Uses and abuses

Derivatives can come in handy for more than just a liquidity stream in tough times

Derivative structures, specifically exchange-traded options, can provide several key advantages to institutional investors and investment managers.

Some of the advantages relate to asset switching and hedging, as well as cost savings and the ability to capture market trends without significant capital outlay.

Asset switching: 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 can an asset manager do to avoid this situation, or at least limit the damage that might be done to a portfolio by it.

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 liquidity. (See note one at the end of the text).

Hedging: Options can be used very efficiently as a long-term hedging strategy against adverse market movements with the additional advantage that the volatility cost of the structures is often relatively cheap when the hedge is created as the perceived risk of an event, such as a steep sell off in the future, is low.

Other factors such as the exponential gamma increase as an option becomes closer to an at-the-money strike, also make options hedging attractive.

Reduced costs: The cost of a downside equity or index hedge could, for example, 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 put purchase.

Trending: Options can also be used effectively in a trending market to participate without using significant capital.

The volumes of derivative products being traded are also testament to their wide ranging and increasing use within the financial community. On the one hand, 2002 was a year of uncertainty, weak earnings and corporate scandal. European equity markets closed the year with losses of between 25% and 50%.

Equally, 2002 was a year of increased hedging activity and growing volumes in derivatives markets. In January 2002 alone, 65 million contracts traded on Eurex, representing a daily average of three million lots and an increase of 22% on January 2001. (See note two at the end of the feature).

Interestingly, this increased derivatives volume has been seen mainly in exchange traded contracts. The quarterly review of the Bank for International Settlements saw the aggregate value of exchange-traded derivatives for 2002 rise by 17% to $694 trillion. (See note three).

Exchange traded options have several advantages over over-the-counter (OTC) packages, which have become increasingly attractive to asset managers.

Given the recent credit downgrading of several large investment institutions, it is perhaps not surprising that traders increasingly prefer to avoid single counterparty risk (no matter how seemingly infallible).

Exchange traded options avoid this by providing a central counterparty ' the exchange clearing house.

In addition, the transparency of the exchange environment provides for open price discovery, and the sheer number of exchange participants generates a more competitive pricing environment than is the case with OTC products.

The most frequent complaint levelled against exchange traded options in the past, has been that the markets are not easily capable of dealing with large denomination trades that could be facilitated by OTC transactions.

Although this might once have been true, it is no longer the case. Increased exchange volumes and open interest demonstrate that these markets can now facilitate large denomination positions that might previously only have been possible in an OTC transaction. (See note four).

The Abuses of Derivatives

Derivative products are not inherently dangerous, as many commentators would have us believe. They are certainly not 'financial weapons of mass destruction', as Warren Buffett has suggested. (See note five).

While some of Buffett's concerns may be true regarding OTC products, this is not the case with exchange-traded products.

Quite the contrary, for many large institutional investors, derivative products have become instruments of financial salvation ' valuable tools in the financial arsenal.

This is not to say that derivatives (like many other financial products) are without risk. Rather it is to point out that what derivative products require above all is clear understanding, correct usage and appropriate position and risk management.

The flexibility and leveraged nature of some options strategies demands monitoring of changes in market conditions, options risk and value, and requires regular re-assessment and, if appropriate, active management.

If this is the case, then it is my firm belief that the many benefits of options (essentially an insurance policy against possible future risks) far outweigh the risks.

The Uses of Derivatives II

There are several ways in which options products may usefully be incorporated into a portfolio. Two examples are: using options to hedge an underlying portfolio risk; and using options in a cash-efficient manner to participate in a trending market.

Hedging Risk

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 out downside risk at the cost of not participating in the upside (beyond 4,225 points).

In graph one on page 41, the red line shows 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.

Trending Markets

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 their capital.

Consider an 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.

An option to buy 100 Nokia stock trades in the market around E162.00. This is to be compared to E1,420 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, an investor can make higher returns if they are confident about the market direction. The second graph shows the profit and loss as a function of the Nokia stock price for a stock position and an options position.

Thus we see that the option position makes slightly less money in absolute terms for a much smaller initial outlay.

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.

As has been illustrated, there exist many advantages to institutional investors and investment managers of using listed options to hedge and to enhance performance, as many market participants currently using these products and their increasing volumes on exchanges around the world would attest.

With correct understanding, usage and risk management, derivatives need not be significantly more 'dangerous' or 'destructive' than the wealth of other financial products used by these investors.

Notes:

(1) During the previous stock market sell-off in 1987 and at several points during the 2000-2002 sell-off, it became effectively impossible to sell holdings of stock and transfer capital into government bonds, due to a lack of liquidity in the underlying cash markets. Asset managers were also faced with the prospect of damaging their own remaining portfolios of stock through forced liquidation. This phenomenon affects bond markets equally ' for example the events of 1994 created an almost complete lack of liquidity on the buy side.

(2) In January 2003 this increased still further ' Eurex traded 85 million contracts ' an increase of 30% on January 2002 and a daily average of 3.9 million lots. Source: www.eurexchange.com Date of Access 30th April.

(3) Bank for International Settlements. Quarterly Review 10th March 2003.

(4) For example, the current open interest in June 2003 options alone on the Bund stands at 746,556. Current open interest across the equity index options on Eurex stands at 14,548,299 Source www.eurexchange.com Monthly Press Releases, as at 30 April.

(5) 'Buffett warns of Derivatives Time Bombs', Andrew Hill, Financial Times, 4 March 2003.

Key Points

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 liquidity.

The timing of any market turnaround and the liquidity of the cash markets at such a critical point are unknown quantities.

With correct understanding, usage and risk management, derivatives need not be significantly more ˜dangerous' or ˜destructive' than other financial products used by investors.