Extreme leverage could conceivably have systemic repercussions. The hedge fund industry and the investment banks trading with hedge funds no longer calculate and apply the leverage concept in the form it is traditionally used.7 Hedge funds define a target value at risk (VaR) or capital allocation to each position. Similarly, investment banks trading with hedge funds control the risks involved with the hedge funds by allocating to the fund a VaR limit. All open positions to the fund - mainly derivatives like futures, swaps, swaptions or forwards - are taken into account in the VaR limit. Offsetting positions are usually netted out. The size of the total position the hedge fund can build up is a function of the variables that determine the VaR, such as the volatility of the underlying asset or the correlation with other instruments. As a measure of risk control the VaR of the fund has to be covered with margins, mostly in the form of securities. Generally speaking, the investment banks apply the well known margin system of futures exchanges to the overall business with hedge funds. There exist additional safety procedures. As a result of a large draw down in the net asset value the VaR limit can be reduced automatically, forcing the fund to reduce or close out its positions. Nonetheless, it should be kept in mind that VaR measures have limitations – they reflect price behavior in normal markets and are not well suited for a stressed market environment.
The sudden stop in capital flows during the initial phases of the crisis and the subsequent rapid increase in capital inflows into emerging-market economies have focused attention on the problem of volatile capital flows. Massive inflows can lead to overheating and asset-price bubbles and as there are no clear guidelines a number of emerging-market economies have chosen to manage massive inflows by introducing a range of capital controls. The member countries have therefore given the Fund the task of drawing up guidelines on how countries should manage such capital flows. This work has been underway for the last 12 months and a proposal for a comprehensive framework will be discussed by the IMF’s Executive Board at the end of October. According to the proposed guidelines, countries should in the first instance review their fiscal and monetary policies in order to manage or counteract major capital flows, and as a complement to this they should use various macroprudential-policy tools. As a final resort they may introduce capital controls. The idea is that the IMF should give advice on how these tools should be designed in order to be effective. No organisation has played a clear role in the liberalisation of capital flows. This is a major difference compared to the liberalisation of trade, where the World Trade Organisation (WTO) played and still plays a prominent role.