Finance, Technology and Macroeconomics

Econ Vocabulary: Global Financial Stability Report September 07

1. Procyclic - A condition of positive correlation between the value of a good, a service or an economic indicator and the overall state of the economy. In other words, the value of the good, service or indicator tends to move in the same direction as the economy, growing when the economy grows and declining when the economy declines.

"Financial regulation is inherently procyclical"

2. Moral Hazard - Moral hazard refers to the chance, or hazard, that a party in a transaction with more information about its intentions or actions behaves in a way that a party with less information would consider inappropriate, or in the extreme, "immoral". It arises because an individual or institution in a transaction does not bear the full consequences of its actions, and therefore has a tendency or incentive to act inappropriately, leaving another party in the transaction to take at least some responsibility for the consequences of those actions.

Moral hazard is related to asymmetric information, a situation in which one party in a transaction has more information than another. A special case of moral hazard is called a principal-agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent may have an incentive or tendency to act inappropriately from the view of the principal, if the interests of the agent and the principal are not aligned. The agent usually has more information about his actions or intentions than the principal does, because the principal usually can not perfectly monitor the agent.

Moral Hazard in Finance

Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. A moral hazard arises if lending institutions believe that they can make risky loans that will pay handsomely if the investment turns out well but they will not have to fully pay for losses if the investment turns out badly. Taxpayers, depositors, other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions.

Moral hazard can also occur with borrowers. Borrowers may not act prudently in the view of the lender when they invest or spend funds recklessly due to the belief that they have access to a large line of credit. For example, credit card companies often limit the amount borrowers can spend using their cards, because without such limits those borrowers may spend borrowed funds recklessly, leading to default.

I encountered this when we were discussing about the opt-out provisions.

3. Propitious - Presenting favorable circumstances; auspicious

4. Hedge fund - a private investment fund charging a performance fee and typically open to only a very limited range of qualified investors. In the United States, hedge funds are open to accredited investors only. Because of this restriction, they are usually exempt from any direct regulation by the SEC, NASD and other regulatory bodies.

A hedge fund's activities are limited only by the contracts governing the particular fund, so they can follow complex investment strategies, being long or short assets and entering into futures, swaps and other derivative contracts. They often hedge their investments against adverse moves in equity and other markets, because a common objective is to generate returns that are not closely correlated to those of the broader financial markets.

In most countries hedge funds are prohibited from marketing to non-accredited investors, unlike regulated retail investment funds such as mutual funds and pension funds. As hedge funds are essentially a private pool of managed assets, and as their public access is commonly restricted by the government, they have little to no incentive to release their private information to the public.

Inarguably private entities, hedge funds have a corresponding reputation for secrecy, and less is known about the methods and activities of hedge funds than about publicly-accessible "retail" funds. However, since hedge fund assets can run into many billions of dollars, and thus their sway over markets—whether they succeed or fail—is substantial, there have been calls for regulation of these private investment funds.

posted by JD @ 2:44 PM