Hedging basically means managing your risk. Risk management is fundamentally about transferring the risk (there's more to it than that, but for the sake of simplicity.....). Risk transference has been around for centuries. Edward Lloyd in his coffee shop in the 1600's offered insurance to major shipping firms. He'd charge them a premium and in return he would insure them against the occurrence of 'an' event - typically the ship sinking. If the ship sunk, he'd pay the firm some cash. If the event didn't happen, he'd pocket the premium. His coffee shop became Lloyd's Of London (not Starbucks as some of you may be thinking....)
Similarly, producers and users of raw materials or commodities, would use a mechanism called a Future to transfer their risk. Futures or derivatives started life as being a way for these buyers and sellers of, for example wheat, to protect against future price movements. For example a brewery uses wheat to make their booze. If they sell their booze for £2, they need to be able to control the price of their raw materials to ensure their profits. Wheat prices can vary widely - wheat crops are not only heavily subjected to the weather, but also the growing global demand - in 2008 wheat prices doubled (before halving again). Lets say your £2 pint of booze consists of 40p's worth of wheat. If wheat prices go up, your margin on your beer reduces. By buying a Wheat Future, you can profit from the increase in the price, hence offsetting the loss you make when you buy the wheat itself. For companies that trade in the underlying commodities, the futures market represents the perfect hedge. They have managed their risk effectively.
The watershed 'moment' for the still relatively archaic futures industry was 1973. A group of economists worked out a way of providing accurate futures prices of stocks and commodities. In effect making them exchange tradeable - meaning anyone could trade a future.
Now instead of Futures just being traded amongst those with vested interests in the physicals, futures trading was now available to the 'speculator' and was traded on regulated exchanges. One of the elements of futures trading is called leverage - Leverage allows me to 'control' for example £1,000 of stock, but only have to 'put up' £100. (10:1 leverage)
As the Futures markets developed, so the concept of the Hedge Fund evolved. The traditional Hedge Fund would typically have investments that were un-corrolated and hedged, meaning they could profit if markets went up or down. Their weapon of choice became the Futures contract.
In the 1990's some of the finest minds in the US including the economists from 1973, created a hedge fund called Long Term Capital Management (LTCM). Their product was simple in concept and was potentially 'a perfect hedge'. Using some pretty complex maths they identified 'similar' US bonds whose price's had diverged. They would then go Long on bond and Short the other, betting that the bonds would converge. The strategy worked, but make real money they needed to invest huge amounts, which they had no problem borrowing from Wall Street. Their strategy also required them to be heavily leveraged - at their peak their leverage was 28-1. All went well for a couple of years and they made incredible returns using this strategy. Their downfall however began when Russia defauled on their debt - effectively devaluing the rouble overnight and causing a ripple throughout the financial system. LTCM themselves had little exposure to the rouble, but because those banks they had borrowed from did have exposure, the markets got jittery and the problem cascaded toward LTCM. They lost $550m in a single day and it was clear they were heading for bankruptcy. The Federal reserve stepped in and effectively bailed them out to the tune of $3.5bn - ensuring a controlled collapse, and thus preventing a potential meltdown. A company that appeared to have created a risk free hedging product, that had made their investors millions of dolars, now lay in ruins.
Roll the clock forward to AIG. The largest insurance conglomerate in the world. A company that understood risk and had grown from a market capital of millions to billions in a couple of decades. AIG in 2008 was very different to the AIG of the 1990's. They were in effect a huge financial services company. They ran a hedge fund out of their London office that had huge exposure to a product called Credit Default Swaps. A CDS provides a creditor with protection against the debtor defaulting on a loan. If the debtor defaults, the creditor in paid under the terms of the CDS. AIG had a gargantuan liability on CDS of $400bn and as companies began to default on loans, so they were obliged to pay creditors under the terms of the CDS. As global economic conditions deteriorated, so more companies defaulted to the point where AIG could not themselves pay their clients. The government of the USA bailed AIG to the tune of $180bn. It was not insurance that killed AIG, its was derivatives.
It was appearent that corrolation had been created where there had never been any corrolation before - Derivatives did not cause this financial crisis, but they seem to have accelerated it.
