What is a derivative?
A derivative is essentially an investment vehicle whose value is based on the value of an underlying asset. This underlying asset can be just about anything—from commodities (such as oil, wheat or gas) to company stock. There are many different types of derivative investments, including options, forwards, futures and swaps.
Derivative investments are typically formalized through contracts entitling the investor to defined payments. The payment or cash flow features of the contract can be quite complex, but if there is enough commonality among the contract terms, it’s possible to organize trading through recognized exchanges. For example, futures contracts are traded on the Chicago Board of Trade and on the New York Mercantile Exchange. Exchange-traded contracts have the advantage of more structure and greater transparency; however, they are also subject to greater regulation.
But since there can be hundreds of minor variations of contract terms to meet specific investor needs, most derivatives are traded over-the-counter (OTC), meaning that they are traded directly with an investment bank or broker. Trading derivatives OTC often means less transparency and higher costs—particularly with custom OTC contracts, which are generally more expensive. However, it may also offer greater flexibility and investment efficiency. Furthermore, a great deal of work has gone into standardizing contract data and enhancing systems to facilitate prompt, automated matching of terms, reducing the need for the more costly custom contracts.
What is leverage?
Many derivative strategies require the use of leverage. It isn’t a simple term to define, but leverage basically involves using borrowed resources to potentially magnify returns. A pension plan using a traditional “buy and hold” or “long-only” strategy wouldn’t usually have accounts payable or liability balances. A simplified balance sheet for a pension plan would normally have invested assets equalling the pension promise or liability. However, derivative trading can result in perfectly normal yet noticeable liability balances, such that the gross invested assets less the investment-related liabilities equals the pension promise. Like most investment strategies, using leverage involves a trade-off: while there’s potential for higher investment returns, the investor also assumes additional risk.
Whether or not to allow leverage is a decision that each plan sponsor must make and document as part of the fund’s investment strategy. Many organizations establish a “no leverage” policy, meaning that the fund cannot enter into a derivative contract unless the fund has enough liquid investments set aside to purchase the assets themselves (referred to as “backing assets”). As gains or losses are realized on the derivative contracts, the size of the backing assets must be increased or decreased accordingly.
| “No leverage” policy = policy whereby the investor cann ot enter into a derivative contract unless enough liquid investments are set aside to purchase the assets underlying that contract. |
How do derivatives work?
Derivatives are usually used to accomplish three main objectives: to replicate investment decisions more efficiently, to hedge risk and to enhance yield. What’s the difference between using a derivative contract and just purchasing the underlying assets? Consider this example:
(Underlying) Asset Cost
| (Underlying) Asset Value | Profit (Loss) | Derivative Value |
| $100 | $0 | $0 |
| $110 | $10 | $10 |
| $85 | ($15) | ($15) |
Whether you purchase the asset or invest in the derivative contract, you will realize the same profit or loss. One advantage to using the derivative contract, however, is that it has no upfront cost—it doesn’t require the initial $100 investment that would be necessary to purchase the asset. Here’s another example. You could buy the 60 stocks that make up the S&P/TSX 60, entitling you to gains, losses and dividends. Or, you could enter into a derivative contract entitling you to gains, losses and dividends for these assets.
The first alternative requires a cash investment with custody implications and results in unrealized gains and losses as market values ebb and flow. In addition, holding the assets means that you would have to sell assets in one class and purchase assets in another class in order to maintain the asset mix policy on an ongoing basis. Frequent trading such as this can be expensive and time-consuming.
The second alternative does not require a cash investment, but it results in realized cash flows for unrealized gains and losses. Furthermore, trades to maintain the asset mix policy can be done quickly and at low cost.
Investing in derivatives requires an account with a bank or broker and the supporting infrastructure—including personnel, technology and operational risk mitigation strategies—to properly manage the trading activity. And, if the underlying asset falls below a certain value, the investor will have to invest additional funds to maintain the contract. However, looking at the requirements versus the potential benefits, on balance, investors may find the derivative contract more appealing.
What are forwards, futures and swaps?
A forward contract is a negotiated agreement between two parties to buy or sell an asset at a predetermined price at a predetermined point in the future. Forward contracts are often used to hedge the future cost of foreign exchange or interest rates. For example, an investor can set the cost of a certain amount of foreign currency in the future by entering into a forward contract to buy that foreign currency at a rate known today, thereby hedging the risk of adverse foreign exchange rate movements. Forwards are generally more tailored to need and are therefore typically traded OTC.
A future is similar to a forward, in that it is a standardized contract to buy or sell a certain underlying instrument at a certain date in the future at a specified price. However, unlike forwards, futures are generally traded on an exchange and have regulated daily cash flows representing the change in contract value. In other words, for every day the value of the futures contract changes, cash is exchanged the next day (often referred to as “maintenance margin”). Futures contracts can end with an exchange of assets (e.g., ounces of gold or barrels of oil); however, because the assets aren’t always suitable for both parties, most futures contracts settle in cash.
A swap is an agreement to exchange one set of cash flows for another. One common type of swap contract is the fixed or floating interest rate swap, in which the cash flows of a fixed rate asset are exchanged for those of a floating rate asset. Interest rate swaps are very versatile and can lead to creative investment strategies. For example, combining an interest rate swap with a fixed rate bond changes the asset mix from fixed to floating rate exposure quickly, efficiently and with virtually no costs associated with transitioning a What are forwards, futures and swaps? portfolio. Swaps can also be used to adjust the duration of a bond portfolio or to change the effective maturity date of a bond portfolio to better hedge the pension promise liability.
Another common swap is the credit default swap, which can either help protect the investor from credit losses (buying protection) or replicate credit exposures (selling protection) much more efficiently than buying the assets. Here’s what a typical buying protection transaction looks like:
Buyer A enters into a credit default swap with Buyer B ↓ Buyer A makes a payment to Buyer B in exchange for future payment if a credit default occurs ↓ Credit event occurs and bond defaults ↓ Buyer B takes defaulted bond and pays Buyer A par value (physical settlement) OR Buyer B pays Buyer A the difference between par value and recovery value of bond (cash settlement) |
What are options?
Another interesting type of derivative contract is the option, which grants the holder the right to purchase or sell an underlying asset at a predetermined strike price on or by a certain maturity date. Depending on the contract, the option can be an option to buy or an option to sell. Some options expire worthless. But if the option is exercised, the investor’s profit will be the difference between the then-current value of the asset and the strike price.
Unlike other types of derivatives, options do have an initial cost: the premium. Put in simple terms, the option premium is similar to the premium that you might pay for insurance. The longer the coverage period (i.e., the time to maturity), or the greater the risk, the higher the premium will be. The value of the premium changes until the option expires or is exercised.
| Strike price = the price at which the underlying asset will be bought or sold if the option is exercised. |
What about risk management?
Like any investment, investing in derivatives has a potential downside. Using derivatives incorrectly—or using a high degree of leverage—may result in significant losses. Consequently, it’s important to understand the risks associated with derivatives and learn strategies to mitigate them.
There are three main types of risk that pension fund investors should be aware of: governance risk, liquidity risk and operational risk.
Governance Risk – Understanding governance risk management means asking the question, Is the pension fund trading derivatives in a manner that is consistent with the intent of the fund’s documented investment policy? If not, and if losses result from the derivative trading strategy, the board will have to answer some tough questions.
Liquidity Risk – Liquidity risk management is also often underestimated. Derivative strategies can change earnings from unrealized events to realized cash flows, which can affect the fund’s liquidity risk management assumptions and the backing asset investment policies.
Operational Risk – Most derivative debacles can be traced back to breakdowns in internal controls, often due to the volume or complexity of the derivative trading. Trustees should ensure that strategies are put in place to minimize operational risk—for example, ensuring not only that they are sufficiently educated, but that management, staff and professional advisors are trained and knowledgeable as well. Asking questions and getting clear answers from the various parties involved is one of the most effective tools available to trustees to help mitigate operational risk.
Checklist for Trustees When looking at derivatives as a potential investment for a pension fund, there are several important questions that trustees should consider. 1. If the fund isn’t currently investing in derivatives, how will it start trading using a derivative strategy? Trustees must examine the process in its entirety—from idea generation to documentation, to final decision-making. 2. If the fund is already investing in derivatives, what types of strategies are being used? Has the performance met the fund’s objectives within the past fiscal year? Reporting is critical in properly evaluating performance. Trustees should decide what information they need, and at what level of detail, both in advance and after the execution of a particular derivative investment strategy. 3. What are the fund’s plans for growing the derivative program in the future? The program will be most effective if there is a documented plan against which to measure progress. Comparing the pension fund to other funds and looking at the strategic differences between them, such as why one uses interest rate risk-oriented derivatives and another uses equity derivatives, may also prove very informative. 4. How does the fund define and use leverage? What types of strategies are or are not included in the definition? Clearly defining terms enables trustees to make more informed decisions. 5. How does the fund manage risk, particularly operational risk? Some common strategies include increasing staffing levels and skills according to the complexity of the derivative strategy, as well as synchronizing the efforts of investment management, finance, operations and technology. The world of derivatives is rapidly expanding, and trustees will need to explore this asset type in greater depth as time goes on. Armed with a basic understanding of derivative investments and how they work, as well as important considerations for future planning, trustees will be better equipped to make decisions about how to use derivative strategies more effectively in pension fund investing. |
Clint Matthews is a consultant on assignment with a large financial institution in Boston. clint_matthews@bell.blackberry.net
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