Return to The Consulting Actuary Index

Session 803 - Basics of Derivatives and
Alternative Investments
Presenters: Eric J. Palley, Albert R. Trezza
Recorder: Michelle Koontz

In recent years, banks and asset managers have been presenting derivative structures and alternative investment vehicles to defined benefit plan sponsors as a means to manage financial risk and to enhance returns.  Speakers at this session explained the basics of derivative products (such as swaps and futures) and alternative investment vehicles (such as private equity and hedge funds): how they work, how they fit into the investment structure of plans and how to implement derivative and other alternative asset strategies.

Basics of Derivatives

Derivatives are financial instruments whose value is derived from the value of some other underlying instrument.  Some examples include swaps, swaptions, stock options, and commodities futures.  Derivatives have a diverse range of underlying assets which include currencies, equities, commodities, interest rates, inflation, credit, and even electricity, weather, and catastrophic events.  To gain a little history, the derivatives market started almost 1000 years ago at European trade fairs which included wheat, coffee, tea, and tulips.  In 1868, the first formal trade exchange, the Chicago Board of Trustees, was established.  This allowed farmers to know where they could sell their harvest prior to planting and allowed producers to know where they could buy their inputs to make their products.  In the late 1990s, accounting and regulation caught up with innovation and, as a result, corporations set new policies.  The use of derivatives as a “generic” corporate finance tool has exploded over the last few years and products have become a standard tool within the treasury tool kit. 

As people gain a greater understanding of these tools, companies have begun to incorporate derivatives to hedge risk on the balance sheet.  It has become very common for asset managers to use derivatives, such as futures, in pension plans.  One way to use derivatives is to hedge risk by maintaining or taking on market exposure. 

The most common derivatives are option contracts.  They give the buyer the right, but not the obligation, to buy or sell a security or other financial asset at an agreed upon price before a specified date. Two types of options are European style and American style.  European options can only be exercised at maturity date while American options can be exercised any day until the maturity date.  Another common type of derivative is a futures contract.  They are contractual agreements to buy or sell a particular commodity or financial instrument at a pre-determined price on a specific date.  These contracts are typically made on the trading floor of a futures exchange.  Some futures contracts require actual delivery of the asset, while others are settled in cash.  A futures contract gives the holder the obligation to buy or sell.  Futures contracts don’t give the option to exercise that options contracts have.

Swaps, another type of derivative, are an exchange of one payment stream for another and are completely flexible in terms of design.  In pension plans, the most common is an interest rate swap.  This is an agreement between two parties where one stream of future interest payments is exchanged for another based on a specified principal amount.  Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate.  At any point in time, one party’s position will be the opposite of the counterparty’s position.  A related derivative is a swaption.  This is an option on a swap that gives the buyer the right, but not the obligation to enter into a swap at an agreed upon price within a certain period of time.

Derivatives have key attributes including those mentioned above.  By using derivatives, the investor can change the distribution of investment outcomes.  When investing in a portfolio of derivatives, the returns will have a bell curve distribution.  By eliminating certain investments in the portfolio, investors can lever the bell curve to achieve the outcome desired.  Derivatives allow for leverage in that investors are exposed to a larger percentage change in value than the change in value of the underlying asset. 

Derivatives are either exchange traded or traded over-the-counter (OTC).  Exchange traded derivatives are based on inflexible terms where OTC trades can have customized terms based on the goal desired.  Exchanged traded derivatives are backed by an exchange, therefore, have no counterparty credit risk.  OTC trades hold bilateral counterparty credit risk with collateral in the case other parties default.  Exchange trades require a margin account to offset any risk of default.  OTC trades require International Swaps and Derivatives Association (ISDA) documentation while exchange trades require minimal documentation.  In most cases, because of the flexibility, OTC trades are worth the work of compiling the large amount of documentation required.

Options are valued mostly by using the Black-Scholes formula.  The factors used to value options are the current price of the underlying asset, the strike price, time to expiration, the interest rate, and volatility.  There are two measures when valuing an option -- one is intrinsic value and the other is time value.  Intrinsic value is the difference between current price and strike price.  Time value represents the value of the chance that the intrinsic value might increase in the future and is a function of time to expiration, interest rate, and volatility.  Time value becomes more relevantt when options have a long duration.

Interest rate swaps are valued like any other annuity.  The first step is to construct a curve to discount zero coupon rates that apply.  The fixed rate is determined by market conditions so that at the beginning of the contract the present value of the swap position equals zero.  In a swap transaction, one party pays the fixed rate to a counter party while they receive a floating rate (usually tied to the LIBOR spot curve).  The floating leg expected payments are calculated by multiplying the implied forward rates (LIBOR spot curve) times the notational amount.  The fixed expected payment is the notional amount times the contractual fixed rate.  When the LIBOR spot curve moves, the present value of the floating rate leg does not change since the changes in rates are offset by the changes in expected future payments.  However, the present value of the fixed rate leg does change since the expected future payments are fixed.

Alternative Investments

Alternative investments include almost any investment that is not made within the traditional stock or bond markets and range from derivatives to private equity.  Within this spectrum, some common features include relative illiquidity, diversifying potential relative to a portfolio of stocks and bonds, high due diligence costs, and unusually difficult performance appraisal.  Some examples of alternative investments are real estate, private equity, hedge funds, commodities, and derivatives strategies.  Alternative investments have only recently come out into the forefront.  Some of the reasons they are gaining more attention in recent years can be attributed to overall and relative performance as well as perceived diversification benefits.  The released performance results, however, are usually skewed in that they only include portfolios that have positive results. 

Private equity is an investment in a company or companies that have either not yet gone public or were public but are going private, including, but not limited to, start-up companies.  Private equity investments generally exhibit low correlation with traditional markets.  Historically, they represent a higher returning asset class despite their J-curve behavior  (This means negative returns in the beginning investment phase followed by high returns in the “harvesting phase.”)  Private equity investments are self-liquidating and can include mergers, acquisitions, IPO’s, and failing businesses.  The typical concerns for these investments include the risk associated with being very illiquid and the fact that it is very difficult to get an accurate performance assessment.

Hedge funds do not have a precise definition, and are rather defined by their investment style.  Hedge fund investment styles, which have their own risk and return characteristics, include relative value, event driven, equity hedge, short selling, and global asset allocators.  The relative value style involves market neutral strategies and earns returns without seeing effects of the market.  Anticipated specific corporate events such as mergers and acquisition define the event driven style.  Equity hedge investments involve exposure to the equity market and short selling takes advantage of declining positions.  Global asset allocators are the “cowboys” of hedge funds that will go anywhere and bet anything to find returns.  A “fund of funds” is a portfolio of underlying hedge funds diversifying in any number of these investment styles to reduce risk.  The correlation between hedge funds and traditional markets varies by each investment style. 

A general trait of hedge funds is that their main focus is on return enhancement rather than return diversification.  Higher investment fees are another defining characteristic of hedge funds.  Hedge fund managers receive a management fee and an incentive fee, the higher the return the higher the fee.  People invest in hedge funds taking on various levels of risk but have the expectation of positive returns in all markets.  Some typical concerns associated with hedge funds include a lack of perceived liquidity and poorly estimated risk metrics.  Also, historical returns have a bias toward survivors.  That is, all the hedge funds that have failed are eliminated from the data after short periods of time.