Understanding Derivatives
Tom May, Chief Executive & Investment Officer
Given the current market turmoil where correlations across asset classes have dramatically come together, multi-asset investors should explore every tool in the box, and derivatives have a key role to play.
A derivative is any financial contract whose value is derived from another and is therefore dependent on the prices of their underlying assets.
These contracts are transacted between parties (the counterparties), enabling these counterparties to secure a future price in the underlying securities.
They are most often used to hedge against future price movements and as a way of limiting the risks of price swings in the underlying assets on which they are based.
"The derivatives market has grown to be incredibly extensive."
The first concrete record of a derivative contract dates to about 600BC, when Greek philosopher Thales of Miletus used his knowledge of astronomy to predict a bumper olive crop and hired all the olive presses, so that when the harvest was ready, he would be able to let them out at a rate that brought him sizeable profit.
His prediction turned out to be correct, and the world’s first derivative trader became very rich.
From this very early start, the derivatives market has grown to be incredibly extensive.
Derivatives are traded privately (over-the-counter, or OTC) or via an exchange.
The OTC market is larger, and unregulated.
As such, OTC derivatives generally have greater counterparty risk.
The advantage, though, is the ability to tailor contracts to very specific needs – it is like being measured for a bespoke suit, but with a weakened right of return if it splits at the seams.
On the other hand, exchange-traded derivatives are off-the-peg but come with more protections.
In 2021, the total notional amount outstanding for OTC contracts in the derivatives market was about $600tn ($491tn), with exchange-traded volumes running up to about $10tn daily turnover in early 2022.
By contrast, the global bond market is estimated to be about $130tn, and the value of stock markets globally slightly less.
Derivatives have myriad different structures and uses, but break down into a handful of fundamental types.
Forward and futures contracts
Forward contracts are the oldest and simplest.
These are OTC contracts to buy and sell an asset at a set price on a specific future date.
"Derivatives do come with risks."
Futures are very similar but are traded on a recognised exchange.
In this case, the buyer and seller do not enter into a direct agreement but have an agreement with the exchange providing enhanced security.
Options
Unlike futures and forwards, options contracts are asymmetrical in relation to counterparty duties and obligations.
Where futures and forwards require both parties to make a transaction at a specified price on a given date, options require one side to do this, while the other has a choice in determining whether the trade takes place with the party; paying more for this privilege.
There are basically two types of option: one where the buyer has the right but not the obligation to transact (or a call option), and the other where the seller has the right (a put option).
For example, airlines often use call options as a way of making their fuel costs more predictable.
Swaps
Swap contracts are where two counterparties agree to exchange their cash flows: a fixed for a floating rate, as is the case with fixed-rate mortgages; or exchanging two different interest rates, underlying currencies or even bond default rates.
"Derivatives can be used to speculate on the direction of an asset's price."
For example, if a firm wants a fixed-rate loan, it can agree a floating-rate loan from a bank and enter an interest rate swap to get a fixed rate and hedge the interest rate risk – something with obvious advantages in the current rising rate environment, if you manage to get the timing right.
Advantages
Derivatives offer investors multiple advantages. Firstly, they can be used to hedge a financial position, protecting against potential losses if the value of an underlying asset changes markedly.
Similarly, derivatives can be used to speculate on the direction of an asset’s price, or to arbitrage market inefficiencies.
In this way, derivatives can increase market efficiency. By using derivative contracts, you replicate the payoff of the underlying assets.
The prices of those assets and their derivatives will tend towards equilibrium, thus aiding market efficiency.
"Derivatives also allow investors to use their capital with greater efficiency."
For example, commodity futures’ spot prices (the price right now) can serve as an approximation of their underlying price.
Derivatives also allow investors to use their capital with greater efficiency, by enabling them to gain exposure to a range of assets without equivalent cash.
In this sense, it is a form of leverage, with the risk that the greater this leverage, the greater the potential for loss.
In markets such as we now face – greater economic uncertainty, higher inflation and interest rates meaning returns are likely to be more uncertain and therefore lower for longer – derivatives can provide predictable returns with a higher probability of securing them.
For instance, we think simple derivative investments linked to the performance of one or more large, liquid equity indices have real value.
One example is a derivative instrument called an autocall.
This provides a defined rate of return over (generally) a five or six-year period alongside a level of capital protection.
The autocall pays out at the end of the first year if markets rise.
"As with any financial market transaction, if there is a big upside, there is an equivalent downside; the same is true with limited upside."
If they fall, it continues, rolling up the annual return until either the market recovers enough to meet the payout criteria or the product matures.
This is well suited to the current period of extreme market volatility, offering investors a degree of predictability in their returns that naked exposure to equity markets cannot provide.
Another application of derivatives in the current environment is to protect against - and even profit from - rising inflation.
Knowing the market and having strong relationships with banks to negotiate optimal OTC contracts can enable an investor to buy inflation swaps at, for example, 3.2 per cent when UK CPI is running closer to 12 per cent, netting a profit on the difference.
Reasons to be cautious
Derivatives do come with risks.
For example, if you enter into a derivative contract, and the market moves against you, you could be exposed to significant losses if the terms of the contract leave you open to such losses.
This is why it is important to have strong relationships with banks so that OTC derivatives can be negotiated on favourable terms.
As with any financial market transaction, if there is a big upside, there is an equivalent downside; the same is true with limited upsides.
And you are exposed to counterparty risk, particularly with OTC derivatives.
The role of derivatives in the global financial crisis is a paper in its own right, but problems stemmed from the way key market participants played fast and loose with derivatives such as credit default swaps (CDSs) based on complex and opaque debt instruments, much of which was ultimately traceable back to the US sub-prime mortgage market.
"Investors are struggling to come to terms with this sea change and what it means for their returns."
Poorly constructed risk models added to this toxic brew, giving the impression that by ‘diversifying’ across inherently unstable debt products you could get something that delivered high returns at low risk.
Though with less far-reaching consequences, it was a similar story with the large sums attracted by funds within the Investment Association’s Targeted Absolute Return sector. The sector’s promise of positive returns in any market conditions frequently disappointed.
From 2013 to 2017, the sector attracted more cash than any other, with the big money takers generally promising around 5 per cent above cash, less charges.
The three, five and 10-year annualised average returns for the sector have not delivered anywhere near this.
When returns dried up, flows went negative, and have stayed that way for almost every quarter since 2018. There was a range of strategies used across the sector, often highly opaque, and often far from clear how they could lead to the return objective.
In both of these cases, while the poor use of derivatives played a central part in what went wrong, blaming the inevitable unravelling on derivatives is a step too far.
"Derivatives strategies have the capacity to deliver the long-run return of shares with greater probability."
While derivatives have caused losses in the past, they are not something to be feared but are instead tools that, like any other, can be used and misused.
Why are they relevant now?
Markets hate uncertainty, which means the current pessimistic outlook is creating attractive long-term opportunities for new defined returns investments.
Embracing the predictable
Investors are struggling to come to terms with this sea change and what it means for their returns. In this context, it will be crucial to move from chasing the highest potential return, with a huge range of uncertainty around it, to instead pursuing the predictable.
For investors who look beyond the short term and do not expect markets to be completely disastrous over the coming few years, the current environment provides an opportunity to lock-in the potential of higher returns and increased protection when compared to recent market performance.
In a world of volatile equity markets and structurally weaker expected returns, derivative strategies have the capacity to deliver the long-run return of shares with greater probability.
At the very least, they offer the possibility of building predictability into multi-asset portfolios in this most uncertain of times.
This article can also be read here: FT Adviser