In the recent past, derivatives have suffered from a poor reputation, with some critics viewing derivative instruments as a form of legalised gambling. While derivatives can be used to speculate on market movements, with the right risk frameworks they can also enhance returns, make markets more efficient and help with managing risk in portfolios.
Derivative instruments have now become an important pillar in modern portfolio management. This article outlines the flexibility and varied applications of derivatives in portfolios, and helps advisers understand the reasons for the rapid growth of the derivatives market.
Definition and types of derivatives
Before we dive into the uses of derivatives in portfolios, it is important to understand the basics of derivative instruments. A derivative is simply an instrument that derives its value from the value of another underlying financial asset. It is traded between two parties, called counterparties.
Broadly speaking, derivatives instruments fall into two categories: exchange-traded derivatives and over-the-counter (OTC) derivatives.
Exchange-traded derivatives are standardised contracts that are traded on an organised exchange by member participants. The exchange is responsible for the contract margins, clearing and settlement process.
An OTC market is an informal market of participants, also called a dealer market. These products can be customised based on the needs of the user and are traded directly between parties. The most commonly-traded derivatives (available on both exchange-traded and OTC markets) include futures, forwards, options and swaps of underlying securities, instruments or indices. These are defined in the table below.
A common factor about all these instruments is that they derive their financial value based on the underlying asset.
Application of derivatives in portfolios
Portfolios typically use derivatives for three reasons: to reduce risk by hedging a position or exposure, to gain access or adjust exposures to specific asset classes and/or factors, in order to add value, and to manage cash flows.
1. Using derivatives to reduce risks
Derivative overlays are used in portfolios to hedge or reduce unwanted risks. These risks are usually market risks, which refer to the sensitivity of an asset or portfolio to overall market prices movements such as interest rates, inflation, equities, and currency. Derivatives can be used to hedge portfolios as well as individual assets.
For example, say an investor owns shares in ABC Company and although the investor believes in this stock in the long run, he/she is worried about short-term losses in the industry.
To protect himself/herself from losses, the investor can buy a put option on the company that gives him/her the right to sell ABC at a specific price. This means that if the stock falls past that price, the losses will be offset by gains in the put options.
There are two types of options: American options can be exercised at any time before the expiration date, while European options can only be exercised at the expiration date.
Investors must keep in mind that every hedge has a cost and it is the price paid to avoid uncertainty.
Tail risk hedging has also evolved since the global financial crisis, with managers using hedges designed to mitigate large adverse moves in the market.
Derivatives in international investing
Currency hedging is used by fund managers who invest across international markets. Currency risk is often a significant portfolio of the total risk of an international equity or fixed income portfolio.
Purchasing foreign currency assets means that the investor is exposed to foreign currencies. Changes in the value of the foreign currency relative to the local currency will result in a change in the value of the asset in local terms.
Often managers will hedge currency risk at the diversified portfolio level rather than individual asset classes or securities. Some portfolios utilise a hedge ratio, where a portion of the portfolio is hedged, achieving a result between that of a fully hedged portfolio and an unhedged portfolio. It should be noted that currency overlay strategies can be used to reduce currency risk (as discussed here) but can also be implemented to enhance returns if there is a view on the direction of currencies.
A range of derivative instruments can be used to manage international exposures, including forward contracts, options, and futures. Currency swap options, called swaptions, can be used to create more unique transactions.
A currency swap involves exchanging interest payments and the principal of two different currencies at an agreed date for an agreed price. The buyer and seller exchange fixed or floating interest payments in their respective swapped currencies over the term of the contract and the principal at the termination date.
Currency hedging also involves a return that is not associated with currency or market movements. The rate differential between currencies is a source of return as an investor earns the domestic interest rate and pays the foreign rate. Historically Australian investors have benefited from higher cash rates relative to global rates. The chart below is a diagrammatic example of a currency swap.
Other than currencies, derivatives can also be used to manage other risks such as commodity prices, interest rates and equity or fixed interest market risk overall.
Derivatives in fixed interest portfolios
Like equities, derivatives can be used to lock in the purchase or sale price of a fixed income security or portfolio. Fixed income managers use derivatives as risk management tools to adjust exposure to interest rate, credit and currency risk.
Derivatives can be used quickly and efficiently to change market exposures without buying and selling the underlying bonds. If interest rate increases are anticipated, bond duration can be hedged by paying a fixed rate of interest rate swaps or taking short positions in bond futures.
A portfolio that is duration hedged can outperform a non-hedged strategy when interest rates rise more than what is embedded in the yield curve. Thus, investors usually use derivatives to implement tactical changes, or short-term changes (less than three months), to interest rate risk in order to add value.
Portfolio managers can also employ derivatives to manage exposure to credit risk. Credit default swaps (CDS) can be purchased on individual bonds or various credit indices to reduce exposure to credit risk without selling individual bond positions.
CDSs are considered to be insurance-like contracts which offer credit protection in the event of a default. These instruments can be used at times when the market becomes overheated during a credit cycle.
The type of instrument used depends on whether the portfolio manager would like to hedge a broad-based risk or one that is more specific. For a broad-based market risk, futures contracts or option on futures can be a good instrument. On the other hand, for specific securities a customised instrument is needed.
2. Gaining exposure or adding value
In addition to risk management, derivatives can also be used in portfolios to gain access to particular markets or factors quickly and inexpensively. One of the basic concepts of derivatives is that they efficiently replicate exposure to an underlying index. Thus passive investors can also access the market through futures or swaps.
Derivatives can also be used to meet asset allocation objectives – rather than buying and selling physical securities to alter exposures, these can be accomplished through appropriate futures contracts at lower transaction costs.
Using derivatives to speculate on market moves has often been criticised and involves risks that investors must be wary of.
As equivalent market exposure can be gained with little upfront capital, derivatives are often levered instruments. For this reason there is potential for large gains and losses.
In a multi-managers environment, many managers use derivatives to achieve a desired asset allocation (for example, the bonds and equities split) without disrupting the specialised underlying managers.
Derivatives also allow fund managers to increase and decrease a portfolio’s beta, while sector overlays can be used to increase or decrease exposure to specific sectors within the portfolio.
Derivatives can also be used in hedge fund replication overlays which attempt to replicate exposures to common factors in hedge funds. Similarly, portable alpha strategies can be used to add value to a portfolio.
Simply put, it involves transporting ‘alpha’ to an index/market tracking return. The index exposure or return is captured through futures or swaps (with little upfront capital) and the remaining cash is managed actively to generate alpha, independent of the index.
3. Managing inflows and outflows
Derivatives can also be used to manage inflows and outflows of cash in a portfolio. A large cash inflow has the effect of reducing the portfolio’s exposure to other assets and changes the chosen asset allocation; a planned withdrawal will also increase cash holdings until the withdrawal occurs.
Rather than sitting on cash or deploying the cash quickly into inappropriate securities, a better strategy would be to use long positions in stock index futures or index call options to gain a similar exposure quickly. This strategy is known as ‘cash equitisation’ – it will reduce cash drag and enable portfolio managers to maintain the overall asset allocation of the portfolio.
Conclusion
Derivatives are critical to managing diversified portfolios and, due to their flexibility and varied applications, derivatives markets have seen rapid growth.
While derivative markets have faced increased scrutiny and regulation in the recent past, derivatives have very useful applications within portfolio management and play many roles in both risk management and return creation.
Daniel Park is the portfolio manager for fixed interest at BT Investment Solutions, BT Financial Group.
