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Course 408
Derivatives

Introduction

For some investors, the term "derivatives" may have a negative connotation because of the role these complex instruments played in recent financial disasters. But many institutional investors, banks, governments, hedge funds, and corporations rely on derivatives as a way to manage risk, pursue hedging strategies, and achieve other financial objectives. Likewise, mutual funds and exchange-traded funds are increasingly using derivatives as part of their investment strategies.

A full discussion of how derivatives work could fill a book, but for investors curious to learn more about what they are and how some funds use them, here's a primer.

Defining Derivatives

The term "derivatives" refers to financial instruments that derive their value from an underlying asset, such as equities, bonds, commodities, or real estate. Some types of derivatives, such as options and futures, might already be familiar to you. These, along with swaps, are among the most commonly used types of derivatives in the financial world. Here are some basic definitions and examples of these three commonly used derivative types.

Futures:Agreement between two parties to buy/sell an asset at some point in the future at a price that is determined today. Although originally developed for use in trading commodities, today commodity futures make up less than one third of futures traded. Other types include equity index (such as the S&P 500) and even interest-rate futures.

Sample uses: A farmer locks in a high price today for crops he will sell at a later date; an airline locks in future jet fuel prices today to guard against potential price increases at a later time.

Options:Gives its owner the right to buy or sell an asset at a given price for a set time period. Because the option represents the right to purchase the asset and not ownership of the asset itself, it typically costs just a fraction of the asset's price. These instruments may be used to gain exposure to equities, ETFs, equity indexes, and commodities. Options come in many varieties and can be used as part of many different trading strategies, such as betting that the price of an asset will go up or that it will go down.

Sample uses: An investor wants to hedge against price swings in a security he or she already owns (covered call); an investor wants to help protect his or her portfolio by buying some downside exposure in case of a market downturn (protective put).

Swaps: Agreement between two parties to trade different payment types over a given time period. These may be used to swap interest-rate or currency exposure, or credit protection (credit default swap).

Sample uses: A bank looking to reduce its exposure to floating interest rates paid on deposit accounts swaps that exposure with another party that can provide exposure to a fixed rate; companies operating in different countries swap currency exposures as a way to reduce currency risk.

Widely Used Among Funds

Mutual funds may use derivatives as a way to gain, hedge, or short exposure to a certain type of asset, often at a cost that is lower than it would take to own the position outright. Use of derivatives is prevalent across fund categories.

Derivatives used by bond funds included bond index and currency futures and forwards, options on bond indexes and currencies, and interest-rate and credit default swaps. Stock funds, on the other hand, were more likely to use equity index and currency futures and forwards and options on indexes and individual equities. Alternative funds tend to be heavy users of derivatives--for example, trading futures and options as part of a long-short equity strategy.

Let’s take an example of how a fund might use derivatives, focusing on a large-blend equity fund that aims to track the S&P 500, with a little bit of extra return thrown in. Rather than simply seeking to hold all the stocks in the index at the appropriate weightings, as a typical S&P 500 index fund would do, a manager could use futures and swaps to gain exposure to the index and its price changes at a much lower cost. This allows him to invest the fund's large pile of unused cash in short-term bonds in an attempt to boost returns and beat the index.

Use of derivatives also is built into the DNA of so-called leveraged ETFs, which rely on them to execute some rather exotic trading strategies in some cases. ProShares UltraShort QQQ is designed to deliver twice the inverse daily return of the tech-heavy Nasdaq 100 Index. On days when the Nasdaq 100 is down, the fund aims to deliver a positive return, times two. And on days when the index is up, the fund will have big losses. The ETF pursues its objectives exclusively through the use of derivatives such as futures and swaps, without holding any of the index's underlying securities. (An ETF like this also illustrates the potential risks of such a leveraged strategy in that a sizable gain in the index would result in a loss twice as large for investors. It should only be used by high-frequency traders and those hedging against or anticipating a near-term drop in the index.)

Transparency an Issue

By now you may be asking yourself, how can I tell if the funds I own use derivatives? It's a good question, as investors have the right to know how money they entrust to a fund company is being invested. However, disclosure of derivative use by funds unfortunately has been inconsistent.

Further exacerbating the transparency problem is the fact that, while some derivatives, such as futures, are traded on regulated exchanges, others, including swaps, are traded privately in the over-the-counter market, potentially adding credit risk.

The use of derivatives by some funds makes knowing how your fund works that much more important. Used properly, they can help manage risk and foster innovative investing strategies. But used irresponsibly, they can court disaster. As an investor, you owe it to yourself to understand how your fund works and whether derivatives are part of its approach. And if your fund company is less-than-forthcoming with this information, you have every right to demand it.

Quiz 408
There is only one correct answer to each question.

1 What is a derivative?
a. Financial instruments that derive their value from an underlying asset, such as equities, bonds, commodities, or real estate
b. Financial instruments used exclusively for hedging
c. Financial instruments used exclusively for managing risk
2 What type of derivatives are agreements between two parties to buy/sell an asset at some point in the future at a price that is determined today?
a. Swaps
b. Options
c. Futures
3 What type of derivative would an airline use to lock in jet fuel prices today to guard against potential price increases at a later time?
a. Futures
b. Options – specifically, covered calls
c. Options – specifically, protective puts
4 Which statement is true:
a. Mutual funds cannot use derivatives
b. Many mutual funds use derivatives
c. Only high-risk funds use derivatives
5 Which statement is false?
a. It’s easy to tell if a fund is using derivatives
b. Used properly, derivatives can help manage risk and foster innovative investing strategies
c. Some derivatives are traded on regulated exchanges while others are traded privately in the over-the-counter market
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