Point of View

As institutional investors rebuild portfolios in the aftermath of the global credit crisis and ensuing recession, they are increasingly considering, and incorporating, derivatives-based strategies. “We have seen increased usage of credit default swaps, commodity futures and interest-rate swaps to manage risk in investment portfolios,” says Shundrawn A. Thomas, president, Northern Trust Securities, Inc. “Prudent risk management should be the cornerstone of any investment strategy,” Thomas adds, “and used intelligently, derivatives can bring an extra element of risk control to a portfolio.”

Both exchange-traded derivatives, which are settled through a centralized clearinghouse, and over-the-counter (OTC) derivatives can be used to provide institutional investors with the type and level of risk mitigation they desire. “There may be any number of objectives a client may have,” Thomas notes. “They may be trying to protect gains, obtain synthetic market or asset class exposure or adjust the duration of a fixed-income portfolio without selling the underlying securities. Derivative-based strategies can be employed to help meet those objectives.”

There has been explosive growth in both exchange-traded and OTC derivatives as investors seek protection from risks such as inflation, rapidly increasing interest rates or market volatility. The Chicago Board Options Exchange (CBOE) reported that average daily volume of futures contracts traded in August 2009 increased 16% over the volume for August 2008. In the first six months of 2009, the notional amount outstanding of interest-rate derivatives, including interest-rate swaps and cross-currency swaps, grew by 3% to $414.1 trillion, according to the Bank for International Settlements (BIS), the Basel, Switzerland-based clearinghouse for central banks.

Although derivatives are sometimes referred to as alternative investment strategies, that label is a misnomer. “Derivatives strategies are becoming mainstream and are increasingly being used by traditional investors as an effective risk management tool,” Thomas says.

Strategies for the Current Environment

One major benefit of using derivatives is that they enable investors to quickly adjust their portfolios to respond to changes in market conditions. For example, Standard & Poor's projects that dividends for the S&P 500 may decrease by 13.3% in 2009, the worst decline since World War II.

Michael Leon, managing director, risk management solutions, Northern Trust Securities Inc., says investors concerned about this decline in dividends can potentially boost the yield of their portfolios through the use of equity index options. “By selling covered call options, for example, an investor can generate incremental cash flow without having to sell the underlying assets in the portfolio at depressed market prices,” Leon explains.

Of course, as with all investment strategies, the risk must be weighed against the return. “Risks are strategy dependent,” notes Leon. “Selling covered calls does generate additional yield, but also caps the investor's upside above the strike price and offers no downside protection. For clients looking to hedge downside risk, there are a number of similar option strategies that can be employed.”

An example of a risk management strategy for both portfolios and single stock concentrations is the zero-premium collar. This strategy allows investors to achieve downside protection by purchasing a put option and offset all or part of this cost by selling an out-of-the money call option. “In the current economic climate, clients are doing shorter-dated transactions in the three- to six-month range and are accepting more downside risk to gain more upside potential,” Leon says.

Hedging Interest Rate Risk

Interest rates currently are at historically low levels, but many institutional investors are wary that rates might start to rise. Gary M. Kramer, of the public and structured finance group at Northern Trust Securities, Inc., has seen an increase in the number of clients using OTC derivative instruments such as interest-rate swaps or interest-rate caps to hedge against potentially rising interest rates.

Consider, for example, a corporation with a long-duration variable-rate loan that is concerned that interest rates will spike. “It may use an interest-rate swap to lock in a fixed funding rate for a period of time,” Kramer says.

“Interest-rate swaps can be customized to the investor’s risk mitigation needs,” explains Kramer. “We look at their specific concerns. Are they worried that interest rates will rise dramatically? Do they need some absolute level of protection at a particular interest rate? While no one knows whether interest rates will rise or fall, any number of risk-mitigation strategies can be deployed to accommodate the client's desires and concerns — regardless of the interest-rate environment.”

Kramer also has seen investors deploying more complex derivatives strategies designed to hedge against the threat of hyperinflation, with some investors even using inflation as a quasi asset class. He says that most investors, however, are looking to keep their use of derivatives simple. “There’s a lot that can be accomplished with plain-vanilla derivatives,” he adds.

Listed vs. OTC Derivatives

The struggles of Wall Street firms last year has heightened investors' concerns over a number of risks, including counterparty risk. The more common derivative vehicles — futures and options — that trade on formal exchanges have features that help mitigate that risk.

Even with increased regulatory pressures and investor focus on counterparty risk, the OTC market in general, and interest rate swaps in particular, will remain strong.

Because exchange-traded, or “listed,” derivatives are settled through a centralized clearinghouse and rely on standardized contracts, the risk that the counterparty will not fulfill their obligation tends to be minimized, explains Leon. By law, the party at risk is required to have funds deposited with the exchange, demonstrating that they can cover any losses. “The central clearing function provides a high level of financial security,” he says. Other benefits of exchange-traded derivatives include a daily mark to market on the options, full price transparency and enhanced liquidity.

OTC derivates do not share these characteristics, so investors should consider ways of reducing counterparty risk. For example, a third-party intermediary with a strong balance sheet could negotiate the bilateral collateral agreement and use its own financial strength to decrease exposure and limit counterparty risk, Kramer says.

Even with increased regulatory pressures and investor focus on counterparty risk, Kramer expects that the OTC market in general, and interest rate swaps in particular, will remain strong. He notes that OTC derivatives are infinitely customizable. “You can come up with an unlimited number of customized solutions based on the specific needs, objectives and constraints of the client. That makes them a useful risk-control tool in a portfolio.”

Determining if Derivatives are Appropriate

While they can meet a wide variety of risk management needs, derivatives are not suitable for every investor. Northern Trust follows a four-step process in helping clients determine if derivatives can help them achieve their investment and risk mitigation goals.

“First, our investment professionals work with clients to identify their objective for wanting to use a derivatives-based strategy,” Thomas explains. “Is the main goal risk mitigation or yield enhancement? Is the client most interested in locking in gains or hedging tail risk? Based on those goals, we analyze the client's existing portfolio and determine areas of risk.” The third step is to consider the client's investing time horizon.

Once all aspects of the client's situation are understood, the fourth step is to advise the client on a customized strategy. “That may or may not include the use of derivatives,” says Thomas. “Our business is to serve clients and provide the best solution,” he adds. “A determination of whether or not a derivatives-based strategy may be appropriate is part of the solution we propose to clients.”

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