how hedge funds work?

Answer 1

Hedge funds are no longer a single class of funds or a single technique so you can't really get this question answered. Hedge funds, originally, held both investments and obligations to deliver investments which they did not yet own as hedges against the ones they did own.

Regulated investment companies in the United States are largely prohibited from using these techniques for a variety of reasons. Mutual funds are meant to be plain vanilla investments. However, the law created a special class of investors called accredited investors. Their income and wealth were so high in 1933 terms that it covered almost no one. They would be the mega rich today. Now most doctors could eventually qualify. There was no inflation indexing.

So now a hedge fund is any unregulated fund operating outside of US Security laws. They are still bound by the fraud provisions, but they are much tougher to police because only in the event of an investor lawsuit could fraud be caught, and even then you would have to be pretty sophisticated, or they would have to be pretty dumb, for fraud to be caught.

Answer 2

Hedge funds and private investment institutions that use certain unconventional techniques to bet on the market. Examples include long and short selling of equities, investing in the options market, investing in foreign currencies and emerging markets, dealing with commodities and debt related assets (such as the recent CDO's or collateralized Debt obligations that is in currently in jeaopardy)