How investors use derivatives, compared with issuers
Companies mainly hedge risks that come from running the business, usually with customized over-the-counter (OTC) contracts. Investors use derivatives more broadly: to hedge, and to add, cut or reshape exposure, often with liquid exchange-traded contracts. Dealers take the other side and hedge their net position.
Before this: How companies use derivatives: hedge accounting, Call and put options: payoff and profit at expiration
On the exam
- Compare the use of derivatives among issuers and investors
Compare issuer and investor uses of derivatives. Expect to pick which use is more typical of an investor, to match a strategy to a goal, and to compute the profit on a covered call.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
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.
- 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.
- 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.
An investor buys a share at 50.00 and sells a call with an exercise price of 55.00 for 1.50. At expiration the share is at 52.00. The profit per share (a negative number is a loss) is closest to:
52.00 − 50.00 + 1.50 = 3.50
Profit at expiration, P3.50
- 52−50+1.5=3.50
- 52ENTER50−1.5+3.50
ENTER enter (on the HP, puts the number on the stack)
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.
Memorize this
MemorizeIssuers vs investors
| Issuers | Investors | |
|---|---|---|
| Main aim | hedge business and financing risk | hedge, add or reshape portfolio exposure |
| Typical market | OTC, customized | more exchange-traded, liquid |
| Accounting | hedge accounting matters | marked to market daily in NAV |
Memory hook Issuers hedge the business. Investors reshape the portfolio.
Know it cold Both can change exposure without trading the cash asset. Dealers take the other side and hedge their net position.
MemorizeCovered call (long share + short call)
| Quantity | Formula |
|---|---|
| Profit | |
| Maximum profit | |
| Breakeven |
Memory hook Premium cushions the fall by c₀. Gains stop at X.
Know it cold Upside capped at X plus premium; downside is the share falling, reduced by the premium.
- 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
- 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
Quick example
Buy at 40, sell a call with X = 44 for 1.20. At S_T = 47 the share is called away at 44: 44 − 40 + 1.20 = 5.20.
- 44−40+1.2= 5.2
- 44ENTER40−1.2+ 5.2
ENTER enter (on the HP, puts the number on the stack)
Quick example
Buy at 40, sell a call with X = 44 for 1.20. The most the position can earn is 44 − 40 + 1.20 = 5.20, however high the share goes.
- 44−40+1.2= 5.2
- 44ENTER40−1.2+ 5.2
ENTER enter (on the HP, puts the number on the stack)
Quick example
Buy at 40, sell a call for 1.20. The position breaks even at 40 − 1.20 = 38.80.
- 40−1.2= 38.8
- 40ENTER1.2− 38.8
ENTER enter (on the HP, puts the number on the stack)
How it is asked
-
Investor or issuer?
Which use is most typical of an investor: swapping a floating loan to fixed, selling index futures before a rebalance, or hedging next year's fuel?
Selling index futures to change equity exposure. The other two hedge operating or financing risk (issuer).
-
Covered call profit
Buy at 42, sell a call with X = 46 for 1.10, share ends at 49. Profit?
Called away at 46: 46 − 42 + 1.10 = 5.10. Traps: 4.00 (ignores premium) and 8.10 (ignores the call).
-
Lengthen duration
A bond fund wants longer duration without buying bonds.
Receive fixed in a swap. Trap: pay fixed shortens duration.
Exam traps
- Thinking investors only hedge. They also add, cut and reshape exposure.
- Thinking issuers mostly use exchange-traded contracts. Hedge accounting pushes them to customized OTC terms.
- Forgetting that a covered call caps the upside at the exercise price plus the premium.
- Ignoring the premium. It adds to every outcome of a covered call, including the losses it reduces.
Checkpoint
5 exam-style questions. About 90 seconds each.
1Which use of derivatives is most typical of an investor rather than a corporate issuer?
2An investor owns a share bought at EUR 30 and sells a call with an exercise price of EUR 33 for EUR 0.90. At expiration the share is at EUR 36. The investor's profit per share is closest to:
3Compared with investors, corporate issuers are more likely to use derivatives that:
4An investor buys a share at USD 80 and sells a call with an exercise price of USD 85 for USD 2.40. At expiration the share is at USD 78. The profit or loss per share is closest to:
5A bond fund wants to lengthen the duration of its portfolio without buying bonds. It could most likely:
Key takeaways
- Issuers hedge business risks with customized OTC contracts and hedge accounting.
- Investors hedge and reshape exposure to markets, rates, currencies, credit and volatility.
- Dealers take the other side of client trades and hedge their net position.
- A covered call earns the premium, caps the gain at X plus the premium and cushions falls by the premium.
Quick example
Buy at 40, sell a call with X = 44 for 1.20. At S_T = 47 the share is called away at 44: 44 − 40 + 1.20 = 5.20.
- 44−40+1.2= 5.2
- 44ENTER40−1.2+ 5.2
ENTER enter (on the HP, puts the number on the stack)
Quick example
Buy at 40, sell a call with X = 44 for 1.20. The most the position can earn is 44 − 40 + 1.20 = 5.20, however high the share goes.
- 44−40+1.2= 5.2
- 44ENTER40−1.2+ 5.2
ENTER enter (on the HP, puts the number on the stack)
Quick example
Buy at 40, sell a call for 1.20. The position breaks even at 40 − 1.20 = 38.80.
- 40−1.2= 38.8
- 40ENTER1.2− 38.8
ENTER enter (on the HP, puts the number on the stack)
All Derivatives formulas, every lesson
Practice exam-style questions on Derivative Benefits, Risks and Uses
Questions about this lesson?
Where this comes back
- Arbitrage, Replication and the Cost of Carry Derivatives
- Introduction to Risk Management Portfolio Construction
Questions candidates ask
How do investors use derivatives?
To hedge (for example currency or market risk), to change exposure quickly (market, duration, credit), to replicate a cash strategy more cheaply, and to create payoffs the cash market lacks, such as a covered call. A fund's prospectus states what is allowed.
What is a covered call strategy?
Owning an asset and selling a call option on it. The investor collects the premium, keeps the asset's gains up to the exercise price and gives up gains above it.
How do issuers and investors differ in derivative use?
Issuers mainly hedge operating and financing risks with customized OTC contracts and seek hedge accounting. Investors hedge, add or reshape exposure, are marked to market daily, and use exchange-traded contracts more often.
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