USD 4. Sign in to Purchase Instantly. Positive feedback trading can arise under a variety of circumstances—some of which can be related to various institutional features of markets. These include dynamic hedging, stop loss orders, and collateral or margin calls. On a less sophisticated level, positive feedback strategies also incorporate general trend-following behavior whereby investors use various technical rules to determine trends and reinforce them with their buying and selling behavior.
Among the strategies that induce positive feedback type behavior, dynamic hedging is the most complex. Dynamic hedging is the practice of altering the amount of the hedging instrument through time to make sure that losses on the underlying instrument are offset, as closely as possible, by gains on the hedging instrument or vice versa. Using currency options as an example, the underlying intuition is as follows.
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Since options sellers know that, with some probability, they will incur losses as the currency depreciates, they sell, in advance, a certain proportion measured by the delta of the amount of currency underlying the options contract. However, as the currency depreciates it becomes more probable that the put options will be exercised. The options seller will then sell increasing amounts of spot currency to cover these potential losses until the amount sold is almost equivalent to the amount underlying the contract. Thus, to hedge themselves, options sellers would be required to sell the currency in a falling market to maintain a hedged position, potentially exacerbating the original movement.
Hedge funds are typically buyers of options and do not need to hedge using dynamic hedging techniques.
However, dealers mostly large commercial and investment banks that sell options to hedge funds either need to offset these positions with other interested parties or need to hedge themselves. Usually, options dealers hold portfolios in which they have a net short position in options, requiring them to manage the associated risk. Their ability to dynamically hedge depends on the liquidity underlying the option.
The theory underlying dynamic hedging requires that price changes be continuous and that hedging will be most effective when adjustments to the amount of the underlying instrument are made on an ongoing basis. The use of dynamic hedging techniques in Southeast Asian currencies purportedly caused a positive feedback response, adding volatility to some of these currencies.
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Apparently, put options on the Thai baht were priced relatively cheaply prior to the depreciation, encouraging hedge funds and other buyers to purchase them as another means of selling the baht. These trades left dealers with less premium with which to offset possible losses than if the puts had been appropriately priced.
Moreover, without offsetting positions from another client base, dealers held net short options positions. However, the extent of dynamic hedging is not verifiable, and since the Southeast Asian currency markets were known to be somewhat illiquid compared with the major currency markets some dealers may have been reluctant to use the technique.
Several other institutional features may also lead to positive feedback response. These are common to many markets and the participants that use them: they are not specific to hedge funds. Stop loss orders can give rise to positive feedback dynamics by having a previously submitted order to sell as losses are generated by price declines.
The selling to limit losses continues to put downward pressure on prices. Similar dynamics exist for losses generated by price increases if short positions need to be closed out. Collateral calls or margin calls can sometimes lead to a positive feedback response as well. Collateral holders may require additional collateral or margin from their customers when prices fall and losses are incurred. Usually the collateral can be obtained by selling any number of instruments.
However, a customer may have to sell the instrument whose price declined and caused the collateral call in the first place, possibly causing further price declines and losses. Although these market features are no different for hedge funds than other investors, some intermediaries that provide margin to hedge funds keep the funds on a very tight leash—margin calls are made daily and margin can be called intraday if necessary.
On the other hand, since many hedge funds maintain short positions, positive feedback responses by hedge funds in market downswings may be less likely as these funds would have profits, not losses, in this environment. Another class of destabilizing trading behavior is the result of participants taking similar positions to those of other market participants rather than basing their decisions explicitly on prices. In particular, managers may rationally ignore their own private information when they perceive that their reputations in the labor market are based, in part, on whether—when they make unprofitable decisions—other managers, too, have low returns.
It is far from clear that hedge fund managers have the same incentives to mimic each other as, say, mutual fund or pension managers, since hedge fund managers have their own wealth invested in the fund and are not compensated relative to a benchmark but on total return. However, many hedge funds probably have access to the same information, and one could imagine, especially for macro hedge funds, that hedge funds could arrive at a similar assessment at approximately the same time, creating the illusion that they collude and purposely execute similar positions.
A second issue is not the question of whether hedge funds herd among themselves but whether other investors herd with them or follow their lead into various markets. Some hedge funds refute that they are leaders, citing that proprietary trading desks of commercial and investment banks are looking at the same information as they are. Others suspect that other institutions are able to detect their positions and ride their coattails. Virtually all hedge funds adamantly deny the claim that they discuss their strategies among themselves.source url
While there is little evidence linking hedge fund strategies to excess market volatility, there is some evidence regarding similar position-taking and the incidence of various investment styles among various institutional groups. Kodres and Pritsker use daily position data from the U. The data not only provide a portrayal of large participants but also allow examination of several institutional subgroups, including hedge funds. The study was originally undertaken to assess whether specific institutional groups were more or less likely to move their positions in concert.
The data, obtained from the Commodity Futures Trading Commission CFTC , span August 3, to August 15, , covering the two exchange rate crises in the exchange rate mechanism of the European Monetary System and the early period of turbulence in world bond markets. The study estimates a necessary but not sufficient condition for herding: the propensity of large participants to buy or sell futures when other large participants buy or sell. The institutional categories examined include broker-dealers, foreign banks, commercial banks domestic , pension funds, mutual funds, and hedge funds.
Similar position-taking was also detected in the deutsche mark and Japanese yen contracts for broker-dealers and foreign banks. In addition, a sub-group consisting of the smallest one-third participants was separated in the data set to examine whether smaller participants herd with larger ones. The results showed little difference: positive co-movement was found for the same contract markets and participant types. Interestingly, however, when the lagged daily price change is added to the model, the results suggest that while hedge funds are mirroring the positions of other hedge funds they are also negative feedback trading—they are together trading against the price trend in a contrarian fashion.
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