Investment surgery
What exactly is a derivative?
It’s an instrument that can be bought or sold, whose price is derived (hence the name derivative) from the capital value of an underlying asset.
What kind of underlying assets?
The underlying asset could be company shares, a range of equity or bond indices, interest rates, currencies, or a hard or soft commodity such as precious metals or wheat. Derivatives can also be based on something that can be measured but not traded such as the weather or longevity.
What is their origin?
The earliest evidence of derivatives being used can be found in Hammurabi’s code (18th century B.C. Mesopotamia) and in the writings of Aristotle (6th century B.C. Greece). Derivatives originated in agriculture and from a desire to reduce risk. Records of trading futures can first be found in 17th century Japan, where rice futures were traded on the Osaka rice markets. The increasing use of agricultural derivatives in 19th century America led to the establishment of the Chicago Board of Trade in 1848.
How are they used today?
There are a whole range of uses for these instruments such as hedging, asset allocation, arbitrage, overcoming trade restrictions and risk management.
Which types of derivative are relevant to pension funds?
Mainly forwards, futures, swaps and options.
How do they differ?
Forwards
A forward is an obligation to buy or sell a given quantity of a particular asset, at a pre-agreed price on a specified future date. Forwards are traded 'off exchange' or 'over-the-counter'.
Futures
A future is an obligation to buy or sell a given quantity of a particular asset, at a pre-agreed price on a specified future date. Futures contracts have standard delivery dates, trading units, terms and conditions and are traded on derivatives exchanges.
Swaps
An agreement between two counterparties to exchange cash on a notional principal sum which is not exchanged. The most common structure is the fixed-for-floating swap in which one counterparty agrees to pay a fixed rate over the term of the swap in exchange for a floating-rate payment made by the other counterparty.
Options
An option contract gives the holder the right, but not the obligation, to buy (call), or sell (put), a specified underlying asset at a pre-agreed price, at either a fixed point in the future (European-style options), or at a time chosen by the holder up to maturity (American-style options).
Call option
An option that provides the right, but not the obligation to buy the underlying asset.
Put option
An option that provides the right but not the obligation to sell the underlying asset.
