Mutual Funds vs. Hedge Funds: Fee Structures, Incentives & Investment Strategies

1. The fee structure of mutual funds typically includes a management fee and an expense ratio. The management fee is a percentage of the fund's assets and is paid to the fund manager for overseeing the investments. The expense ratio covers the operational expenses of the fund, including administrative costs. In contrast, hedge funds typically have a fee structure known as '2 and 20,' which refers to a 2% management fee and a 20% performance fee. The management fee is similar to that of mutual funds, but the performance fee is a percentage of the fund's profits.

The difference in fee structures impacts the incentives to invest as follows: Mutual funds are incentivized to generate consistent returns to attract and retain investors, as they earn a management fee based on the fund's assets. Hedge funds, on the other hand, have a stronger incentive to generate high returns since their performance fee is a percentage of profits. This can lead to more aggressive investment strategies and potentially higher risks taken by hedge funds.

2. (i) To hedge against a large change in the gold price using a forward on gold, traders would use the Greek parameter delta. Delta measures the sensitivity of the option price to changes in the underlying asset price. By taking an opposite position in a forward contract on gold, traders can offset the risk of a change in the gold price. The delta of the forward contract would be -1, indicating a perfect negative correlation with the price of gold.

(ii) To hedge against a large change in the gold price using a call option on gold, traders would use the Greek parameters delta and gamma. Delta measures the sensitivity of the option price to changes in the underlying asset price, while gamma measures the rate of change of delta. By taking a long position in a call option on gold, traders can benefit from the upside potential while limiting their downside risk. The delta of the call option would be positive, indicating a positive correlation with the price of gold. The gamma would be positive as well, as it captures the convexity of the option's value.

Traders hedge in each case as frequently as necessary to maintain their desired risk exposure. The frequency of hedging depends on various factors such as market volatility, the desired level of risk management, and the trader's investment strategy. Traders may use various instruments and strategies to adjust their hedges as market conditions change.

3. A bank can attenuate the maturity mismatch between its liabilities and assets through various strategies. One common approach is to match the duration of assets and liabilities. Duration measures the sensitivity of the value of a financial instrument to changes in interest rates. By aligning the durations of assets and liabilities, a bank can reduce the impact of interest rate changes on its net interest margin.

Other strategies include using interest rate swaps or other derivative instruments to manage the interest rate risk associated with the maturity mismatch. Additionally, a bank can adjust its funding mix by issuing longer-term debt or attracting longer-term deposits to better match the maturity profile of its assets.

The mismatch between liabilities and assets occurs due to differences in the nature and timing of the bank's obligations. Banks typically have short-term liabilities, such as deposits, that can be withdrawn by customers on short notice. In contrast, their assets, such as loans or investments, may have longer maturities. This maturity mismatch exposes the bank to interest rate risk, as changes in interest rates can impact the profitability and stability of the bank's operations.

4. Securitization is the process of pooling various types of debt, such as mortgages or auto loans, and converting them into tradable securities known as asset-backed securities (ABS). These ABS are then sold to investors in the secondary market, providing the original lender with liquidity and transferring the credit risk to the investors.

In the financial crisis of 2007/8, securitization played a significant role as mortgage-backed securities (MBS) were widely securitized and sold to investors. The securitization process allowed banks to offload the credit risk associated with mortgages, leading to a rapid expansion of mortgage lending. However, the quality of the underlying mortgages deteriorated, and when the housing market collapsed, the value of MBS plummeted, leading to significant losses for investors and financial institutions.

Credit rating agencies contributed to the financial crisis by assigning overly optimistic ratings to many of these securitized products, including MBS. These ratings gave investors a false sense of security and led to a mispricing of risk. The reliance on credit ratings as a measure of the creditworthiness of these complex securities created a systemic risk as the underlying assets turned out to be riskier than anticipated.

5. In the scenario where the probabilities of the weather outcomes are unknown, replicating a risk-free asset using weather derivatives would not be possible. In order to replicate a risk-free asset, one would need to have certainty in the probabilities of different outcomes.

Weather derivatives are financial contracts whose value depends on specific weather-related variables, such as temperature, rainfall, or wind speed. They are typically used to hedge against the financial impact of adverse weather conditions. However, without knowledge of the probabilities associated with each weather outcome, it would not be feasible to create a risk-free asset using weather derivatives. The lack of probability information would make it difficult to accurately assess and manage the risks involved.