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Unit 11: Introduction to Derivatives

An income fund has a large portfolio of corporate bonds. This portfolio stands to make Notes
losses when credit spreads of these bonds degrade or when defaults take place. Hence, the
fund may choose to buy credit derivatives, which pay when these events happen.
Every equity portfolio has exposure to the market index. Hence, the fund may choose to
sell index futures, or buy index put options, in order to reduce the losses that would take
place in the event that the market index drops.
The regulatory concerns are about (a) the effectiveness of the hedge and (b) its size.
‘Hedging’ a ` 1 billion equity portfolio with an average beta of 1.1 with a ` 1.3 billion short
position in index futures is not an acceptable hedge because the over hedged position is equivalent
to a naked short position in the future of ` 0.2 billion. Similarly, ‘hedging’ a diversified equity
portfolio with an equal short position in a narrow sectoral index would not be acceptable
because of the concern on effectiveness. A hedge of only that part of the portfolio that is invested
in stocks belonging to the same sector of the sectoral index by an equal short position in the
sectoral index futures would be acceptable.

‘Hedging’ an investment in a stock with a short position in another stocks’ futures is not an
acceptable hedge because of effectiveness concerns. This would be true even for merger arbitrage
where long and short positions in two merging companies are combined to benefit from deviations
of market prices from the swap ratio.
Hedging with options would be regarded as over-hedging if the notional value of the hedge
exceeds the underlying position of the fund even if the option delta is less than the underlying
position. For example, a ` 2 billion index put purchased at the money is not an acceptable hedge
of a ` 1 billion, beta = 1.1 fund, though the option delta of approximately ` 1 billion is less than
the underlying exposure of the fund of ` 1.1 billion.

Covered call writing is hedging if the effectiveness and size conditions are met. Again the size of
the hedge in terms of notional value and not option delta must not exceed the underlying portfolio.
The position is more complicated if the option position includes long calls or short puts. The
worst-case short exposure considering all possible expiration prices should meet the size condition.

11.2.3 Portfolio Rebalancing

The use of derivatives for portfolio rebalancing covers situations where a particular desired
portfolio position can be achieved more efficiently or a lower cost using derivatives rather than
cash market transactions. The basic idea is that the mutual fund has a fiduciary obligation to its
unit holders to buy assets at the best possible price.

Thus if it is cheaper (after adjusting for cost of carry) to buy a stock future rather than the stock
itself, the fund does have a fiduciary obligation to use stock futures unless there are other
tangible or intangible disadvantages to using derivatives. Similarly, if a synthetic money market
position created using calendar spreads is more attractive than a direct money market position
(after adjusting for the credit worthiness of the clearing corporation), the fund would normally
have a fiduciary obligation to use the calendar spread. If a fund can improve upon a buy-and-
hold strategy by selling a stock or an index portfolio today, investing the proceeds in the money
market, and having a locked-in price to buy it back at a future date, and then it would have a
fiduciary obligation to do so.

11.2.4 Derivative Products

Derivative is a product/contract that does not have any value on its own i.e. it derives its value
from some underlying.

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