Wall Street Journal – A lot of what is said about hedge funds and derivatives is nonsense. At one extreme, hedge funds are attacked as dangerously unregulated cabals wielding newfangled instrumentsof finance like unguided missiles aimed at the heart of world capitalism. At the other, hedge funds are celebrated as the greatest market development since mutual funds, and derivatives the bestinnovation since insurance was created.
The proliferation of investment channels outside traditional banks and bonds — hedge funds — and of financial instruments that, for instance, can allow a bank to lend to General Motors and lay off the risk of bankruptcy on some high roller — derivatives — add to the stability of the economy and reduce the frequency of crises.
There are now mechanisms to insure against almost any risk and someone willing to sell the insurance (or, depending on how you look at it, place a bet). These innovations may actually reduce market volatility if they give big bucks to nimble investors who search constantly for anomalies in market prices and eagerly buy what’s out of favor and sell what’s in favor.
But if there is a financial earthquake, will these new institutions and mechanisms turn it into a tsunami? Will we have fewer crises, but bigger ones, the sort that jar whole economies, not just shake up a few greedy, leveraged investors?
