Role of derivatives in portfolio investment

Striking characteristics of derivatives

• not perfectly in sync with underlying assets (extent depends on the level of market
efficiency)

• are available on various asset classes (financial, real and synthetics) with un-
systematic risks having completely remote origin

• commodities derivatives are considered as good hedge against inflation

• have the natural risk mitigation characteristics for different risk exposures

• being levered positions instigate a lot of search resulting into relatively rich
information flows into the markets helping in better price discovery
 Issues in use of derivatives as an asset class: Roll yield
(Contango and Normal Backwardation)

Investment in the underlying: Cost of carrying (more significant in case of commodities)

Investment in the derivatives: Roll yield
 Issues in use of derivatives as an asset class: leverage
• Derivatives are highly leveraged instruments allowing managers to achieve leveraged
returns,

• To mitigate the problem of undesired leverage, manager can partially/fully

collateralize his exposure by taking a long position in t-bill (fully funded).
T bill risk + risk of the asset in the derivative using leveraged position
 Diversification view

• Allows for diversification into newer types of assets having remote origins and low
correlations

• Commodities, Currencies, Interest rates, Equity derivatives…

Matrix
• http://www.mrci.com/special/correl.php
Discussions
• https://
www.fxstreet.com/education/market-correlations-101-stocks-bonds-forex-201107
270000
• http://
stockcharts.com/school/doku.php?id=chart_school:overview:intermarket_analysis
 Efficiency in transaction cost

• Suppose a pension fund manager wants to take long position worth of 100m in
S&P500 for 3 months. But she is not sure what would be the market’s direction
after 3 months.

• She can do it in two ways

– Can either buy each of the stock as per S&P500 composition and keep on rebalancing it to mimic the
market proxy (high transaction cost)

– Can buy a futures on S&P500 index to the extent of the required exposure and keep rest of the fund
in a t-bill (low transaction cost)

• For a large fund manager impact cost could also be reduced

• At the end of 3 months she will find it less costly in case she needs to shift
allocation to T Bonds
 Hedged position

• To cash match a liability schedule

• To protect portfolio value through uncertain volatile periods
 Spot-derivative hedge

Spot long position (Managed Index)

Forward short position (Index)

Use the short proceeds to invest in T bills to fully collateralize the exposure.
Note that the portfolio returns in this case will comprise of T-bill returns only.
 Portfolio hedge with forwards/futures
Investment strategy: Follow S&P500 index and time the market using a two asset class (rf,
risky security); Portfolio 100m , forecast horizon 3 months
• After a bull run, suppose manager now has an expectation of bear market for the next 3
months after which she has no clear view
• Therefore Manager should move to the T bill position
• She can do so by selling her position (after 3 month she will decide again).
• Instead she can maintain her current position and a forward (short) position of similar
exposure in S&P500 index. Use the proceeds to go long with interest rate derivatives (T-
bill forwards/futures) to gain the exposure equal to S&P500 long position value
Event Actual market portfolio Forward short position
Market down Loss Gain
Market up Gain Loss
• Its a perfectly negatively correlated position having zero beta with low transaction cost
• Return of this position will depend on the yield of the interest rate derivative (which
essentially is a contract for delivery of T-bills on maturity)
 Protective put
• In the previous example potential upside was surrendered to protect from the
potential downside
• Objective: to hedge downside without compromising on the upside gains
• Time 3 months, size S&P500 for 100m, premium for 100m put options on S&P500
is 1.324
Alternative 1: invest in S&P500 as earlier and buy a 3 month put option (S&P500)
Potential Value of put Cost of put Net protective
port value option options put position
60 40 -1.324 98.676
70 30 -1.324 98.676
80 20 -1.324 98.676
90 10 -1.324 98.676
100 0 -1.324 98.676
110 0 -1.324 108.676
120 0 -1.324 118.676
130 0 -1.324 128.676
140 0 -1.324 138.676
 Protective put…Continued…

Alternative 2:
• Sell S&P500 position and buy T bills and a call options on S&P500
• Decision would depend on the transaction cost and expected returns from T-Bills

CF
Potential Cost of call from Net
port value option T bills Call payoff
60 -0.56 99.236 0 98.676
70 -0.56 99.236 0 98.676
80 -0.56 99.236 0 98.676
90 -0.56 99.236 0 98.676
100 -0.56 99.236 0 98.676
110 -0.56 99.236 10 108.676
120 -0.56 99.236 20 118.676
130 -0.56 99.236 30 128.676
140 -0.56 99.236 40 138.676
 Collar agreement (protective put without cost)
• 100m 3 months; put premium for Strike price 97m is 0.56m
• Objective: crate a cost less protective position
• Purchase a 3 month out of the money put option with an exercise price of 97m.
• Sell a call option with a 3 months expiration and an exercise price of 108m (or desired)
such that the premium from writing the call should be equal to the premium paid for
the put

Value of
Pot. Net Value of Call Net collar
port options Put(St pr (written) Protect
value exp 97m) (St pr Posit
108m)
80 .56-.56= 97-80=17 0 80+17=97
0
90 0 70 97
97 0 00 97
100 0 00 100
108 0 00 108
110 0 0 -2 108
120 0 0 -12 108
 Portable alpha
• Portable alpha is the transfer of alpha from one portfolio to another. It is a process that
requires hedging the beta of the portfolio from which alpha is being separated, and position
in a portfolio to which alpha is transferred.

Example
• A pension fund has diversified investments. This includes a conservatively run UK portfolio
which has a beta of 1.0 (relative to the FTSE 100).
• Fund managers X want to invest more aggressively to increase returns, but she is out of
investment avenues in-house

A possible solution is:

• Sell part of the UK portfolio, in order to fund more aggressive investments
• This leaves the UK portfolio with a beta of less than one. Use part of money raised (from
selling) to enter into FTSE 100 index futures such that you get back to the beta to 1.0.
• Invest rest of the money in a Small Cap active fund where a manager Y is expected to possess
skill. This fund will have its beta. Sell a Small Cap Index futures of equivalent to the exposure
(sales proceeds if any should also be invested in the small cap active fund).
• The end result is that the alpha of the actively managed portfolio of Y is added to the returns
of the pension fund’s UK equities portfolio without affecting its beta.
 Difficulties in using derivatives for portfolio investment

• Lack of liquidity for forwards, swaps and also for some markets and contracts
• Roll over risk and difficulty in constructing a long term portfolio without transaction
cost
• Lack of long term perspective without switching (transaction cost ; adds to the cost
of fund management)
• Leverage in derivatives markets: induces high risk for conservative and risk averse
investment settings (marked to market)
• Search cost (forwards and swaps)
• Low level of sell side research and short shelve life of research value (high cost)

• Hedge funds have been active users of investment strategies using derivatives to
generate and alpha through a delta neutral portfolio

• Portfolio insurance is emerging as a major field with arrival of new instruments and
innovations in investment strategies (Darren Pain, 2008, Recent Developments in
Portfolio Insurance, Bank of England Quarterly Bulletin 2008 Q1)
 Research view on use of derivatives in PM

• Kingslay Fung, David R. Gallagher, Aaron Ng (2005) W.P. Univ. of New South Wales,
Sydney

• The study is an empirical examination of use of derivatives in institutional

investments settings
• Findings
– Use of derivatives had a very low impact on returns of funds
– In general there was a low level of exposure to derivatives
– Options trading patterns of active institutional investors are shown to be
consistent with the execution of momentum trading strategies
– Active fund managers prefer not to use options markets to engage in informed
trading