Business Finance: Bear Stearns

File:Bear Stearns.svg

Introduction

Hedge funds have played a significant part in the financial markets in the recent decade. Armed mostly with funds obtained from 99 investors (according to US regulations), hedge funds have been known to use ever increasing amounts of leverage to garner enough funds to overpower the fundamental prices of securities and commodities. Worst still is the involvement of hedge funds in derivatives which Warren Buffett coined as the financial weapons of mass destruction. However, it is not only derivatives like the Collateral Debt Obligation (CDO) that investors must worry about. In today’s highly complex financial market, investors must never forget the basic principles of investment risk and return and must learn of in some cases relearn to respect risk. This research paper is focused on the failure and collapse of two hedge funds under Bear Stearns investment bank whose reputation is now at stake in the midst of the subprime crisis.

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Business Finance. Bear Stearns

Comments
2 Responses to “Business Finance: Bear Stearns”
  1. hishamh says:

    James,

    Nice paper, but I think you missed some of the significance of CDOs in the Bear Stearns funds collapse, as well as the culpable role played by the ratings agencies. CDOs are essentially structured investments, i.e. divided into tranches with a different risk-reward profile for each tranche. The highest risk tranche will offer the highest returns and vice-versa. It’s possible to buy into the lowest risk tranche at AAA and not have it default, even if the assets underlying the highest risk tranches do default.

    The problem from a market perspective is that the ratings agencies put blanket ratings on CDOs, and not individual ratings for each tranche. Worse, the best tranches were used as the benchmark for the whole CDO. Hence you can get what amounts to junk bonds with a AAA rating, thus giving a completely misleading picture of a fund’s actual risk profile. This would not have been a problem if investors bought into all tranches equally (portfolio theory suggests this would actually reduce their portfolio risk in terms of volatility of returns, but obviously reducing the mean return), but being able to buy into individual tranches separately meant that the risk picture was significantly distorted.

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