Tackling the topic of ‘risk’ at the recent Mako/IPE roundtable on derivatives, I was surprised at the somewhat hazardous perception today’s institutional investors have of derivatives, even in the difficult market environment we are experiencing today.
On reflection though, this concern is understandable. In the first instance, derivatives products are, after all, relative newcomers to the world of finance.
Consider that the modern era of exchange-based derivatives trading only began in 1973 with the introduction of the Chicago Board Options Exchange (CBOE) and the Options Clearing Corp (OCC).
Furthermore, options on stock indices were only introduced in 1983. Compare this short history with that of the New York Stock Exchange (NYSE), founded in 1790, and you can see why such an arriviste might be treated with some suspicion.
This is compounded by the apparent complexity of derivatives products, which have a language of their own. Research reports are filled with discussion of gamma, theta, delta and the relative strengths of one pricing model over another. Additionally, the sheer range of derivatives contracts that can be traded can be baffling: options trade on frozen orange juice, world indices and even the weather!
Perceptions of derivatives are also inextricably linked with the high-profile ‘disasters’ involving their use. Mention that you are a derivatives trader, and most people (even those with expertise in other financial areas) invariably compare you to Nick Leeson.
Otherwise, derivatives are closely linked with the comments made by one of their most high-profile users – Warren Buffett. His claim that derivatives were “financial weapons of mass destruction” has stuck firm. The fact that he is one of the most successful money managers of our time has added credence to his comments.
However, while these arguments may seem compelling on first appearance, they all hide serious flaws. Whilst it is true that listed options as we know them are new, there is also a long history of successful derivatives use, stretching back to olive producers in the Roman Empire, tulip growers in sixteenth century Holland and currency traders in the post-Bretton Woods era. With regard to the Barings derivatives disaster, whilst it is true that derivatives trading effectively bankrupted the institution, it is also clear on closer examination that it was the trader himself, the lack of supervision and distinct lack of risk management that led to the losses, not the derivative products themselves.
Equally, Buffett’s comments, taken to be representative of all derivatives, were in fact the result of his own very personal experiences at Gen Re, and specifically his use of over-the-counter (OTC) rather than listed options.
Similarly, although derivatives can appear complex, they are in reality no more complicated than other financial instruments. Options trading is ultimately underpinned by several key theoretical and pricing principles that are startlingly simple. With the appropriate education, derivatives are both easy to understand and use.
And the reality is that derivatives are being used prolifically by investors.
This can be demonstrated by the fact that exchanges introduced 127 new derivatives contracts in the second quarter of 2003 alone. Likewise, investment in exchange-traded funds has expanded rapidly in recent years.
No greater a financial giant than Alan Greenspan also agrees that derivatives are sound risk management tools: “The use of an array of derivatives and the related application of more sophisticated methods for measuring and managing risk are key factors underpinning the enhanced resilience of our largest financial intermediaries. The benefits of derivatives, in my judgement, have far exceeded their costs. These increasingly complex financial instruments have especially contributed, particularly over the past couple of stressful years, to the development of a far more flexible, efficient and resilient system than existed a quarter of a century ago,” the chairman of the US Federal Reserve said last year.
The myths dispelled, the starting point for any examination of derivatives is the way in which institutional investors can use (and are already using) derivatives to their benefit. At the Mako/IPE roundtable, a great deal of the conversation revolved around the matching of assets to liabilities – a task that has become more difficult as interest rates have steadily declined since 1996. The discussion focused on the risk of finding appropriate assets offering the relevant level of return in a low or declining interest rate environment. Here it was acknowledged that derivatives could be instrumental in mitigating the liability risk for institutional investors.
Moreover, there are several key ways in which derivative products can be used to safeguard a portfolio.

Asset switching
Take asset switching, for example. The timing of any market turnaround and the liquidity of the cash markets at such a critical point are unknown quantities. The obvious question is what an asset manager can do to avoid this situation or at least limit the damage that might be done to their portfolio . Derivatives products provide a continual liquidity stream even during distressed market times and at a cost that is significantly less than the results of no liquidity or limited liquidity1. A second crucial point covered at the IPE roundtable was the ability of fund managers to prosecute long-term strategies in an increasingly volatile world where extreme movements in asset valuations threaten both the fund strategy and ultimately the solvency of the underlying company that guarantees these funds. Option overlay (one of the specific derivative strategies used to control adverse price movements) removes the necessity of having to sell into falling market where a seller will not get a fair price – potentially affecting the valuation of the remaining portfolio. This was seen by participants at the Mako/IPE roundtable as a clear benefit of using derivative products.

Long-term hedging
Given this view, it is still surprising that the boards of many insurers and pension funds remain suspicious of instruments designed to accrue value as the underlying asset loses value, thus hedging against adverse price movements. Options can be used very efficiently as a long-term hedging strategy against adverse market movements. A further advantage is that the volatility cost of the structures is often relatively cheap when the hedge is created because the perceived risk of an event such as a steep sell off in the future is low. The cost of a downside equity or index hedge can also be offset by selling calls. An asset manager who calculates the absolute return required on the portfolio is then able to write calls above this level, reducing the cost of the put purchase.
An example helps to illustrate the point. Consider an investor who has bought a FTSE future on 22 May 2003 expiring on 19 September 2003 at a level of 3,920 points. According to information implied by the options market, the expected volatility of this portfolio is 26.2%. An investor may be concerned that if there is a market crash the portfolio will lose a significant amount of its value. One option is to buy a September put option with strike 3,475 and write a September call option with strike 4,225. These have similar prices and so for little cost one can effectively sell downside risk at the cost of not participating in the upside (beyond 4,225 points).
The red line in Figure 1shows the profit and loss if no option position is held and the blue line shows the profit and loss if the option position described above is held. Without options the downside and upside has no limit; with options both are capped. It can be shown that the expected value of both positions on 19 September 2003 is in both cases 3,920. But, while the volatility of the portfolio without options is 26.2%, the volatility of the portfolio with options is 13.6%. Thus the volatility has approximately been halved for very little cost. (The put is nine points more expensive than the call in this example.)

Migrating risk
Migrating risk is another important strategy key to investment managers. Different corporates, pension funds and money managers possess different risk profiles and appetites for risk. Moreover, these risks are dynamic and as such, constantly changing. A risk that does not currently suit XYC corporation might enhance the portfolio of ABC insurance company, and vice versa. At some future point these risks might be reversed, or different in some way. Where one user might be over-exposed to gamma, or to theta, another may well desire greater exposure. In these situations, investors need a liquid and transparent repository of risk into which they can deposit and withdraw risk as it suits them. Mako’s market-making expertise enables end-users to access an attractive liquidity pool to migrate their risk efficiently.

Portfolio enhancement
Finally, a further significant use of derivatives is as portfolio enhancement tools, particularly relevant to institutions today that are having trouble finding asset classes that will return the kinds of levels needed to fund any pension or insurance guarantees.
For example, in a trending market an investor who is confident of a particular stock strongly rising or falling in value can participate in this opportunity without using large amounts of capital. Consider a hypothetical option on the Finnish technology stock Nokia. The price on 22 May 2003 is e14.20. An investor who thinks that this price will rise over the next few months could buy a call option on Nokia stock with a strike price of e14.00.
An option to buy 100 Nokia stock trades in this market would cost around e162.00. This is to be compared to e14.20 to buy 100 stock. If the stock were to rise to say e17.00 on 19 September 2003 then the option would be worth e300 (a profit of e138). This equates to an 85% rise in the option price for a 20% rise in the stock price. Therefore our investor can make higher returns if he is confident about the market direction. Figure 2 shows the profit and loss as a function of the Nokia stock price for a stock position and an options position.
The option position makes slightly less money in absolute terms for a much smaller initial outlay. However, this equates to a much higher return. A similar result can be obtained by buying a put option if the investor is confident that a stock price will fall.

Not a liability but an asset
The above findings suggest that the goal of all managers of assets and their various boards of directors should not be to ignore risk in the form of derivatives, but to look closely at where they might gain from their deployment.
Nonetheless, there are areas that need to be addressed for derivatives trading to be successful. The Futures and Options Association recently published a dossier Managing Derivatives Risk to acknowledge potential risks and help end-users in their derivatives trading. One of its key recommendations was that investors should create an effective policy for derivatives. This includes the establishment of a senior level risk management and audit programme across all products, approved at board level and consistent with the underlying strategy, objectives and risk appetite of the organisation.
A good risk management system, combined with traders and managers who understand the derivative structures they are using, transparent and liquid pricing and no counterparty credit exposure (in other words exchange-traded futures and options), mean that derivatives offer the most efficient way to protect against, and even benefit from, an uncertain and inherently risky world.
With these kinds of safeguards in place, derivatives should not be a liability but rather a benefit to a company.