRATEGIES OF HEDGE FUNDS:

Hedge funds do not constitute a homogeneous asset class. The bulk
of hedge funds describe themselves as long / short equity, perhaps because
this is the least specific of the available descriptions, but many different
approaches are used taking different exposures, exploiting different market

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Hedge Funds 

opportunities, using different techniques and different instruments: Hedge

funds use a wide variety of investment styles and strategies.

Even among hedge funds that claim to use the same investment
strategy or invest within the same asset class, there is a wide range of
investment activities, performance and risk levels. Because the investment
activities of hedge funds are so diverse, the hedge funds assigned to a
particular investment category are likely to exhibit less similarity than more
traditional investment vehicles, such as registered investment companies.

Although classification systems vary, hedge funds may generally be

classified according to broad style and strategy categories, including:

2.5.1 Market Trend (Directional/Tactical) Strategies:

Macro:

These funds may take positions in currencies (often unhedged) based

on their opinion of various countries' macroeconomic fundamentals.

For example, if a country's economic policies look inconsistent and

its ability to sustain its exchange rate appears questionable, macro funds
may take positions designed to profit from devaluation, usually by selling
the currency short.

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Hedge Funds 

Long/Short:

(includes sector and market neutral/relative value funds): These funds try
to exploit perceived anomalies in the prices of securities. For example, a
hedge fund may buy bonds that it believes to be under priced and sell short
bonds that it believes to be overpriced.

No matter what happens to overall interest rates, as long as the

spread between the two narrows, the fund profits. Conversely, if spreads
widen, gains can turn quickly into losses. Long/short equity is the most
frequently used strategy among hedge funds.

2.5.2 Event-Driven Strategies: 

Distressed Securities:

These funds may take long and/or short positions to attempt to profit from
pricing anomalies among securities issued by companies going through
bankruptcy or reorganization.

Risk/Merger Arbitrage:

These funds attempt to profit from pending merger transactions by, for
example, taking a long position in the stock of the company to be acquired
in a merger, leverage buyout or takeover and simultaneously taking a short
position in the stock of the acquiring company.

2.5.3 Arbitrage Strategies:

Convertible Arbitrage: This strategy involves taking long positions in a
company's convertible bonds, preferred stock, or warrants that are deemed

25 
 
Hedge Funds 

to be undervalued while taking short positions in the company's common

stock.

2.5.4 Fixed Income Arbitrage:

Hedge funds in this category seek to provide stable, positive returns by
exploiting the relatively small pricing inefficiencies of fixed income
instruments.

For example, a newly issued (“on the run”) 10-year Treasury bond
may trade at a slightly higher price than a similar previously issued (“off-
the-run”) 10-year Treasury bond. A hedge fund may seek to profit from
this disparity by purchasing off-the-run Treasuries and selling on-the-run
Treasuries short.

2.5.5 Statistical Arbitrage:

Funds in this category attempt to profit from pricing inefficiencies
identified through the use of mathematical models. Statistical arbitrage
attempts to profit from the likelihood that prices will trend toward a
historical norm.

2.6 HEDGE FUND INVESTMENT ACTIVITIES COMPARED TO

THOSE OF REGISTERED INVESTMENT COMPANIES:
As discussed, registered investment companies typically seek
positive returns compared to the performance of a particular asset class or
index (“benchmark”). Webster’s dictionary defines a benchmark as a
“standard or point of reference in measuring or judging quality, value etc”.

26 
 
Hedge Funds 

Thus, in a declining market, a registered investment company may

be considered successful even if it loses money, so long as the company
outperforms its benchmark (i.e., its relative return is positive). In a rising
market the registered investment company may be considered unsuccessful
if the company, though profitable, underperforms the benchmark (i.e., its
relative return is negative).

In brief, in the relative return paradigm, downside risk means the risk
of failing to perform as well as the benchmark. In contrast, a hedge fund
that utilizes an absolute return strategy may be considered successful only
if it is profitable in both rising and declining markets.

In the absolute return paradigm, downside risk means the risk of

failing to make money.

Registered investment companies generally have less flexibility to

change their investment objectives than do most hedge funds.

As a result, these funds provide investors with greater certainty of

the risks their advisers will take, but provide their advisers with a
diminished ability to take alternative investment approaches when market
conditions change.

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Hedge Funds 

2.7 LEVERAGE:

2.7.1 Background
Goldman Sachs (2000) extend their previous study to new data and
believe that hedge funds pursue a variety of investment strategies as well as
employ differing degrees of leverage. Leverage is an important component
of many hedge fund investment strategies.

Leverage can be defined in numerous ways. As a general matter,

however, leverage, can be viewed as a means of potentially increasing an
investment’s value or return without increasing the amount invested.

Although leverage historically was obtained primarily by purchasing

securities with borrowed money, today futures, options and other derivative
contracts may be a major source of leverage.

The use of leverage may have a significant impact on investment

results because, while it may enhance investment gains, it may also
magnify investment losses. Leverage also may increase the risk caused by
holding assets that are illiquid or whose full value cannot be realized in a
quick sale.

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2.7.2 Use of Leverage by Hedge Funds:

The degree to which a hedge fund uses leverage depends largely on
its investment strategy. Macro funds and funds that attempt to capitalize
on small inefficiencies in relative values (e.g., fixed income arbitrage and
statistical arbitrage) are more likely to engage in leverage and to take more
highly leveraged positions than are hedge funds that use other investment
strategies, such as investing in distressed securities situations.

A hedge fund’s limitation on its use of leverage is often dictated by

any margin or collateral requirements imposed on lenders or on others
(e.g., broker-dealers), and the willingness of lenders or other counterparties
to provide it with credit.

For example, a broker-dealer extending credit to a hedge fund in

connection with a short sale would have to comply with Regulation T
issued by the Board of Governors of the Federal Reserve System.

The hedge fund could also be required to provide additional

“maintenance margin” for transactions in short sales under margin
requirements imposed by self-regulatory organizations.

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2.7.3 Use of Leverage by Registered Investment Companies:

Although registered investment companies may use leverage and sell
short, their ability to use these tools is more limited than is the case with
hedge funds.

For example, the Investment Company Act generally allows open-

end investment companies to leverage themselves only by borrowing from
a bank, and provided that the borrowing is subject to 300 percent asset
coverage. Closed-end investment companies are subject to less restrictive
limits.

The Commission and staff have applied the Investment Company

Act provisions governing use of leverage to permit registered investment
companies to engage in certain transactions involving leverage (“senior
security transactions”), generally, however, only if the registered fund
“covers” the transaction by setting aside liquid assets in an amount equal
tothe potential liability or exposure created by the transaction.

A registered investment company’s board of directors has certain

responsibilities in connection with the company’s use of leverage, and
information about the characteristics and risks of permitted leverage
transactions must be disclosed to investors in fund prospectuses.

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2.7.4 SHORT SELLING:

A short sale is the sale of a security that the seller does not own or a
sale that is consummated by the delivery of a security borrowed by, or for
the account of, the seller. In order to deliver the security to the purchaser,
the short seller borrows the security, typically from a broker-dealer or an
institutional investor.

The short seller later closes out the position by returning the security
to the lender, typically by purchasing equivalent securities on the open
market, or by using an equivalent security that it already owns.

In general, short selling is utilized to profit from an expected

downward price movement, to provide liquidity in response to
unanticipated demand or to hedge the risk of a long position in the same or
a related security.

Short selling can provide the market with important benefits,

including market liquidity and pricing efficiency. Market liquidity is
provided through short selling by market professionals, such as market
makers (including specialists) and block petitioners, who offset temporary
imbalances in the supply and demand for securities.

Short sales affected in the market by securities professionals add to

the trading supply of stock available to purchasers and thus may reduce the
risk that the price paid by investors is artificially high.

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Short selling also can contribute to the pricing efficiency of the

markets. Efficient markets require that prices fully reflect all buy and sell
interest.

When a short seller speculates on or hedges against a downward

movement in a security, the transaction is a mirror image of the person’s
who purchases the security based upon speculation that the security’s price
will rise or in order to hedge against such an increase. The strategies
primarily differ in the sequence of transactions.

Market participants who believe a stock is overvalued may engage in

short sales in an attempt to profit from a perceived divergence of prices
from true economic values. Such short sellers add to stock pricing
efficiency because their transactions inform the market of their evaluation
of future stock price performance. This evaluation is reflected in the
resulting market price of the security.

Although short selling serves useful market purposes, it also may be used
to manipulate stock prices. One example is the “bear raid” where an equity
security is sold short in an effort to drive down the price of the security by
creating an imbalance of sell-side interest.

Unrestricted short selling can also exacerbate a declining market in a

security by eliminating bids and causing a further reduction in the price of
a security by creating an appearance that the price is falling for
fundamental reasons.

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2.8 PERFORMANCE IN A PORTFOLIO CONTEXT:

An important attribute of hedge funds which makes them even more
popular are its diversification benefits on addition in a traditional portfolio
of stocks and bonds. Among the studies which brought this out, Edwards
and Lien (1999) studied the diversification benefits of hedge funds and
managed futures funds and found them to enhance portfolio performance.

Purcell and Paul Crowley’s (1999) study too supports the

diversification advantage hedge funds provide as the inclusion increases
expected portfolio return by 200 basis points. A major plus point in a
portfolio context is that They too state that hedge funds have a low
correlation with all the other asset classes including the S&P 500.

The benefits of including hedge funds in plan sponsors’ portfolios is

also evident as shown by Goldman Sachs and Co. (1998) in terms of the
risk/return, correlation and other performance characteristics of four major
categories (Market Neutral or Relative Value, Event Driven, Long/Short
and Tactical Trading) of hedge funds.

Though the hedge funds are excellent diversifiers they are extremely
risky along another dimension: as the cross sectional variation and the
range of individual hedge fund returns are far greater than they are for
traditional asset classes, the investors in hedge funds face a substantial risk
of selecting a dismally performing fund or a failing one as pointed out by
Malkiel and Saha (2005).

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One can conclude here by saying that over concentration in any

particular fund produces improper risk for the manger which can be
reduced by limiting exposure to any one fund. Moreover tightening
restrictions shifts the efficient frontier downwards.

2.9 Literature Review of the Indian Capital Market:

2.9.1 INTRODUCTION:
Economics experts and various studies conducted across the globe
envisage India and China to rule the world in the 21st century.

For over a century the United States has been the largest economy in
the world but major developments have taken place in the world economy
since then, leading to the shift of focus from the US and the rich countries
of Europe to the two Asian giants- India and China.

The rich countries of Europe have seen the greatest decline in global
GDP share by 4.9 percentage points, followed by the US and Japan with a
decline of about 1 percentage point each.

Within Asia, the rising share of China and India has more than made
up the declining global share of Japan since 1990. During the seventies and
the eighties, ASEAN countries and during the eighties South Korea, along
with China and India, contributed to the rising share of Asia in world GDP.

According to some experts, the share of the US in world GDP is expected

to fall (from 21 per cent to 18 per cent) and that of India to rise (from 6 per

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cent to 11 per cent in 2025), and hence the latter will emerge as the third
pole in the global economy after the US and China. By 2025 the Indian
economy is projected to be about 60 per cent the size of the US economy.

The transformation into a tri-polar economy will be complete by

2035, with the Indian economy only a little smaller than the US economy
but larger than that of Western Europe.

By 2035, India is likely to be a larger growth driver than the six

largest countries in the EU, though its impact will be a little over half that
of the US. India, which is now the fourth largest economy in terms of
purchasing power parity, will overtake Japan and become third major
economic power within 10 years.

2.9.2 ISSUES AND PRIORTIES FOR INDIA:

As India prepares herself for becoming an economic superpower, it
must expedite socio-economic reforms and take steps for overcoming
institutional and infrastructure bottlenecks inherent in the system.
Availability of both physical and social infrastructure is central to
sustainable economic growth.

Since independence Indian economy has thrived hard for improving its
pace of development. Notably in the past few years the cities in India have
undergone tremendous infrastructure up gradation but the situation in not
similar in most part of rural India. Similarly in the realm of health and
education and other human development indicators India's performance has

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been far from satisfactory, showing a wide range of regional inequalities

with urban areas getting most of the benefits.

In order to attain the status that currently only a few countries in the
world enjoy and to provide a more egalitarian society to its mounting
population, appropriate measures need to be taken. Currently Indian
economy is facing these challenges:

ƒ Sustaining the growth momentum and achieving an annual average

growth of 7-8 % in the next five years.

ƒ Simplifying procedures and relaxing entry barriers for business

activities.

ƒ Checking the growth of population; India is the second highest

populated country in the world after China. However in terms of
density India exceeds China as India's land area is almost half of
China's total land. Due to a high population growth, GNI per capita
remains very poor. It was only $ 2880 in 2003 (World Bank figures).

ƒ Boosting agricultural growth through diversification and

development of agro processing.

Expanding industry fast, by at least 10% per year to integrate not only
the surplus labor in agriculture but also the unprecedented number of
women and teenagers joining the labor force every year.

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Developing world-class infrastructure for sustaining growth in all the

sectors of the economy. Allowing foreign investment in more areas
Effecting fiscal consolidation and eliminating the revenue deficit through
revenue enhancement and expenditure management..

Empowering the population through universal education and health

care. India needs to improve its HDI rank, as at 127 it is way below many
other developing countries' performance.

The UPA government is committed to furthering economic reforms and

developing basic infrastructure to improve lives of the rural poor and boost
economic performance.

Government had reduced its controls on foreign trade and investment in

some areas and has indicated more liberalization in civil aviation, telecom
and insurance sector in the future.

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2.9.3 SOME HIGHLIGHTS:

• India has more billionaires than China. This year there were 15
billionaires in China but last year in India, there were 20 billionaires,
according to the Forbes magazine.

• India has emerged as the world's fastest growing wealth creator,

thanks to a buoyant stock market and higher earnings.

• Ninan (2003) states that medium to long-term outlook for the Indian
stock is positive in the coming years.
• A number of Indian companies surpassed last year's net profit in just
six months of the current fiscal, reflecting an accelerated growth in
corporate earnings.

• Large funds from the US, Europe, Japan and other developed
countries continue to hedge their investments in markets like India
to improve returns (Shashikant, 2006).

Forty-four per cent of Top 100 Fortune 500 companies are present in
India.The economy has grown by 8.9 per cent for the April-July quarter of
'06-07, the highest first-quarter growth rate since '00-01 and is poised to
grow more than 9% this fiscal.

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Due to a global liquidity glut, the Indian equity market is soaring

along with the rest of the emerging markets. The Morgan Stanley Emerging
Market index, the benchmark used by most international fund managers,
gained 23.05% in the year to date (YTD) in 2005 while the MSCI India
index recorded one of the smartest rises ever gaining 24.54% YTD
(Lohade, 2005).

The Indian IT industry has been growing at a rapid rate with its
silicon city being named as the “back office of the world”. Further, the
government has been continuously promoting this sector as it has identified
it as one of the potential employment generators and foreign exchange
earner by making the labor laws more flexible in this labor-intensive sector
(Jagnani and Dagli, 2005).

Barua (2006) emphasizes that the Indian growth rate is likely to accelerate
in the long-term on back of few fundamentals.

First, infrastructure spending is increasing by leaps and bounds.

Second, India is experiencing a service industries boom due to arbitrage of

human intelligence. More and more people are recognizing the smart, hard
working Indian worker not only as cost saving but also as productivity
enhancing.

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Third, the availability of jobs through outsourcing is leading to higher

consumption that is also fuelled by expansion of retail credit and changing
demographics.

With positive indicators such as a stable 8-9 per cent annual growth,
rising foreign exchange reserves of close to US$ 180 billion, a booming
capital market with the popular "Sensex" index topping the majestic 14,000
mark, the Government estimating FDI flow of US$ 12 billion in this fiscal,
and a more than 35 per cent surge in exports, it is easy to understand why
India is a leading destination for foreign investment.

2.10 HISTORY OF INDIAN CAPITAL MARKETS:

The history of the Indian capital markets and the stock market, in
particular can be traced back to 1861 when the American Civil War began.
The opening of the Suez Canal during the 1860s led to a tremendous
increase in exports to the United Kingdom and United States.

Several companies were formed during this period and many banks
came to the fore to handle the finances relating to these trades. With many
of these registered under the British Companies Act, the Stock Exchange,
Mumbai, came into existence in 1875.

It was an unincorporated body of stockbrokers, which started doing

business in the city under a banyan tree. Business was essentially confined

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to company owners and brokers, with very little interest evinced by the
general public. There had been much fluctuation in the stock market on
account of the American war and the battles in Europe.

The planning process started in India in 1951, with importance being

given to the formation of institutions and markets The Securities Contract
Regulation Act 1956 became the parent regulation after the Indian Contract
Act 1872, a basic law to be followed by security markets in India.

The stock markets have had many turbulent times in the last 140
years of their existence. The imposition of wealth and expenditure tax in
1957 by Mr. T.T. Krishnamachari, the then finance minister, led to a huge
fall in the markets. War with China in 1962 was another memorably bad
year, with the resultant shortages increasing prices all round.

This led to a ban on forward trading in commodity markets in 1966,

which was again a very bad period, together with the introduction of the
Gold Control Act in 1963. The markets have witnessed several golden
times too. Retail investors began participating in the stock markets in a
small way with the dilution of the FERA in 1978.

The next big boom and mass participation by retail investors

happened in 1980, with the entry of Mr. Dhirubhai Ambani. Dhirubhai can
be said to be the father of modern capital markets.

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The Reliance public issue and subsequent issues on various Reliance

companies generated huge interest. The general public was so unfamiliar
with share certificates that Dhirubhai is rumored to have distributed them
to educate people.

Mr. V.P. Singh’s fiscal budget in 1984 was path breaking for it
started the era of liberalization. The removal of estate duty and reduction of
taxes led to a swell in the new issue market and there was a deluge of
companies in 1985.

Mr. Manmohan Singh as Finance Minister came with a reform

agenda in 1991and this led to a resurgence of interest in the capital
markets, only to be punctured by the Harshad Mehta scam in 1992.

The end-1990s saw the emergence of Ketan Parekh and the

information; communication and entertainment companies came into the
limelight. This period also coincided with the dotcom bubble in the US,
with software companies being the most favored stocks.

There was a meltdown in software stock in early 2000. Mr. P

Chidambaram continued the liberalization and reform process, opening up
of the companies, lifting taxes on long-term gains and introducing short-
term turnover tax. The markets have recovered since then and we have
witnessed a sustained rally that has taken the index over 13000.

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Chhabria (2006) states that the good thing about the Indian market,
riding on the back of an economy that has grown by over 7 per cent in the
last two years, is that investors can't miss being part of the growth if they
invest in the Indian stock markets carefully.

On an average 70% of Indian population of below 35 yrs present a

rosy picture with a lot of money to be spent. It is estimated that every
month around Rs.50-60 crore flows into the capital markets in the way of
SIP and some other instruments which helps in increasing the market
capitalization.

The surge in SENSEX and NIFTY, the benchmark indices of Indian

stock market is also attracting many retail investors to look for more
returns there by directly increasing their investments in stocks.

There are many equity analysts who assert Indian capital markets to
achieve quantum leaps in the future. Based on technical analysis using
Glen Neely’s Neowave Theory, Karandikar (2005) predicts the Sensex to
be between 18000- 40000 till 2010.

He emphasized that the Sensex would have to grow earnings at a

compounded annual growth rate (CAGR) of 17% to get to 18000 in five
years and at 36% to get to 40000. Further, other analysts like Jhunjhunwala
(2002), Jhunjhunwala (2006) and Barua et al (2006) advocated that
investing in the Indian equity market would give attractive returns over the
long run backed by strong fundamentals..

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Moreover, Krishnamurthy (2004) studied that Indian stocks offer

extraordinary high sustainable returns and are expected to maintain this
trend.

Recently a study conducted by the Economic Times Investor’s Guide

consisted of over 1300 Indian companies listed on the Indian stock
exchange.

The net profits for the sample had grown 37% over the first quarter
of the year 2006 (Q1FY07). This appeared way above market expectations,
which were in the 15-20% range for financial year 2007 as a whole. It was
concluded that corporate India surprised the market with its strong growth
in the first quarter of financial year 2007.

It was also observed that the growth momentum was as broad-based

as ever in this rally and not that only a handful of companies were
contributing to net profits (Economic Times, 2006).

On the contrary Varadarajan (2000) argues that share prices of the

Indian stocks are overvalued which would eventually lead to a downfall in
the share prices. He uses two indicators to determine whether current share
prices are overvalued: the price-to-earnings ratio of stocks and the spread
between the yield on bonds and shares.

He argues that such a correction has been on the cards for quite some
time now; the only element missing is a proximate trigger which would

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sooner or later burst the share bubble. JP Morgan identifies levels of

uncertainties that are generating volatility in the Indian equity market and
suggest that India should correct by 4-5% for the markets to look attractive
in the future years (www.moneycontrol.com)

In addition, Zore and Sen (2006) analyze that both globally as well as
in India there are a lot of issues that cause concern. The global interest rate
scenario will slacken the growth of the Indian economy to a great extent.

2.11 DIFFERENT PLAYERS IN INDIAN CAPITAL MARKETS:

2.11.1 MUTUAL FUNDS

Mutual fund is a form of collective investment that pools money
from many investors and invests their money in stocks, bonds, dividends,
short-term money market instruments, and/or other securities. In a mutual
fund, the fund
manager trades the
fund's underlying
securities, realizing
capital gains or
losses, and collects
the dividend or
interest income. The
investment proceeds
are then passed
Figure 2: Working of Mutual  Fund

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along to the individual investors. The value of a share of the mutual fund,
known as the net asset value per share (NAV), is calculated daily based on
the total value of the fund divided by the number of shares currently issued
and outstanding. The flow chart below describes broadly the working of a
mutual fund.

2.11.2 History: -

The origin of mutual fund industry in India is with the introduction

of the concept of mutual fund by UTI in the year 1963. Though the growth
was slow, but it accelerated from the year 1987 when non-UTI players
entered the industry.

In the past decade, Indian mutual fund industry had seen dramatic
improvements, both quality wise as well as quantity wise. Before, the
monopoly of the market had seen an ending phase; the Assets Under
Management (AUM) was Rs. 67bn.

The private sector entry to the fund family rose the AUM to Rs. 470
bn in March 1993 and till April 2004, it reached the height of 1,540 bn.
Putting the AUM of the Indian Mutual Funds Industry into comparison, the
total of it is less than the deposits of SBI alone, constitute less than 11% of
the total deposits held by the Indian banking industry.

The main reason of its poor growth is that the mutual fund industry
in India is new in the country. Large sections of Indian investors are yet to

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be familiarized with the concept. Hence, it is the prime responsibility of all

mutual fund companies, to market the product correctly abreast of selling.

2.11.3 FOREIGN INSTITUTIONAL INVESTOR:

Foreign Institutional Investor [FII] is used to denote an investor -

mostly of the form of an institution or entity, which invests money in the
financial markets of a country different from the one where in the
institution or entity was originally incorporated.

An investor or investment fund that is from or registered in a country

outside of the one in which it is currently investing. Institutional investors
include hedge funds, insurance companies, pension funds and mutual
funds.

The term is used most commonly in India to refer to outside

companies investing in the financial markets of India. International
institutional investors must register with the Securities and Exchange
Board of India to participate in the market. One of the major market
regulations pertaining to FIIs involves placing limits on FII ownership in
Indian companies.

FII investment is frequently referred to as hot money for the reason

that it can leave the country at the same speed at which it comes in.

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India opened its stock markets to foreign investors in September 1992 and
has, since 1993, received considerable amount of portfolio investment from
foreigners in the form of Foreign Institutional Investor’s (FII) investment in
equities.

This has become one of the main channels of international portfolio

investment in India for foreigners13. In order to trade in Indian equity
markets, foreign corporations need to register with the SEBI as Foreign
Institutional Investors (FII). SEBI’s definition of FIIs presently includes
foreign pension funds, mutual funds etc.

The trickle of FII flows to India that began in January 1993 has
gradually expanded to an average monthly inflow of close to Rs. 1900
crores during the first six months of 2001. By June 2001, over 500 FIIs
were registered with SEBI.

The total amount of FII investment in India had accumulated to a

formidable sum of over Rs.50,000 crores during this time . In terms of
market capitalization too, the share of FIIs has steadily climbed to about
9% of the total market capitalization of BSE (which, in turn, accounts for
over 90% of the total market capitalization in India).

The sources of these FII flows are varied. The FIIs registered with
SEBI come from as many as 28 countries (including money management
companies operating in India on behalf of foreign investors). US-based
institutions accounted for slightly over 41%, those from the UK constitute

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about 20% with other Western European countries hosting another 17% of
the FIIs that these national affiliations do not necessarily mean that the
actual investor funds come from these particular countries.

Given the significant financial flows among the industrial countries,

national affiliations are very rough indicators of the ‘home’ of the FII
investments. In particular institutions operating from Luxembourg,
Cayman Islands or Channel Islands, or even those based at Singapore or
Hong Kong are likely to be investing funds largely on behalf of residents in
other countries.

2.11.4 RETAIL INVESTORS:

Retail investors according to SEBI rules are those investors whose

investment corpus is not more than Rs. 1 lakh. In India, retail investors play
a very small role in capital markets. This is mainly due to the risk aversion.

The retail investors are mainly concentrated in four metros and

Ahmedabad. Ahmedabad has major chunk of retail investors who are very
much active in the stock investors.

But slowly this scenario is changing with the increase in the number
of Demat accounts through which these investors mainly invest. Slowly the
retail investors’ confidence has increased in the Indian Stock markets.

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Their total share in the market capitalization is around 3%which is

very much less compared to that of USA where it is around 20-25%. But
with Indian capital markets gaining popularity, there is high scope that the
participation of retail investors will gradually increase.

2.12 HEDGE FUNDS IN ASIA:

Though Hedge funds seek absolute return strategies, but due to the
herding mentality the returns are getting diminished. And some of the
major debacles of Hedge funds like the AMARANTH Advisors LLC and
LONG TERM CAPITAL MANAGEMENT LLC forced the hedge funds to
look into some greener pastures like Asia where the market is in premature
stage. Hedge funds started investing in Asian markets after the Tech
Bubble which forced many hedge funds to liquidate their net positions.

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, Japan’s Government Pension Fund one of the world’s

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.

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From an investment perspective, the volatility in the Asian markets

in recent years has allowed long-short and other strategic players to out
perform 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.

2.13 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 securitized 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

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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.

2.14 HEDGE FUNDS IN INDIA:

With the notification of SEBI (Mutual Fund) Regulations 1993, the
asset management business under private sector took its root in India. In
the same year SEBI, also notified Regulations and Rules governing
Portfolio Managers who pursuant to a contract or arrangement with clients,
advise clients or undertake the management of portfolio of securities or
funds of the client.

Recently, RBI through liberalized remittance scheme, allowed

resident individuals to remit up to US $ 25,000 per year for any current or
capital account transaction. The liberalized scheme will allow Indian
individual investors to explore the possibility of investing in offshore
financial products.

Considering the existing limit being only US $ 25,000 per year,

Indian market may not be attractive to hedge fund product marketing. As
long as there will be restriction on capital account Convertibility, foreign

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hedge funds, by virtue of their minimum investment limit being $ 100,000

or higher, do not seem to be excited to access investment from Indian
investors in India.

Some hedge funds have invested in offshore derivative instruments

(PNs) issued by FIIs against underlying Indian securities. Through this
route hedge funs can derive economic benefit of investing in Indian
securities without directly entering the Indian market as FIIs or their sub-
accounts.

Through recent amendments to the FII Regulations (Regulation 15A

and 20 A), the regulatory regime has been further strengthened and
periodic disclosures regime has been introduced.

As at the end of March, 2004, total investment by hedge funds. In

the offshore derivative instruments (PNs) against Indian equity, are Rs.
8050 crores which represent about 8% total net equity investments of all
FIIs.

On the basis of market value, the hedge funds account for about 5%
of the market value of the total assets held by the FIIs in India. The fiscal
year (2003-2004) has seen a spectacular increase in FII activities in Indian
market. Till this report is filed FIIs have already invested US $ 10 bn.
during this year alone which is a record.

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Robust economic fundamentals, strong corporate earnings and

improvement in market micro structure are driving the FII interest in India.
Investors all over the world are keen to come to Indian market.

From informal discussions with institutional investors including

some reputed and well established hedge funds, one could gauge the extent
of interest they have about Indian markets.

From informal discussions with institutional investors including

some reputed and well established hedge funds, one could gauge the extent
of interest they have about Indian markets.

During the discussions they have requested whether India, like other
Asian emerging markets, can provide a regulatory framework that will
allow them to directly invest in Indian market in a transparent manner.

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2.15 PARTICIPATORY NOTES:

Participatory notes are instruments used by foreign funds / investors

who are not registered with the SEBI but are interested in taking exposure
in Indian securities.

Participatory notes are generally issued overseas by the associates of

India-based foreign brokerages. Brokers buy or sell securities on behalf of
their clients on their proprietary account and issue such notes in favor of
such foreign investors.

Participatory Notes are simple derivative instruments that investors

not registered in India or Mauritius use to trade in Indian markets. These
investors place their order through brokerage houses that have Mauritius-
based FII accounts.

The brokerage houses then repatriate the dividends and capital gains back
to these entities. In this case, the broker acts like an exchange: it executes
the trade and uses its internal accounts to settle the trade. They keep the
investor’s name anonymous. That is why capital market regulators dislike
P-notes.

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2.16 WHY HEDGE FUNDS ARE LOOKING AT INDIA:

Unlike China, where stock markets are not well developed and
company information is relatively opaque, experts note that India has much
of the necessary institutional framework for hedging, including a regulatory
regime and good information disclosure standards.

"Investors look at multiple markets around the world," says Marti G.

Subrahmanyam, a professor of finance at New York University's Stern
School of Business. "There is a sense that the changes taking place in India
are going to result in superior performance in the economy, and that the
corporate sector will be a big beneficiary.

Now, obviously the Chinese economy is larger, but the capital

markets are better developed in India. If you look at the stock market, even
if you were to include Hong Kong, the market cap in China relative to its
GDP is lower. So if you're looking for investment opportunities where you
won't suffer the consequences of illiquidity, India is the more attractive
opportunity."

In addition, notes Subrahmanyam (2002), India is the largest market

for single stock futures in the world and has a well developed derivatives
market in index futures and options."This gives you hedging possibilities
not available in other emerging markets," he says. There is also enough
liquidity in the big stocks for [domestic] investors to sell short. Even
though there are restrictions, these are less binding than in other emerging
markets.

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2.17 ADVANTAGE INDIA:

Since hedge funds are investors shrouded in mystery, they are made
scapegoats whenever there is a crisis of some sort in the market. Kamdar
(2004) concurs and says, "The only matter that I find worrisome is that
most of the time, without any substantial evidences the world over, any
crisis in stick market is conveniently attributed to hedge funds. This was
one of the causes stated by market participants for the May 17, 2004
downfall of 15% in the stock price."

   Hedge  funds  also  bring  in  the  much  welcome  volumes,  and  thus, 
liquidity  in  the  market.  Moreover,  as  all  market  experts  will  concede, 
market liquidity  leads to better price discovery  in  the market. Now, with 
the transaction tax levied on trades carried out in the stock market, these 
increased volumes will also lead to revenue for the government.   

  

2.18 THE RISKS ASSOCIATED WITH HEDGE FUNDS:

Although hedge fund strategies vary significantly, they project a
general set of risk factors to the markets they invest in. According to the
authors of Sound Practices for Hedge Fund Managers (2000), the three
quantifiable risks, market risk, credit risk and liquidity risk are interrelated
and as such should be studied separately as well as together, i.e. their
overlap should be properly identified and evaluated.

Furthermore, the effect of leverage on all three key risk factors

should also be properly assessed, as insolvency risk becomes a vital point.

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Botteron and Villager(Risk Management Overview 2002) go further and

divide the risk universe into exogenous intertwining risks, common to all
markets, which include market, credit and liquidity risks, and endogenous
risks, addressed by internal measures and regular due diligence, including
operational and model risks.

Figure 3 : Risk Galaxy 

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Hedge Funds 

Source: - The Risks Underlying Hedge Funds Strategies.

One of the major sources of risk by Hedge funds investment is

Market Risk. Due to global macroeconomic perspectives their can be an
event of market sudden slump. And the herding mentality of the Hedge
Funds adds to this slump by continuously withdrawing money from the
markets.

This leads to the devaluation of the fund’s NAV and also culminates
into shareholder value depreciation. Mostly interest rates, bond yields and
the security prices are inter-related. So a small slump in one market leads to
an adverse effect in other markets also.

2.18.1 MARKET RISK: COMPONENTS:

• Interest rate risk: This risk is mostly the impact of fixed income
instruments; when interest rates go up, bond prices go down. The
strategy of Fixed income instruments is to invest in corporate bonds
and government bonds, so as to get risk free rate of return. The bond
yields depends a lot on the Interest rate prevailing and also inflation
figures.

Figure 4: market risk 

Figure 5: Internal Rate return 

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The spread between long-term interest rates and short-term interest rates
reflects, for example, the degree of inflation risk. When anxiety is high
regarding inflation, the spread widens as investors demand higher long-
term rates as compensation.

Hedge funds known as Hot Money, if they sense in any risk in near
future they exit the market. But due to the huge investments and huge
leveraged positions it carries out results in turmoil in the bond market.

The 1994 Bond market is a classical example to show the effect of

this kind of investment strategy.

2.18.2 EQUITY RISK:

This includes delta risk and volatility risk

Delta tells how sensitive the option is to changes in the

underlying stock price. A position with a delta of zero is called delta
neutral or delta hedged. Rebalancing or periodic adjustment is necessary to

keep a position delta hedged as delta changes all the time. This provides

Figure 6: Equity risk

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protection against small stock price movements. However, for larger

movements, gamma1 neutrality is required.

Here we can point out that India is known for single largest futures
and options in the world and Futures & Options price directly impacts the
underlying price of that particular script or commodity. This is also one of
the impacts on the Indian Capital Market.

2.18.3 Volatility risk:

There are two main causes for stock market volatility: the random arrival of
new information about a stock’s future returns and the level of trading
activity (Hull 1999).

The Greek letter Vega measures the impact of the change in

volatility on the value of an option. When Vega is high, the option is very
sensitive to small changes in stock price volatility. Vega neutrality protects
from such situations.

Gamma is the first derivative of delta; it measures the delta

sensitivity to changes in the underlying stock price. The larger the gamma,
the more sensitive is the delta to stock price changes and the more frequent
the required rebalancing.

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2.18.4 CORRELATION RISK:

It measures the degree to which two series of returns move up or
down together. For example the correlation between the stock prices
and their derivative instruments.

Correlation between different industries like the construction and

steel and cement industry. There is also reverse correlation between
stock prices plummeted and bond markets rose and vice-versa (Jaeger,
R. 2000).

2.18.5 COMMODITY RISK:

“This risk arises from the sudden change in the price of
commodities. This is particular to Managed Futures. Just like equities,
commodities are subject to delta and volatility risks. When the market
environment changes, the price of commodities fluctuates”.

Figure 7: Commodity risk 

Delta “tells us how responsive the option is to changes in the

underlying commodity price. Rebalancing or periodic adjustment is
necessary to keep a position delta hedged as delta changes all the time”.
Due to alternative positions of hedging the volatility of the derivative
prices increases. In order to get absolute gains, Hedge Funds try to increase

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bets on one position and keep on adding to that net position. Amaranth
LLC is the best example to suit this type of risk.

Amaranth LLC kept on playing on the derivative options of Feb &

Mar Crude futures. Due to huge leverage positions build up in these two
futures, the losses kept on accumulated. Due to huge losses the fund has to
be liquidated there by impacting to a great extent the futures price of the
crude.

2.18.6 CURRENCY RISK:

“This risk arises from the sudden change in the foreign exchange. This
is particular to Managed Futures”. The strategy of managed futures is to get
money out of the arbitrage of currency fluctuations. Hedge Funds are not
long-term players and they invest for a short period of time. So this Hot
money may try to capitalize the currency fluctuations that happen
regularly.

East Asian crisis and the recent Yuan Carry of trade phenomenon can
be attributed to this type of Managed Futures trading strategy of Hedge
Funds.

The impact of the East Asian crisis which materialized in the middle of
1997, and the subsequent turbulence that swept the world’s 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

64 
 
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wrought on emerging market economies, but also in terms of drawing the

world’s attention to outstanding issues concerning the structure, operation
and regulation of the international financial system.

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. This led to the Asian Financial
Crisis.

2.18.7 CREDIT RISK:

“This refers to the risk of downgrades (and possibly default) in the

credit quality of the fund’s investments or that of counterparties dealing
with the fund”. This type of risk becomes critical while handling
derivatives. When investors perceive a high credit risk, they demand a
higher yield on the money they lend and vice-versa.

Indian markets follow the system of Mark-to-Market settlement. But

this system is not exercised in case of private players who take a large
leverage positions. Due to the large leverage position builds up and due to
the increase in volatility of the prices of derivative instruments this type of
risk arises.

The mayhem created in the stock markets in May 2006 can be

attributed to the credit risk arising of the Distressed securities and
Convertible arbitrage strategies.

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The index was down by 10% on a single day because of the margin
system problems. In May – 2006 there was news going around that some
FII’s were banned to invest in Indian markets and also the capital gains that
are earned by the way of investment in Indian markets will be treated as
Business income.

Due to this their was a slump in the market to a certain extent. But
due to the drop in prices their was a call by many players to withdrew from
the market.

Due to this selling many big investors suffered and to cut down the
losses and pay the margin money their was an across the board selling.
Thus if big and hot money like Hedge Funds leads to this type of margin
pressures there could be a bigger slump and increased volatility in the stock
prices.

2.18.8 LIQUIDITY RISK:

Liquidity risk is defined “as the decline in a fund’s liquidity leading

to devaluation in its NAV or a decline in its ability to fund its investment”.
It can be further subdivided into three risks. The First one is related to short
selling activity; a manager might be forced to repurchase a borrowed asset
due to an adverse market condition.

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The second risk affects the cash reserves of a fund, as it may have to
redeem part of its debt obligations or pay margin calls. The third risk is
faced when investors seek to redeem their shares in the fund creating a
mismatch in the assets and liabilities of the fund (Botteron and Villiger
2002).

Liquidity is one of the main problems in the Indian Stock markets.

The main players in the Indian markets are FIIs, Mutual Funds and
Promoters and to a small extent retail investors. Liquidity problem is the
main problem facing FIIs.

Till now FIIs have invested around $22 bn in Indian markets till the
end of 2006. But they can’t liquidate their positions because of the huge
chunk of stocks they own. Unfortunately for them, even after investing
more than $20 billion in the Indian markets, they are unable to sell beyond
Rs 20 crore to 75 crore in a day.

The reason is simple: they don’t have any buyers from the Indian
side. The only option for FIIs is to trade among themselves. If they don’t
trade among themselves and try to sell aggressively, they cannot exit from
the market in the first instance. There is also the danger that they may lose
value of their investments if they sell in a big way.

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2.18.9 OPERATIONAL RISK:

Figure 8: Operational Risk 

It encompasses human risk, or human error and internal fraud, model

risk, physical events such as destruction by fire or other catastrophes, and
external risk, for example external fraud.

2.18.10 MODEL RISK:

It occurs due to the incorrect valuation of an investment opportunity
by a financial instrument. Sophisticated software has been heavily relied
upon in the past and will continue to do so and erroneous results could
jeopardize a whole strategy.

The simplest example would be an out dated model that is no longer

reliable to correctly evaluate present new market conditions. It is worthy to
mention here executive risk arising from an error in hedging against
currency risk, due both to managers and/or technology.

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Indeed, all funds that are faced with foreign exchange issues try to
put in place effective hedging techniques using futures, forwards and other
swap instruments; sometimes, they fail and losses arise.

2.18.11 HUMAN RISK:

• Inappropriate fund allocation: manager choosing to allocate funds
into the wrong sector, strategy or instruments and as a result harming
returns.

• Style drift manager changes direction from the proclaimed style (and
area of expertise) of the fund to seek better long term or short term
(bets) opportunities elsewhere and consequently changes the
risk/return profile, while failing to inform investors.
 

• For example, in 1995, Fenchurch Capital Management, a fixed

income arbitrage fund switched from U.S. bond basis trading and
U.S. yield curve arbitrage to European bonds and equities, an area
virtually unknown to its managers causing large undeclared losses.

• Fraud: can range from reporting false performance figures to

downright theft of the money to be managed.

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Hedge Funds 

For example, in 2000, Cambridge Partners LLC, a long/short equity

fund, was caught falsifying audits, tax documents and monthly statements
and overstating performance. The fund pleaded guilty to securities fraud,
theft and misappropriation of property.

2.19 RESEARCH DESIGN:

2.19.1 INTRODUCTION:

This chapter will provide a plan of the study which should include
statement of the problem, objectives, scope of the study/significance of the
Dissertation, methodology, sample design, sources of data, tools and
techniques for data collection, plan of analysis, limitations.

2.19.2 RESEARCH METHODS:

a) Type of Study: In the study carried out the exact problem is not
known. The study has been done to get an insight into the Hedge Funds and
their investment strategies, so as to make an analytical study about their
impact on Indian Capital markets. Hence, the research type is Exploratory.

b) Type of data: The type of data collected is mainly secondary

data.

c) Technique of Analysis :First the a the relationship between the

key Index and the Hedge Fund inflows is established so as to justify
whether there is any impact of Hedge Funds is their in Indian capital
markets.

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After the relationship is established, a detailed analysis of the hedge

fund strategies of investment is done. Also an analytical study of Hedge
funds impact on Indian Capital markets is done based on individual
investment strategy.

2.19.3  RESEARCH DESIGN:

A research design lays the base for conducting the project and
ensures that the research plan is conducted efficiently and effectively. This
research has been undertaken to explore the possible impacts of hedge
funds on the Indian Capital Market. For this as discussed earlier
Quantitative research is adopted in which certain statistical techniques are
utilized.

The Statistical techniques used to analyze the data are CHI-

SQUARE and COEFFICIENT OF CORRELATION.

2.19.4 STATEMENT OF THE PROBLEM:

In view of the increasing popularity among the Hedge funds as well
as their increasing interest in the Indian market, this dissertation tries to
unravel the myth behind the working of Hedge Funds.

This study is to elucidate the different strategies of Hedge Fund

managers and their possible impact on Indian Capital markets and to
understand how hedge funds are beneficial.

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2.19.5 LIMITATIONS OF THE STUDY:

Problems of Inflation: Huge amounts of FII fund inflow into the

country create a lot of demand of rupee & the RBI pumps the amount of
rupee in the market as a result of demand created.

Problems of small investors: The FII profit from investing in

emerging financial stock market. If the cap is High they can bring a huge
amounts of funds in country’s stock market & is influence in stock market
is going up or down.

Adverse impacts on exports: F II flow leading to appreciation of

the currency may lead to the exports.

Hot money: “ Hot Money” refers to the that are controlled by

investors who actually seeks short term return. These investors scan the
market for short term, high interest rate investment opportunities.

“Hot money” can have economic & financial repercussions of

countries & bank. When money is injected in the country, the exchange
rate for the country gaining the money strengthens, where the exchange
rate of the country losing the money weakens. If the money is withdrawn
on the short term notice, the banking instution will experience a shortage of
funds.

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Chapter : -

3 ANALYSIS & INTERPRETATION 

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Hedge Funds 

This study entitled “HEDGE FUNDS AND THEIR POSSIBLE

IMPACT ON INDIAN CAPITAL MARKETS “was carried out to
address the problem related to study whether their would be any possible
impact on Indian markets if Hedge Funds were allowed freely to invest in
India rather than through indirect routes like Participatory Notes.

The objectives of this study were to study the Hedge Fund

investment strategies, as these investment vehicles are dreaded in many
countries. After doing a detailed study of the strategies, an analytical
framework is done whether there is any potential for Hedge Funds in India
and also to study the possible impact of Hedge Funds on the Indian
Financial Markets.

Towards this, first a relationship between the key Index (SENSEX)

and the Hedge Fund inflows is established so as to justify whether there is
any impact of Hedge Funds in the Indian capital markets. After the
relationship is established, a small study on the relationship between the
key Hedge Fund indices and the corresponding Strategy Index is taken to
establish whether the Hedge Fund strategies has any direct relationship to
four biggest crisis in the Financial World.

The four crises taken for study are:

1) 1994 Bond Crisis
2) 1997 Thai Crisis
3) 1998 Russian Crisis
4) 2000 TMT Crisis

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Hedge Funds 

After the relationship is established, a detailed analysis of the hedge

fund strategies of investment is done.

Also an analytical study of Hedge funds impact on Indian Capital

markets is done based on individual investment strategy.

3.1 CORRELATION BETWEEN HEDGE FUND INFLOWS AND

SENSEX RETURNS:  
For establishing the relationship between SENSEX and Hedge Fund
inflows, the inflows of Hedge Funds into Indian markets is taken from
2003 onwards till April, 2007. The data from 2003 is taken because, after
in 2003 free regulations regarding FII were introduced.

ESTABLISHING RELATIONSHIP: HYPOTHESIS TESTING

To establish a relationship between the Sensex and the Hedge Fund

Inflows a Chi Square Test is done.

Let, Null HYPOTHESIS(H0): Then there is No significant

relationship between hedge fund flows & Sensex Returns

Let,Alternative HYPOTHESIS(Ha): Then there is significant

difference between Hedge Fund Flows & Sensex Returns

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Hedge Funds 

Tables showing the flow of Hedge Funds from 2003 and SENSEX
return for the corresponding year:

Table 2 : Flow of Hedge Funds from 2003 and SENSEX return for the
corresponding year
2003 HF INFLOWS SENSEX RETURN
(In Million Rs) (%)
Jan 115.20 -3.76
Feb 80.40 1.02
Mar -14.40 -7.15
April 2.40 -2.92
May 65.20 7.47
June 201.2 13.41
July 300.80 5.14
Aug 192.00 11.92
Sep 383.20 4.91
Oct 616.40 10.19
Nov 300.8 2.81
Dec 633.20 15.74

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Using Bar diagram for the year 2003:

700
633.2
616.4
600

500

400 383.2

300.8 300.8
300

201.2 192
200

115.2
100 80.4
65.2

2.4 7.47 13.41 5.14 11.92 4.91 10.19 2.81 15.74

1.02
0
‐3.76
JAN FEB ‐7.15
MAR
‐14.4 ‐2.92
APR MAY JUN JUL AUG SEPT OCT NOV DEC
‐100 HF INFLOWS SENSEX RETURNS

Figure 9: Bar Daigram 2003 

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Testing the correlation:

Table 3: Hedge funds inflow & sensex return for the year Apr 03 to Apr 04

Hedge fund inflow & sensex return of financial year April 03 to March 04:
Year X Y X=(x-x) Y=(y- X2 Y2 XY
y)
Apr 2.40 -2.92 -309.63 -8.28 95870.74 68.56 2563.74
May 65.20 7.47 -246.83 2.11 60925.05 4.45 -520.81
Jun 201.20 13.41 -110.83 8.05 12283.29 64.80 -892.18
Jul 300.80 5.14 -11.23 -0.22 126.11 0.05 2.47
Aug 192 11.92 -120.03 6.56 14407.20 0.31 -787.40
Sep 383.20 4.91 71.17 -0.45 5065.17 0.20 -32.03
Oct 616.40 10.19 304.17 4.83 92519.39 23.32 1469.14
Nov 300.80 2.81 -11.23 -2.55 126.11 6.50 28.67
Dec 633.20 15.74 321.17 10.38 103150.17 107.74 3333.74
Jan 172.80 -2.45 139.23 -7.81 19385 61 1087.38
Feb 285.60 -0.49 -26.43 -5.85 698.55 34.22 154.61
Mar 320.60 -1.36 8.77 -6.72 76.91 45.16 -58.923
∑X=3744.4 ∑Y=64. - - ∑X2= ∑Y2 = ∑ XY=
37 404633.69 416.34 6348.37
45
X = ∑X\n = 3744.40\12 = 312.03

Y= ∑Y\n = 64.37\12 = 5.36

Finding the correlation(r): ∑ XY\√∑X2 * ∑Y2

= 6348.3751\ √404633.69 * 416.3145

= 0.4891.

Testing the above data by applying correlation. As the correlation co-

efficient is 0.4891.

So, the Variables, Hedge Funds & Sensex return are partial positive with
each other.

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Hedge funds inflow & sensex return% of the year 2004:

Table 4: Hedge funds inflow & sensex return for the year 2004

2004 HF INFLOWS SENSEX

(In Million Rs) RETURN (%)
Jan 172.80 -2.45
Feb 285.60 -0.49
Mar 320.80 -1.36
April 253.60 1.15
May -268.00 -15.83
June -20.00 0.75
July 11.20 7.82
Aug 242.00 0.42
Sep 193.20 7.54
Oct 117.60 1.59
Nov 574.42 9.91
Dec 506.63 5.91
 

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Using Bar diagram, to show the year 2004:

700
600
500
400
300
200 HF Inflows
100 Sensex return
0
‐100 JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC
‐200
‐300
‐400

Figure 10: Bar Daigram 2004

Testing the correlation :Hedge fund inflow & sensex return% of financial
year April 2004 to March 2005:

Table 5: Hedge funds inflow & sensex return for the financial year Apr 04 to Mar 05

2004 X Y X=(x- Y=(y- X2 Y2 XY

x) y)
Apr 253.60 1.55 -155.93 -0.3 24314 0.09 46.78
May -268 15.83 -677.53 -17.28 459047 298 11707.72
Jun -20 0.75 -429.53 -0.70 184496 0.49 300.67
Jul 11.20 7.82 -398.33 6.37 158667 40.6 -2537.36
Aug 242 0.42 -167.53 -1.03 28066 1.06 172.56
Sep 193.20 7.54 -216.33 6.09 46799 37 -1317.45
Oct 117.60 1.59 -291.93 0.14 85223 0.02 -40.87
Nov 574.42 9.91 164.89 8.46 27189 72 1394.97
Dec 506.63 5.91 97.10 4.46 9428 20 433.07
Jan 49.60 -0.71 -359.93 -2.16 129550 4.67 777.45
Feb 1145.44 2.41 744.91 0.96 554891 0.92 715.11
Mar 2099.68 -3.29 1690.15 -4.74 2856607 22.47 -8010.60
∑X= ∑Y= ∑X2 = ∑Y2= ∑XY=
4914.37 17.67 4564277 497.32 3642.05

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Testing the correlation(r): X= ∑X\n = 4914.37\12 = 409.53

Y= ∑Y\n = 17.67\12 = 1.45

Finding the Correlation(r) : ∑XY\√∑X2* ∑Y2

= 3642.049\ √45642.77* 497.32

= 0.076.

Testing the above data by applying correlation. As the correlation co-

efficient is 0.076.

So, the Variables, Hedge Funds & Sensex return are partial positive with
each other.

Hedge funds inflow & sensex return% of the year 2005:

Table 6: Hedge fund inflow & sensex return for the year 2005

2005 HF INFLOWS SENSEX

(In Million Rs) RETURN (%)
Jan 49.60 -0.71
Feb 1154.44 2.41
Mar 2099.68 -3.29
Apr -66.00 -5.21
May -74.69 9.11
Jun 676.60 7.13
Jul 513.56 6.14
Aug 138.40 2.23
Sep 192.40 10.62
Oct -547.20 -8.60
Nov 56.40 11.36
Dec 689.60 6.93

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Using Bar diagram of 2005:

2500

2000

1500

1000
HF INFLOWS
500 SENSEX RETURN

0
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC
‐500

‐1000

Figure 11: Bar Daigram 2005

Testing the correlation: Hedge fund inflow & sensex return% of financial
year April 2005 to March 2006:

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Table 7: Hedge fund inflow & sensex return for the financial year Apr 05 to Mar 06

Year X Y X=(x-x) Y=(y- X2 Y2 XY

y)
Apr -66 -5.21 -282 -10.09 79524 101.80 2845.38
May -74.69 9.11 -290.69 4.23 845400 17.90 -1229.62
Jun 767.60 7.13 460.60 2.25 212152 5.06 1036.35
Jul 513.56 6.14 297.56 1.26 88542 1.59 374.93
Aug 138.40 2.23 -77.60 -2.65 6021.76 7.02 205.64
Sep 192.40 10.62 -23.60 5.74 556.96 32.95 -135.46
Oct -547.20 -8.60 -763.20 -13.48 582474 181.71 10288
Nov 56.40 11.36 -159.60 6.48 25472 42 -1034.21
Dec 689.60 6.93 473.60 2.05 224297 4.20 970.88
Jan 447.20 5.55 231.20 0.67 53453 0.45 154.90
Feb 654.40 4.54 438.40 -0.34 192194 0.11 -149.05
Mar -88.80 8.77 -304.80 3.89 92903 15.13 -1185.67
∑X=2591. ∑Y= ∑X2= ∑Y2= ∑XY=
87 58.57 2402989. 409.92 12142.07
76

X= ∑X\n = 2591.87\12 = 216

Y= ∑Y\n = 58.57\12 = 4.88

Testing the Correlation(r) : ∑XY\√∑X2 * ∑Y2

= 12142.07\ √2402989.76 * 409.92

= 0.3869

Testing the above data by applying correlation. As the correlation co-

efficient is 0.3869.

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So, the Variables, Hedge Funds & Sensex return are partial positive with
each other.
Hedge funds inflow & sensex return% of the year 2005:

Table 8: Hedge fund & sensex return for the year 2006

2006 HF INFLOWS SENSEX

(In Million Rs) RETURN (%)
Jan 447.20 5.55
Feb 654.4 4.54
Mar -88.80 8.77
Apr -663.60 6.76
  May -995.20 -13.65
Jun -6.80 2.03
July -261.60 1.27
Aug 122.00 8.89
Sep 414.4 6.46
Oct 460.00 4.07
Nov 670.80 5.67
Dec 339.20 0.66

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Using Bar Diagram of 2006:

800
600
400
200
0 HF INFLOW
‐200 JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC SENSEX RETURN
‐400
Series 3
‐600
‐800
‐1000
‐1200

Figure 12; Bar daigram 2006

Testing the Correlation: Hedge fund inflow & sensex return% of financial
year April 2006 to March 2007:
Table 9: Hedge fund & sensex return for the financial year Apr06 to Mar07

Year X Y X=(x-x) Y=(y- X2 Y2 XY

y)
Apr -663.60 6.76 -709.73 5.32 503717 28.30 -3775.76
May -995.20 -13.65 -1041.33 -15.09 1084368 227.71 15713.67
Jun -6.80 2.03 -52.93 0.59 2801 0.35 -31.23
Jul -261.60 1.27 -307.73 -0.17 9470 0.029 52.31
Aug 122 8.89 75.87 7.45 5756 55.50 565.23
Sep 414.40 6.46 368.27 5.02 135623 25.20 1848.71
Oct 460 4.07 413.87 2.63 171288 6.92 1088.48
Nov 670.80 5.67 624.67 4.23 390213 17.89 2642.35
Dec 339.20 0.66 293.07 -0.78 85890 0.608 -228.60
Jan -65.60 2.21 -111.73 0.77 12483 0.593 -86.03
Feb 354 -8.81 307.87 -9.62 94784 92.54 -2961.71
Mar 186 1.04 139.87 -0.40 19564 0.16 -55.95
∑X= ∑Y=17. ∑X2=25 ∑Y2=4 ∑XY=
553.60 28 15957 55.80 15336.70

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X = ∑X\n = 553.60\12 = 46.13

Y = ∑Y\n=17.28\12 = 1.44

Correlation(r) = ∑XY\√∑X2 * ∑Y2

= 15336.70\√ 2515957 * 455.80

= 15336.70/33864.04

= 0.4528

Testing the above data by applying correlation. As the correlation co-

efficient is 0.4528

So, the Variables, Hedge Funds & Sensex return are partial positive with
each other.
By using the data of the above 2 variables and to find out the combinations
of Hedge Fund Inflow, Hedge Fund outflow, Sensex Increase & Sensex
Decrease as follows:

INCREASE IN DECREASE IN SENSEX

SENSEX
INFLOW OF 30 8
HEDGE FUNDS
OUTFLOW OF 7 5
HEDGE FUNDS

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COEFFICIENTS:

a11 26.42
a12 13.2
a21 8.58
a22 2.64

Now, calculating the correlation of the above combinations using the

correlation coefficient formula.

Now, applying chi-square formula:

O E O-E (O-E)^2 (O-E)^2/E

30 26.42 3.58 12.8164 0.4851022
8 13.2 -5.2 27.04 2.0484848
7 8.58 -1.58 2.4964 0.2909557
5 2.64 2.36 5.5696 2.109697
4.9342397

χ 2 cal value = 4.9342397

χ 2 tab value = 3.8412

Conclusion: since, χ 2cal (4.9342) > χ 2tab (3.8412) , H0 is rejected.

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INFERENCE:

Since the calculated value is more than the theoretical value the null
hypothesis is rejected. Therefore it is thus established that there is strong
relationship between the Hedge Fund inflows and the Sensex returns

Also the correlation between the Hedge Funds turnover and the
Sensex returns is 0.4605. Therefore the Hedge fund inflows result in a
positive return in the Sensex.

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3.2 ESTABLISHING A RELATIONSHIP BETWEEN THE

FINANCIAL CRISIS AND HEDGE FUND PERFORMANCE:

In order to establish a relationship between the Hedge funds and the

different Financial crisis, the returns of various hedge fund strategies
indices is compared with the returns during that particular crisis.

The different crisis taken into consideration are The 1994 Bond
Crisis, The 1997 Thai Currency Crisis, 1998 Russian Crisis and The 2000
Technology, Media & Telecom Crisis. The returns are compared and an
analytical framework is arrived in the end by observing the returns.

CONVERTIBLE ARBITRAGE:

1994 Bond Crash:

CSFB/Tremont Convertible Arbitrage Sub index lost 3.32% in the
three months from February to April and losing 8.5% in the year since
January The HFRI Convertible Arbitrage Index lost 4.62%.

1997 Asian Crisis:

CSFB/Tremont Sub-index was up by 5.64% during this period, and
14.5% for the whole 1997 year. The HFRI was up by 5.67%.

1998 Russian Crisis:

The CSFB/Tremont Sub-index was down 12.03%. This was its worst
performance on record. The HFRI was down by 4.69%.

TMT Crash:
The CSFB/Tremont Sub-index was up 28.44%. The HFRI was up by
20.74%.

FIXED INCOME ARBITRAGE:

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Here we compare the movements in the CSFB/ Tremont sub index

and HFRI during the four financial crisis in the fixed income arbitrage.

1994 Bond Crash: CSFB/Tremont Sub-index HFRI was

was up by 3.85%. up by
3.58%.
1997 Asian Crisis CSFB/Tremont Sub-index HFRI lost
lost 11.75%. 13.18%.
TMT Crash: CSFB/Tremont Sub-index HFRI was
was up 12.06%. up 7.57%.

EQUITY MARKET NEUTRAL:

Here we compare the movements in the CSFB/ Tremont sub index
and HFRI during the four financial crisis in the equity market neutral.

1994 Bond Crash: CSFB/Tremont Sub- HFRI was up

index was up 0.25%. 1.94%.
1997 Asian Crisis CSFB/Tremont Sub- HFRI was up
index was up 4.65%. 7.31%.
1998 Russian Crisis CSFB/Tremont Sub- HFRI was down
index was up 2.56%. 1.48%.
TMT Crash: CSFB/Tremont Sub- HFRI was up
index was up 18.52%. 21.43%.

MERGER ARBITRAGE:

Here we compare the movements in the CSFB/ Tremont sub index

and HFRI during the four financial crisis in the merger arbitrage.

1994 Bond Crash: CSFB/Tremont Sub-index HFRI was up

was up 0.44%. 0.77%.
1997 Asian Crisis CSFB/Tremont Sub-index HFRI was up
was up 6.54%. 9.91%
1998 Russian Crisis CSFB/Tremont Sub-index HFRI was down

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was down 4.52%. 2.00%.

TMT Crash: CSFB/Tremont Sub-index HFRI was up
was up 15.14%. 13.78%.

DISTRESSED SECURITIES:
Here we compare the movements in the CSFB/ Tremont sub index
and HFRI during the four financial crisis in the distressed securities.

1994 Bond Crash: CSFB/Tremont Sub- HFRI was down

index was down 2.86%. 1.38%.
1997 Asian Crisis CSFB/Tremont Sub- HFRI was up 6.98%.
index was up 9.32%.
1998 Russian Crisis CSFB/Tremont Sub- HFRI was down
index was down 12.94%. 12.43%.
TMT CSFB/Tremont Sub- HFRI was up 8.32%
Crash index was up 15.51%

GLOBAL MACRO:
Here we compare the movements in the CSFB/ Tremont sub index and
HFRI during the four financial crisis in the global macro.

1994 Bond Crash: CSFB/Tremont Sub-index was HFRI was down 10.70%.
down 11.12%.
1997 Asian Crisis CSFB/Tremont Sub-index was HFRI was up 8.88%.

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up 20.01%.
1998 Russian Crisis CSFB/Tremont Sub-index was HFRI was down 5.93%.
down 20.14%.
TMT Crash: CSFB/Tremont Sub-index was HFRI was up 3.98%.
up 28.75%.

LONG/SHORT EQUITY:

Here we compare the movements in the CSFB/ Tremont sub index and
HFRI during the four financial crisis in the Long/Short Equity.

1994 Bond Crash: CSFB/Tremont Sub-index HFRI was down

was down 7.74%. 2.85%.
1997 Asian Crisis CSFB/Tremont Sub-index HFRI was up 13.5%.
was up 13.45%.
1998 Russian Crisis CSFB/Tremont Sub-index HFRI was down
was down 6.76%. 2.38%.
TMT Crash: CSFB/Tremont Sub-index HFRI was down
was down 9.72%. 7.89%.
4.2.8 EMERGING MARKETS:

Here we compare the movements in the CSFB/ Tremont sub index and
HFRI during the four financial crisis in Emerging Markets.

1994 Bond Crash: CSFB/Tremont Sub-index was down 13.58%.

1997 Asian Crisis CSFB/Tremont Sub-index was down 3.49%.

1998 Russian Crisis CSFB/Tremont Sub-index was down 27.53%.

TMT Crash: CSFB/Tremont Sub-index was down 16.59%.

Inference:

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Market 1994 crisis 1997 crisis 1998 crisis TMT Crash

Impact
Hedge fund High(-) High(+) High(-) High(+)
strategies
Convertible High(+) Medium(+) High(-) High(+)
arbitrage
Fixed inc Low(+) High(+) Medium(+) High(+)
arbitrage
Eq. market Low(+) High(+) High(-) High(+)
neutral
Merger\Risk Medium(-) High(+) High(-) High(+)
arbitrage
Distressed High(-) High(+) High(-) High(+)
securities
Global Macro High(+) Low(+) High(+) High(+)
Short Sellers High(-) High(+) High(-) High(-)
Long\Short High(-) High(-) High(-) High(+)
Equity
Emerging Medium(+) Medium(+) High(+) Medium(+)
Market

From the above data it is clear that there is a high correlation between the
Hedge Funds returns and the corresponding indices. This proves that
Hedge Funds played a vital role in the culmination of the above said crisis.

Hedge funds as a whole are becoming an important segment of the asset

management industry and gaining popularity from investors particularly
from the high net worth investors, universities, charitable funds,
endowments, pension funds, insurance and other institutional investors.
The assets under management of the hedge funds are growing on a double

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digit rate. All hedge funds are not necessarily speculative funds though
most of them provide an alternative investment options for the investors
through innovative investment strategy.
 

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3.3  SUMMARY OF FINDINGS:

After doing a detailed analysis of Hedge funds and their investing
strategies, one can infer that Hedge funds are both a boon and bane for any
capital markets. Some of the advantages and disadvantages associated with
these funds are listed below:

1. Research and trading strategies of a large number of hedge funds

are aimed at deriving profits from the perceived mispricing of
securities. Mispricing between assets arises because market traders
do not have costless and immediate access to all publicly available
markets, exchanges and information while trading.

For example, an option on the S&P–500 index trades in Chicago,

while the underlying stocks trade on various exchanges, like
NASDAQ and NYSE. If the derivatives price and the underlying
stock prices do not properly reflect each other (e.g. do not satisfy the
relevant no–arbitrage relationships), mispricing occurs. Of course,
very few mispricings are quite so obvious, perhaps exactly because
hedge funds by their trading push prices towards and inside the no-
arbitrage set.

2. Traders profiting from the resulting arbitrage opportunities induce

prices to move towards the true price, and hence allow trades to
happen that otherwise would not have taken place. Such activities
can further aid efficiency by increasing the competitive pressures on

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market makers or intermediaries, whose bread and butter are the

various spreads.

To cite the regulator (SEC, 2003b), “The absence of hedge funds

from these markets [of innovative financial instruments] could lead
to fewer risk management choices and a higher cost of capital.”

3. Traditional fund managers are usually constrained by their mandates

in choosing trading strategies, while individual investors are usually
constrained both by transaction costs and technological know-how.
Hedge funds are not subject to such constraints and so may provide
investment strategies preferred by investors, but otherwise
unobtainable.

4. Considerable empirical and theoretical evidence demonstrates that

hedge funds provide investors with risk–return tradeoffs not
available from traditional funds. Caution should, however, be
applied to any such analysis due to the inherent biases and non-
linearities in hedge fund data. Patton for instance studies the
empirical properties of so-called “market-neutral” hedge funds, in
particular in view of the fact that hedge funds self-classify
themselves into categories such as market-neutral.

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5. Rapid advances in financial technology and data availability,

encouraged by Basel–II, have brought advanced trading and risk
management techniques within the reach of just about any financial
institution and investor. This has resulted in the information
available to market participants and their resulting behavior being
more uniform than at any other time.

This phenomenon is especially damaging during financial crises,

where highly correlated information and behavior conspire to
amplify the severity of financial crises, by leading to a reduction of
liquidity at a time when it is needed most. Furthermore, since hedge
funds are unencumbered by mandated risk limits and generally
operate at the top end of the technological chain, they have the
possibility to act counter cyclically during a crisis, providing
liquidity and reducing volatility.

6. Hedge funds are frequently accused of destabilizing the

international financial system. This is especially true for macro
funds, which take large positions on the long–term direction of
macroeconomic developments. While a hedge fund’s interest in a
country may not be to the government’s liking, this does not mean
that the hedge fund is necessarily predatory or destabilizing. It may
simply be exploiting the difference between the real state of the
economy and market prices.

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7. The available empirical evidence on whether hedge funds are

destabilizing is mixed. Hedge funds are considered to have exerted
a significant market impact during the ERM crisis, but not during
the Asian crisis. Indeed, during the Asian crisis, foreign hedge funds
sometimes seem to have had a stronger belief in the economic
fundamentals of the crisis countries than the often better-informed
domestic investors.

8. Hedge funds, unlike regulated financial institutions, do not have an

upper limit on allowable leverage. This leverage is argued to
increase both the likelihood and severity of hedge fund defaults,
potentially leading to financial crises. Whilst such concerns have
long been expressed, they were amplified following the LTCM
collapse. At present, hedge funds do not appear to employ very high
levels of leverage.

9. Since hedge funds are unencumbered by mandated leverage

restrictions, with primary activities focussed on relatively high risk
trading, hedge fund defaults may be more likely and more damaging
than in the case of regulated financial institutions. Essentially,
hedge funds cause counterparty risk for regulated trading partners
(such as prime brokers) and investors, thus increasing credit risk in
the regulated part of the financial system.

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10. Counterparty risk was an important issue in the LTCM crisis, where
a key concern was the high exposure of major investment banks to
LTCM settlement risk, and lack of information about overall
exposures. Because of network linkages of their inter–bank
exposures, both LTCM creditor banks, and financial institutions
with no direct connection to LTCM were exposed to indirect
counterparty risk. The main worry in such networks is the triggering
of domino style defaults throughout the banking system.

11. Hedge funds are often accused of herding, with the ERM and Asian
currency crises cited as prime examples. The academic notion of
herding refers to the phenomenon by which funds mimic other
funds, despite the fact that their own private information or
proprietary model suggests different strategies. The latter
informational requirement implies that herding is inefficient as it
prevents the release of valuable information.

12. Hedge funds of course may act as a catalyst, by triggering (whether

accidentally or on purpose) herding by other investors. Intentional
herd induction goes counter to the casual observation that hedge
funds could always reveal trades so as to encourage herding, but
hardly ever do.

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Available empirical event–studies have not found evidence of such

triggered herding. Fung and Hsieh find indirect evidence that hedge
funds were late comers to the trade during the Asian crisis, while
Eichengreen and Mathieson find no evidence that other traders were
guided by the positions taken by hedge funds in prior periods.

Indeed they argue that the data suggests that hedge funds often act as
‘contrarians’

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3.4  SUGGESTIONS:

In view of the increasing popularity among the institutions as well as

their increasing interest in the Indian market, it might be time to provide a
limited window to this growing segment of asset management industry
within the existing framework of the SEBI (Foreign Institutional Investors)
Regulations. While opening up our market one cannot be oblivious to the
special concerns associated with the creative fund management strategies
used by these funds.

In this context, following additional provisions have been suggested

with respect to hedge funds seeking registration as FII:

1. The investment adviser to the hedge funds should be a regulated

investment advisor under the relevant Investor Advisor Act or the fund
is registered under Collective Investment Fund Regulations or
Investment Companies Act.

2. At least 20% of the corpus of the fund should be contributed by the

investors such as pension funds, university funds, charitable trusts or
societies, endowments, banks and insurance companies. The presence of
institutional investors in the fund is expected to ensure better
governance on the part of the fund manager and fund administrators.
Further, institutional investors may help fund managers to take a long
term perspective of the market.

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3. The fund should be a broad based fund in terms of the SEBI (Foreign
Institutional Investors) Regulations, particularly in terms of the
explanation to Regulation 6(1)(d).

4. The fund manager or investment adviser must have experience of at

least 3 years of managing funds with similar investment strategy that the
applicant fund has adopted.This provision is expected to allow well
managed funds to access our market and at the same time, keep our
markets insulated from the possible adverse effects of ‘trial and errors’
by uninitiated rookies.

5. The fund should have a stipulated lock-in period so as to avoid any

adverse impact like increase in volatility. The conditions for minimum
period of investment should be clearly stipulated.

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3.5 CONCLUSION:
Hedge funds as a whole are becoming an important segment of the
asset management industry and gaining popularity from investors
particularly from the high net worth investors, universities, charitable
funds, endowments, pension funds, insurance and other institutional
investors.

The asset under management of the hedge funds is growing on a

double digit rate. All hedge funds are not necessarily speculative funds
though most of them provide an alternative investment options for the
investors through innovative investment strategy.

Based on the dissertation I can conclude by saying that though

Hedge funds investments have a direct bearing to the culmination of some
of the worst crisis in the world, they bring with them a lot of advantages
too.

If SEBI is considering allowing of Hedge Funds to directly invest in

Indian markets it should bring in some regulations as mentioned in the
suggestions part, so that their investments may add to share holder value
appreciation.
Also the fact of current account convertibility should be taken into
account, because if Hedge Funds are freely allowed into Indian Capital
markets, there is also a possibility of free flight of money outwards thus
created mayhem in the markets as well in the whole Economy.
 

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4 BIBLIOGRAPHY:
• Knowledge @whorton India –journal

• Bloomberg market magazine

• Soueissy, M. & Sidani, R (2003), ‘The Risks Underlying Hedge

Funds Strategies

• Knowledge@Wharton (2005) - ‘hedge funds are growing: is this

good or bad?’ 
 
 

• Hedge Fund Review-risk book(magazine)

Web Pages:

www.hedge fund review.com

www.hedge week.com/news

www.hedge fund.net

www.hedge co.net

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5 INDEX

EQUITY RISK:, 61  Risk 

hedge fund, 9,   CORRELATION RISK, 63 
Interest rate risk, 60  Interest rate risk, 60 
MODEL RISK, 68  RIsk 
risk, 58  COMMODITY RISK, 63 

105