Given the use of derivatives it is an interesting question to consider whether derivatives should be considered as an asset class in their own right.
Derivatives are all about managing risk. They give a financial exposure to the underlying asset or assets on which they are based. There is also a leverage effect within the derivative that can act as a multiplier on the expected return and provides a key feature of interest for the investment manager. As instruments of risk, derivatives can be traded for outright exposure/speculation, to hedge existing exposure and change the risk profile or to enhance a portfolio’s expected return, either through leverage or the extra yield generated by selling options.
Linear derivatives, such as forwards or equity swaps can be used as a substitute product to the physical underlying – perhaps for cost or efficiency reasons. It may be cheaper to trade, say, a stock forward or an equity swap than to invest directly in the physical stock, perhaps because of stamp duty that may be payable directly on the stock. Non-linear derivatives, such as options or convertible bonds will be used to change the risk profile of the investment portfolio.
Leverage is a feature of all non-linear derivatives and it can be used to good effect within the more traditional investment management businesses. At its simplest, yield enhancement can be achieved by selling calls or puts. Investment traditionally involves having ‘long’ positions in assets. If a fund wishes to be long a stock, a call sold above the market will cap the upside in terms of performance but would generate more profit than just holding that stock to the target price.
If a fund believes that a stock has a bullish future, buying a reverse convertible (a bond with an embedded short equity put option) would generate a long position with a limited upside potential of the premium received, usually included within the coupon of the product and generally paid over the life of the deal. This may be a useful strategy, especially if the fund is in competition to meet a benchmark yield target. This is an especially popular product when interest rates are low and equity volatility is high as it generates a good uplift over typical interest rate returns. A popular trade type involves an option paying off an amount based on the weighted average performance of a group of stocks – this is called a basket option. It is very similar to the concept of index options only the basket is made up of individually chosen stocks. Basket-type trades are popular with funds as they can add geared upside performance potential to their portfolio. The cost of the basket is less than buying the same option exposure individually due to the correlation of the component assets. However, when volatility is expensive and/or correlations high, something that often occurs at the same time, baskets can get expensive. Specific basket derivative features can include:
q Capped basket Set a level above which there will be no further payout. In effect, this is the same as buying an option at one strike and selling another at a higher strike. For example, if a call option was bought with a strike of 100 and a similar call sold at a strike of 120 the maximum payout on the option would be 20. Contrast this with the potentially unlimited payout on just buying the option with a strike of 100. As you would expect, the capped option will cost less than the outright call.
q Asian element As the stock price changes over time this movement is averaged. The average is used to determine the payoff of an Asian option. The effect of averaging the stock level over time reduces the potential payout in comparison to a normal option but the result is a cheaper option. The risk management implications of this averaging feature are that the sensitivity to volatility will be a lot earlier in the option life. Sometimes the Asian feature is incorporated into setting the strike and expiry level of baskets to prevent manipulation at the maturity in favour of the basket option vendor.
q Barrier features can also be used in basket trades. When the underlying asset price reaches the barrier the option will either cease to exist or will be created if it did not exist in the first place. These features are called knockout/knockin options. The ability for this sort of feature to affect the price of an option is significant. The risk management of these options becomes technically complex around the barrier.
A more hedge fund-oriented strategy might be convertible bond arbitrage. The fund would seek out convertibles that have low implied equity volatility, buy the convertible and hedge the risk of movements in the underlying stock price by selling stock. Generally the interest rate risk and credit risk can be stripped out of the convertible by an asset swap. As the underlying equity price moves around so the trader dynamically re-hedges the stock position. The trader is looking to make more money on its stock trading (after all costs) than it loses by holding the convertible. Expected returns might be low in absolute terms, say 2% but these can be geared up through borrowing say, 10 times, to an annualised expected return of 20% by only needing to put up capital of 10%.
When considering the use of derivatives it is important to understand the exposures and risks they generate. These exposures relate to the underlying asset market and usually another underlying market but also to the behaviour of those markets. For instance, the volatility exposure generated by holding a derivative position relates specifically to the behaviour of the underlying market. If the outright volatility of a market is traded through a derivative then ‘volatility’ should be considered as a new asset class.
There are clearly many ways in which derivatives can be used within investment portfolios’, it is even possible to have a portfolio constructed entirely of derivatives. The knowledge, expertise and technology exist to analyse derivative products into their underlying exposures and risks, a substantial portion of which fall into the traditional asset allocation categories. Those that do not should in fact form asset classes in their own right, say volatility or correlation.
In conclusion, the analysis and breakdown of exposures for derivatives can be done and where necessary new asset classes should be created for the exposures generated by holding derivatives. Since they cover a variety of exposures it would be wrong for derivatives themselves to be classified as an asset class in their own right. Derivatives should be seen as tools generating exposures, which can be used to manage the specific risk and return demands of the investors in conjunction with the more traditional instruments.
Stephen Ashworth is senior managing director, consulting division at Reech Capital in London

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