Derivatives are often perceived to be complicated financial contracts, best left only to the experienced or risk savvy investor.  But if used appropriately, the derivative market opens up many doors for risk management rather than speculative trading.

Derivatives are contracts, linked to various securities from which they derive their value. The derivative itself has no intrinsic value; it receives its value from its underlying investment. The vast world of the derivative markets centres around three main financial strategies, being Options, Forwards/Futures, and Swaps.

Options

Options are contracts between two parties to buy or sell an underlying asset or instrument. The option that gives the owner the right to buy something is known as a ‘call’ option, while one that gives the owner the right to sell something is called a ‘put’ option.

Options give the holder the right (but not the obligation) to buy or sell the underlying asset at a predetermined price (referred to as a strike price) on or before the contract expires.
Forwards and futures

Forwards and futures

Forwards and futures are contracts entered into by two parties for an asset to be delivered or settled in cash on a future date at a predetermined price. The fundamental difference is that futures are exchange traded standardised contracts while forwards are traded over-the-counter in a customised nature.

Swaps

Swaps are the exchange of one financial security for another, taking place at a predetermined time. Swaps are traded over-the-counter with dealings typically taken care of by banks. Currency and interest rates swaps are the two leading contributors to the swap market.

Because of their complex nature, and lack of understanding by investors many myths have arisen about derivatives. For example, many investors believe that derivatives are “purely speculative highly leveraged instruments and are a form of gambling in one’s portfolio”. In reality, they are used extensively as a risk management tool.  It is also believed that only large corporations and banks have a need for using derivatives when in fact companies of all sizes use derivatives to meet their specific risk-management objectives. Through astute implementation businesses can protect themselves on the downside as a form of insurance.

Derivatives have many uses in financial markets; through hedging out risk and managing exposures, they are frequently implemented in portfolios to bring about efficiency. As an illustration of this, let’s look at an equity-only fund manager. They are required to have a cash buffer to meet potential cash outflows on a daily basis. If it is assumed that the manager needs a 3% cash buffer, he is limited to a maximum equity exposure of 97%. To mitigate this loss in exposure, as cash will have a drag on upside performance, the manager can increase his equity exposure to 100% by entering into an index future with equal exposure to the cash buffer.

In the case of a cash transition between two equity-only portfolios, the time taken to transition will force the new manager to hold an increased cash position for an extended period of time, limiting any upside gains. Traditionally portfolio managers would start to buy stock and gradually increase the new fund’s equity exposure over time. Preferably the manager would like to increase their equity exposure to 100% immediately so that they can participate in any upside gains during the transition period. The use of derivatives through an index futures vehicle can ensure 100% equity exposure through the transition. The manager will then progressively reduce the future’s exposure as shares are acquired over time.

The use and implementation of financial derivatives should be one of integration within a well-managed portfolio rather than a strategy that is feared for its complex nature.  The idea of derivatives as a risk management tool to limit losses coupled with their ability to perform on the upside should find managers aligning the use of these financial strategies to their portfolios in the future.

– Andrew Bovell
Mullti-manager Solutions, RisCura

– Nikolaas Delpoort
Single-manager Solutions

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