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Hedge funds generally make financial markets work more smoothly

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Published on Wednesday, 09 April 2014

Financial markets generally work better thanks to so called “hedge” funds. “Although hedge funds are not well understood by the general public, they provide many important services to the wider economy,” said Dr Kalle Rinne, a researcher at the Luxembourg School of Finance, the department of Finance at the University of Luxembourg.

Standard investment funds purchase a range of traditional financial instruments (typically shares and bonds) and this type of fund is generally favoured by households. However, hedge funds use all kinds of sophisticated financial tools on behalf of their knowledgeable clients, such as pension funds, banks and wealthy individuals.

Kalle Rinne, working together with Petri Jylha and Matti Suominen, studied the performance from 1994-2011 of the US stock market and a representative sample of hedge funds. They found that, in general, hedge funds made it easier to buy and sell shares by increasing market “liquidity” on the stock market. As well, share price volatility was reduced. Both of these are desirable and encourage investment in stock markets, so helping companies with their growth plans.

However, there were occasions when the hedge fund market became stressed and these funds too then demanded more liquidity than they provided. However, in the period studied, hedge fund crises normally happened at different times to troubles on stock markets. The exception was 2008/9 when these problems coincided, with investors rushing to pull money out of every type of fund. Otherwise, for example, during the crash after the late 1990s “dotcom » boom, hedge funds continued to help the market work more efficiently.

A unique study, this research has attracted considerable attention. It is due to be published this year by the Review of Finance, one of the leading academic journals in the field, and already available online on their website.

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Do Hedge Funds Supply or Demand Liquidity? by Petri Jylha, Kalle Rinne and Matti Suominen

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