A hedge is a countervailing investment made to protect an asset. Derivatives are frequently used in a defensive way by fund managers to protect investors from the downside of their investment. Hedge funds speculate quite aggressively, employing considerable leverage to maximize returns. They can commit up to 20 times the worth of their assets to the financial markets by the trading of derivatives such as futures contracts. An agreement is thereby made to buy or sell a fixed amount of a currency, bond or commodity at a fixed date. Only a small value of the face values needs to be put up as margin or collateral because the goods have not actually been traded when the derivative position is taken on. Concerns have been expressed about the excessive use of financial derivatives in that investors may be drawn into highly speculative investments whose risks they do not fully understand. Regulators are concerned that large institutional investors may find themselves out of their depth if the market falls heavily. In a falling market, a fund manager's liability could quickly outpace the assets of his fund entraining other stockbrokers working as counter-parties in the same deals. The consequent domino effect could lead to the collapse of the world banking system.
The renowned financier George Soros was believed to be managing between from US$9 to 13 billion through several funds in 1994. By investing in futures contracts, this can have the effect of an investment many times the initial amount, namely US$90 billion with an average leveraging of 10 times asset value. It is not known exactly how much hedge funding there is because they are not subject to the reporting practices of ordinary funds, being often set up as limited partnerships for the very wealthy with a minimum investment of US$ 1 million. Many are based in off-shore havens. It has been estimated that they reach US$100 billion with some leveraging up to 20 times their asset value with consequently a very large impact on the financial markets. Hedge funds were blamed in 1993 for the wave of selling that forced the devaluation of the French franc and in 1994 for the volatility experienced in the bond market.
The real fear is of the unknown. Derivative investment inevitably involves high notional sums of money. By a laying out only a small portion of the full amount of the investment investors can take a position.
Through hedging, commodity futures exchanges provide a mechanism for shifting the risks associated with commodity ownership to those who are not risk-averse (speculators) and who are willing to incur such risks. Many finance houses have very sophisticated risk management systems.