Derivatives are unfamiliar territory for many investors. But they can be a strong ally to your portfolio. Using derivatives prudently in your portfolio can mean additional opportunities to expand your exposure to potentially attractive investment opportunities that can enhance performance, or reduce your exposure to potentially harmful ones, while effectively allocating and managing risk.
What is a derivative?
A derivative is essentially a financial tool widely used to protect against and manage risk, or to make an investment in specific assets. It’s a contract between two parties regarding a transaction to be fulfilled in the future, at a specific price. It gets its name from the fact that it derives its value from an underlying asset like stocks, bonds, commodities, currencies or indexes. Without having to own the underlying asset, investors can use derivatives to take a position based on a view of where the price of the underlying asset will go.
A real-world example
Consider a portfolio manager who expects the U.S. stock market to outperform the European stock market over the next several years. To reflect this view, the portfolio manager could sell European stocks within his portfolio and buy U.S. stocks. However, this would generate many transaction costs. Instead, he could use the futures market to enter into this transaction. The portfolio manager could buy an S&P 500 futures contract and sell a Euro Stoxx 50 contract with a set term to expiry. He would need to put down only a portion of the capital required to reflect this view—typically less than 10%. In this case, the portfolio manager would achieve his asset allocation goal, with fewer transactions and associated costs.
Key benefits of using derivatives
- They improve market efficiency for the underlying asset, in terms of both cost and price.
- They offer low transaction costs compared with the cost of investing directly in the underlying asset.
- In the case of futures, they are highly liquid and standardized to ensure efficient trading.
- They are subject to regular reporting of information, and their performance is highly transparent—much like stocks.
Debunking the myths
Derivatives are new and complex products.
Derivatives have existed for years via the bartering of goods and services. In fact, they date back to a time when organized markets didn’t yet exist.
Derivatives are risky.
If the underlying assets of a derivative product cannot be properly valued, then investors may be exposed to excess risk. A good example of this were the unreliable models behind collateralized debt obligations that led to the 2008 financial crisis. But, properly valued and employed, derivatives can be an efficient tool to generate returns and manage risk.
Derivatives are useful only for institutional investors, i.e., large banks and financial institutions.
When used prudently, as part of an individual investor’s diversified portfolio, derivatives can potentially boost performance and protect against risk.
Types of derivatives
The main types of derivatives are futures, forwards, swaps and options.
Both futures and forwards involve an agreement to buy and sell a certain financial asset at a predetermined price at a specific time in the future. Futures contracts are standardized, legal, market exchange-traded contracts, while forward contracts are private agreements between two parties, tailored to those involved.
A swap is an agreement between two parties to exchange cash flows for a specified period. This type of arrangement can be based on interest rates, stock indices, currency exchange rates or commodities prices.
An option is a binding contract that gives the buyer the right to buy or sell an underlying asset at a specific price on or before a certain date.
How derivatives are used in investing
Derivatives provide an opportunity to invest directly in certain assets without buying and holding the asset itself. One of the most important uses of derivatives is risk management within an investment portfolio. They allow for specific risks to be targeted, and can be used for two main purposes: to help boost performance (use derivatives to support an investment thesis to help make profits) and to hedge (reduce risk) on investments.
How derivatives are used in currency management
Investing in international securities will result in volatility when currency rates change, or when the value of the investment is calculated in a local currency. Portfolio managers can use dynamic hedging strategies to manage currency risk, with a chance to improve returns from currency exposures and to manage the volatility associated with currency fluctuations. With a currency strategy in place, a currency manager can increase or decrease foreign currency exposure, depending on the view of the currency.
To learn more about currency risk, read How to Manage Currency Risk in Your Investments.