• Visit Our Network:
  • gtnews
  • Corporate Treasurers Council
  • AFP Advisors Network
  • CIEBA
The Resource for the Global Finance Profession

Derivatives

Executive Summary 

The term "derivative" is used to describe any of a number of financial instruments or contracts whose value "derives" from the value of another asset or market index.  Pension funds, like other investors in global capital markets, have benefited from the rapid evolution and innovation in financial derivatives.

The Employee Retirement Income Security Act of 1974 (ERISA) established current standards of conduct for private plans.  ERISA requires that plan fiduciaries make investment decisions that provide the best possible assurance that the pension promise will be honored; therefore, the overall return on the funds should be maximized subject to a prudent level of risk.  Fiduciaries reduce the risk of the total portfolio by diversifying investments among and within asset classes.  Derivatives are an important tool for efficient implementation of investment decisions.

The use of derivative instruments has grown rapidly over the last 15-20 years and has moved into the mainstream of finance.  Pension funds and their investment managers use derivatives to implement asset allocation decisions, manage currency exposure, and manage the maturity of fixed income portfolios.  Through derivatives, the complex risks that are bound together in traditional instruments can be separated and managed independently.  In short, derivatives are cost-effective tools for implementing investment strategies and controlling risk.  Their prudent use enhances the benefit security of our private pension system.

A formal survey of CIEBA's members regarding their use of derivatives was last conducted in 1994, in the aftermath of a number of companies having problems with derivatives. At that time, the median private pension fund's commitment to derivatives was 7.9 percent of plan assets.  The survey indicated that 85 percent of the 118 respondents, (representing 95 percent of the $613 billion in assets under management at that time) used derivatives, primarily exchange-traded futures, options and foreign currency forward contracts. Although no survey update has been made, anecdotal evidence suggests that derivative usage continues and has likely increased due to the increasing sophistication and understanding by senior financial management.

The use of derivatives to create highly leveraged positions within portfolios has resulted in large and highly publicized financial losses by a small number of investors.  These investors ranged from very speculative and sophisticated hedge funds to banks, governments, corporations and mutual funds.  Notable examples are Gibson Greetings, Sumitomo, Procter & Gamble (1993), Barings (1995), and Long Term Capital Management (1998). However, CIEBA survey respondents as a group undertook minimal leverage, both implicit and explicit, in their application.  Additionally, the majority of respondents and their investment managers have policies, procedures, and controls with respect to the use of derivatives.

Back to top 

 

 

bulletTable of Contents 

bulletHow are Derivatives Used? 

bulletIntroduction 

bulletWhat are the Risks? 

bulletExecutive Summary 

bulletSummary 

bulletWhat is a Derivative? 

 

 

 

 

 

 

Click here for a printable version
(Requires use of
Adobe Acrobat) 

You May Also Be Interested In...

Copyright © 2014 Association for Financial Professionals, Inc. - All rights reserved.
AFP, 4520 East-West Highway, Suite 750, Bethesda, MD 20814, Phone 1.301.907.2862
Follow Us AFP on LinkedInAFP on TwitterAFP on YouTubeAFP Newsfeed