How investors use derivatives, compared with issuers

How do investors use derivatives?

Investors use derivatives to modify exposure : to add, cut or reshape their exposure to markets, rates, currencies, credit and volatility without trading the cash assets. Greater liquidity and lower capital needs often make a derivative the easier way to hold a position. A fund’s prospectus normally states which derivatives it may use and for what purpose.

Investor uses of derivativesa fund prospectus states which are allowed

• Hedge Use it offset adverse moves in part of the portfolio
  • Currency hedging sell the foreign currency forward
  • Market hedging sell index futures
• Modify exposure Use it add, cut or reshape without trading the cash assets
  • Market exposure index futures overlay
  • Duration receive-fixed swap lengthens it
  • Credit exposure credit default swap (CDS) on an index
• Replicate a cash strategy Use it a derivative copies the return more cheaply
• Create payoffs the cash market lacks Use it covered call, calls for upside

Goal	Example
Change market exposure quickly	a pension fund sells index futures to cut equity exposure before a rebalance
Change duration	a bond fund receives fixed in a swap to lengthen duration without buying bonds (duration management )
Hedge currency	a Swiss investor sells USD forward against US share holdings (currency hedging )
Take a view on a range	a manager sells calls on a holding, expecting a flat market
Gain exposure cheaply	a fund buys commodity index futures instead of physical metal
Change credit exposure	a fund buys credit default swap (CDS) protection on a high-yield index

How is that different from issuers?

Issuers use derivatives mainly to hedge market risks that come from operating and financing the business. Investors hedge too, but they also add or reshape exposure to pursue returns. Investors care less about hedge accounting, because a fund’s derivatives are marked to market every day and included in its net asset value. That is also why investors transact more often in standardized, liquid exchange-traded markets than issuers do.

Derivative usersthree groups, three main aims

• Issuers (companies) Memorize hedge operating and financing risk
  • Mostly OTC custom terms for hedge accounting
• Investors Memorize hedge, add or reshape portfolio exposure
  • OTC and exchange-traded more often standardized and liquid
• Dealers (financial intermediaries) Know the idea serve clients, earn spreads, hedge the net position

Financial intermediaries complete the picture. Dealers make markets in OTC derivatives, take the other side of client trades, earn the spread and hedge their net position, in part through central clearing. They are the counterparty to many issuer and investor trades.

What is a covered call?

A covered call combines a long position in an asset with a sold call option on it. The investor receives the premium now and gives up gains above the exercise price. It suits a manager who expects a flat or slightly rising market.

$$P = \min(S_T, X) - S_0 + c_0$$

$$P_{max} = X - S_0 + c_0$$

$$B = S_0 - c_0$$

Exam tip The covered call caps the upside at X plus the premium. It does not remove the downside, it only softens it by the premium.

Go deeper Overlays and portable alpha

An investor can separate where the return comes from from how the market exposure is held. A manager might hold cash and futures to get market exposure cheaply, and use the freed capital to pursue other returns. The idea rests on the same operational advantages as in the first lesson, and it adds the risks of the second: leverage, basis and liquidity risk.

Go deeper How dealers manage the risk they take on

When a dealer takes the other side of a client’s swap or forward, it ends up with an exposure it does not want. It hedges by trading offsetting positions with other dealers, on exchanges, or through central counterparties, and manages the credit exposure with collateral. The profit comes from the spread between the prices it quotes, not from a view on the market.