Hedge funds are speculators. Hedge funds are pools of money that are raised from wealthy individuals, pension funds, endowments, corporations, and others and are managed by a fund manager.
Traditionally, a hedge fund would try to do just what its name suggests: the hedge against risks like currency risk.
Nowadays, hedge funds are much less concerned with hedging risk. They prefer taking on risks instead by buying some currencies while selling others to try to make more money.
Hedge funds typically use massive amounts of leverage when they trade in the Forex market. This means that they borrow money from someone with whom they have a credit agreement (a bank or other large financial institution), then turn around and use that borrowed money to buy and sell currencies.
This system seems to work pretty well when the credit market is functioning well. But when the credit market freezes up and stops functioning, this system of borrowing money to invest in the Forex market can unravel quickly, causing huge price swings in the value of various currencies.
We learned this lesson during the financial crisis of 2008.
Heading into 2008, many hedge funds had leveraged up, getting into “carry trades” with the Japanese yen.
A carry trade is a currency trade that is established to take advantage of large interest-rate spreads that may exist between two countries. Essentially, you sell the currency with the lower interest rate, and you use the funds to buy the currency with the higher interest rate.
By doing so, you will have to pay the lower interest rate for the currency that you sold, but you earn the higher interest rate on the currency that you bought and you get to keep the difference.
This strategy unraveled for hedge funds in 2008 when the financial crisis caused the credit market to freeze.
You see, the money that hedge funds borrow from banks and other financial institutions to leverage their trades is loaned on a short-term basis often only overnight.
So when the credit market froze, Hedge funds were cut off from their capital supply and were forced to unwind their carry trades because they could no longer meet their margin requirements the amount of cash that must be on hand to hold a trade.
It didn’t matter if the hedge funds thought the trades were still good trades or not. They didn’t have the money so they couldn’t hold the trades.