How are Derivatives Used?

General 

The use of derivatives has developed in the context of evolving financial markets and computer technology.  Floating exchanges rates and increased volatility of interest rates are just two examples of evolution in the financial markets.  Technology has facilitated virtually instant global dissemination of information.  Powerful computers, using sophisticated software, are able to analyze large amounts of data.  These developments have created a growing demand for efficient financial products and tools to manage risk.

Derivatives can play an important role in advancing new techniques to manage investments.  They can benefit a wide variety of investors and issuers of securities.  In July 1993, the Group of Thirty published the results of their study entitled "Derivatives: Practices and Principles".  The study explored who used derivatives and why, and made recommendations about their usage. 

Derivatives are used by corporations, governmental entities, institutional investors, and financial institutions.  These participants use derivatives to:

In addition, derivatives have been used to implement very risky strategies such as leveraged bets on the direction of changes in interest rates.  These leveraged strategies can result in large gains or losses when the market (interest rates) moves significantly.  However, the use of derivatives to implement speculative strategies involving excessive leverage is minimal compared to the more standard uses of these instruments by pension funds.

Pension Funds 

Based on the CIEBA survey results, the three major reasons private pension funds use derivatives were:

Asset allocation / substitute for physical securities 

In some cases, derivatives may be more efficient vehicles than the underlying securities.  An example of this is the use of stock index futures rather than individual stocks to achieve a market position.  Index futures provide a quick and cost-effective means for immediately deploying fund contributions in the stock and bond markets. 

In a single transaction, an investor can gain instant participation in the performance of a diversified basket of stocks, such as the S&P 500 index, without incurring the transaction costs associated with the purchase of each of the underlying securities.  The ability to gain instant market exposure largely eliminates the potential opportunity cost of the market advancing while the fund is still carrying out its equity deployment.

Pension funds may shift the asset mix of their portfolios in response to changing patterns of opportunity in the market.  A shift in asset mix can be accomplished either through the purchase and/or sale of underlying assets in the portfolio or through the purchase and/or sale of futures contracts.  Trading the underlying assets can incur significant commission and execution costs, whereas the vast size and liquidity of the futures market generally results in very low transaction costs. This is also used effectively in portfolio transitions when changing investment managers.

Currency exposure management 

There is a continuous trend toward international diversification by pension funds.  In addition to the price exposure implicit in any security portfolio, pension funds with international investments are also exposed to currency volatility.  Derivatives can help to control the risk or even exploit the opportunities associated with foreign exchange rate movements. 

The simplest and most commonly used form of hedging foreign currency is through the forward market.  For example, an investment manager of a U.S. pension fund portfolio who is holding Japanese equities might sell yen forward against dollars.  Any adverse movement in the yen that reduces the value of the equity holding would be offset by a gain in the dollar value of the forward contract.  Thus the manager captures the Japanese equity market return while avoiding the volatility, or risk of foreign exchange.  The portfolio manager can also hedge currency risk by using currency futures contracts or the currency option market.

Active fixed income management 

Fixed income managers of U.S. pension funds use derivatives in a number of ways including managing portfolio duration (maturities and yields), enhancing portfolio yield and, in general, implementing strategies in a more efficient manner.  Interest rate derivative instruments have become important components of fixed income portfolio management.  Interest rate derivatives are used to alter the interest rate sensitivity of fixed income portfolios; to exchange a fixed rate payment stream of interest for a floating rate payment stream or vice versa; or to create unique rate structures to meet a specific portfolio objective.  In addition, fixed income managers invest in mortgage and asset-backed securities which derive their values from cash flows associated with underlying pools of home mortgages, credit card debt, and other types of receivables.

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