If derivatives are used directly by a pension fund carrying out its own management, the fund should have clear policy guidelines on their use. Similarly, to obtain permission to deal in derivatives for a client, an investment manager should clearly define their policy. This would need to cover such criteria as:
o definition of derivatives and the purpose for which they should be used
o types of derivatives to be used
o internal and external constraints
o procedures for seeking approval for usage of new types of derivatives or those which have been materially altered
o counterparty policy
o who within the organisation is authorised
o procedures for monitoring of derivatives activity
A robust policy reduces the risk of derivatives being misused and means that trustees and investment managers should be clear as to both why and where derivatives can be used.
To satisfy efficient portfolio management requirements there are certain criteria that need to be met. These are that the transactions must be “economically appropriate”, any exposure must be fully covered by cash, or other scheme property sufficient to meet any obligations to pay or deliver, and that the derivative transaction must result in one or more of the following:
o reduction of risk,
o reduction of cost,
o generation of additional capital or income for the company with no, or an acceptably low, level of risk.
The first two of these allow for a switch in exposure through use of derivatives rather than dealing in the underlying stock. There are regulations, however, which state that a derivative transaction should not remain in the portfolio indefinitely, ie the company must revert to some kind of transferable security within a reasonable time. Definitions of reasonable time and transferable securities should be included in the funds’ derivatives policy.
Exchange traded derivatives have standardised contracts, which facilitates transaction efficiency and hence liquidity. Centralised trading of these derivatives gives price transparency and a position can be closed out by taking an equal and opposite position in the same product. There is also a requirement to deposit initial margin and then variation margin on a daily basis to cover day to day movements in the price of the contract. This margin is paid to the clearing house which acts as guarantor of the contracts performance to all parties.
Over The Counter (OTC) instruments, on the other hand, are derivatives that are not listed. Therefore they do not have a clearing house to guarantee contract performance. When two parties are entering into an over the counter trade each must consider the credit worthiness of the other party.
Tony Whalley is investment director at Scottish Widows Investment Partnership in Edinburgh