What are derivatives?

How do derivatives impact mutual funds and stock portfolios?

Mutual Funds, Stocks
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October 2016

In financial terms, a derivative security is generally referred to as a financial contract whose value is derived from changes in the value of an underlying asset, or simply "the underlying," over a predetermined period of time. Today, derivatives are traded on a wide variety of financial and non-financial assets, including specific stocks, equity indices, currency cross rates, fixed-income instruments, expected volatility embedded in market prices, commodities, credit events, and even other derivative contracts. Depending on the type of underlying, the value of a derivative contract can be derived from changes in the value of the underlying equity prices, interest or inflation rates, foreign exchange fluctuations, commodity price changes, market sentiment, and the probabilities of certain credit events. 

Participants in the derivative markets are typically classified into one of two categories: they're either grouped with the "hedgers" or the "speculators." Hedgers enter a derivative contract to protect against adverse changes in the value of their assets or liabilities. For instance, a U.S.-based conglomerate selling to retailers abroad in the emerging markets and extending credit with typically terms (such as net 30 or net 60 day payment) will produce these goods with costs denominated in the U.S. dollar, yet they won't be paid for another 30 or 60 days, in the Argentine Peso or the Turkish Lire -- with the inherent volatility in these currencies, if my sale today amounts to a required payment in 30-60 days of 1,000 Argentine Peso, today this is worth around $65. But, the Argentine Peso could be cut in half over the next 60 days, making my receivable of 1,000 ARS worth only $32.5 when translated back to USD, meaning I suffer a significant loss. In this case, I would want to hedge this exposure to fluctuation in the Argentine peso by entering into a contract with a "speculator" or another hedger who has a future liability to pay in Argentine peso and seeks to protect his purchasing power. 

"Speculators," on the other hand, seek to profit from anticipated changes in equity prices, credit markets, interest rates or inflation / foreign exchange, defaults on credit instruments or a lack thereof, or changing commodity prices, among other things. 

There are four main types of derivatives (without getting into the more exotic types): (1) Forwards, (2) Futures, (3) Options, and (4) Swaps.

Forwards and Futures are similar as both represent an agreement to buy or sell a specified quantity of an asset at a specified price with delivery at a specified date in the future. The differences in futures vs. forwards is that futures are exchange-traded, standardized agreements with daily settlement for changes in the value of the underlying. In contrast, forwards are what's referred to as "Over-the-Counter" contracts, which are agreed upon between two parties and loosely regulated (since they're not exchange traded and no clearinghouse exists for these contracts). 

In an Options transaction, the purchaser pays the seller - or "writer" - of the option for the right to buy or sell the underlying asset at a specified price (the "exercise" or "strike" price) in a specified quantity anytime prior to the option's expiration (the "expiration date"). Note this refers only to "American-Style" options, whereas "European-style" options allow the buyer the option to buy/sell the underlying only on the expiration date. Options can either be in the form of "calls" or "puts." A call option gives the option-buyer the right to buy the asset at the strike price any time prior to expiration, such that if the price of the underlying rises over the option's term, the option rises in value. If the underlying's price rises above the strike price, the option will be exercised, at which point the buyer receives the difference between the excess of the price of the underlying over the exercise price, multiplied by 100 (reflecting the leverage inherent in options trading). On the flipside, a "put" option gives the option-buyer the right to sell an asset at a predetermined price (the "exercise price") over the option's term. Those who expect the underlying to appreciate in value will buy calls, while those anticipating the underlying's value will fall buy put options. Option writers, or those guaranteeing the option, receive an option "premium" in exchange for the inherent value of the option. Those who buy options (calls or puts) anticipate volatility in the underlying asset, whether to the upside or to the downside. Conversely, option writers expect little movement in value of the underlying, such that the option will expire worthless (otherwise known as "out-of-the-money"). 

Swaps are agreements between two parties to exchange a series of cash payments for a stated period of time. The period payments can be exchanged based on the receipt of cash flows using the differential between fixed and floating interest rates, multiplied by an agreed upon amount, called the "notional value" of the swap. 

Now that I've explained the basics, I can address your question as to the impact of derivatives of stock and mutual fund portfolios. Hedging or speculating is not the only drivers of derivatives transactions today.

Fund mangers often use derivatives to achieve specific asset allocation targets for their portfolios. Mutual funds today come in a variety of forms and pursue a variety of different strategies. A bond fund manager may hold interest rate derivatives to protect the total portfolio from declines in the value of fixed income investments resulting from a hike in the Fed Funds Rate or a general tightening in the credit markets. A mutual fund pursuing a global macro strategy (more common to hedge funds, but certain mutual funds pursue this strategy) may hold a significant share of derivatives, reflecting the fund manager's expectations for the direction of interest rates in various geographies and the corresponding monetary policy action, foreign exchange movement, and economic activity. Mutual funds pursuing a long equity strategy may used some "covered calls" to boost returns. With a covered call, upside is limited if the stock takes off big, but if it rises in value without going beyond the strike price on the short call (with a short call, a fund manager agrees to give the counter-party the option to buy 100 shares of the stock he holds at a price above its current price, over a pre-specified time period, and receives a premium in exchange). As long as the option held by the counter-party is never exercised, the fund manager pockets the premium and boosts returns on his overall equity portfolio. 

October 2016