Derivatives

A powerful tool for hedging and investment

Derivatives can be very useful investment tools for fund managers, like Jupiter, to help them achieve their aim of maximising returns and minimising risk.

So what are derivatives and how do they work ?

Derivatives are financial contracts or agreements, rather than physical assets such as shares, bonds or commodities. When they are traded, no legal ownership of an underlying asset is exchanged, so you do not have to own the asset before you sell a derivatives contract. This means that you can use them to gain from falling prices (by selling or going ‘short’), as well as in a rising market (by buying or going ‘long’).

The price at which the contract is traded is closely related to the underlying asset – derivatives ‘derive’ their value from movements in the asset to which they relate.

They come in a variety of forms. Perhaps the most common are futures and options which are traded on an exchange. But there are derivatives with similar characteristics to futures and options which are traded over-the-counter, which simply means they are traded directly between two counterparties – for example, Jupiter and an investment bank. The most common of these are swaps and contracts for difference, which have similar characteristics to futures and over-the-counter options.

There are derivatives on stocks, market indices, currencies, gold and oil. There are even derivatives on agricultural products such as pork bellies – immortalised in the 1983 comedy film Trading Places starring Eddie Murphy and Dan Akroyd. In fact, uncertainty surrounding the economics of agriculture was one of the main reasons derivatives were developed.

“Futures contracts”, have their origins in the rice markets of Osaka, Japan in about 1650. India and the US have had commodity-related derivative exchanges since the nineteenth century. In its simplest form, a “futures” contract is an agreement to buy or sell an underlying asset at a future date using a price agreed today. This notion of agreeing price and contract terms today to do something in the future is a common characteristic of all derivatives.

Let’s look at an example to see how futures work in the unit trust environment.

Using derivatives for investment purposes

John Smith is the manager of the £50m Hot Topic Fund.He believes the UK stock market is due for a correction, but he doesn’t hold a portfolio of UK equities.He simply looks to profit from the fall in the market.To do this he creates a‘short’position in using derivatives.This is often called a‘synthetic short’position as it creates exposure to price movements to the underlying asset, yet doesn’t involve a transaction in the physical asset.John simply agrees to pay any losses his short position incurs.

The cost of transaction is low.The fund would typically need to pay an initial deposit of about 5 % of the notional value of the contracts sold.This deposit is designed to cover market losses and is returned if no losses are incurred.The futures position would also be re - valued each day or‘marked - to - market’as it is called.This means the potential profit or loss is calculated daily and John might have to provide more funds(as part of a‘margin call’) if the market moves against his positions.The fact that derivatives are‘leveraged’ in nature is a key benefit but also increases risk(losses could be greater than the amount paid for the contract).

As the position only costs £250k(rather than the notional value of £5m) to establish, John has a lot of cash to invest elsewhere.When investing this cash, John will need to retain enough money in the fund to cover any losses the position attracts and will be limited by rules governing the spread of investments and risk within the fund.However, it is because of this ability to create leverage by using derivatives that a fund can potentially have market exposures of greater than 100 % of its net asset value.

The low cost of derivatives, therefore, has the potential to enhance returns, but also losses.However, the ability to use leverage in a UCITS III fund is tempered by risk and portfolio construction constraints.

Hot Topic Fund short sells 100 FTSE 100 Index futures contracts at a FTSE 100 index level of 5000 with an equivalent notional value of £5m.The initial cost of this position is £250k.

If market falls to 4, 700:
The futures position produces a £300k profit.This is a return of 125 % on the initial deposit.

If market rises to 5, 300:
The futures position loses £300k or 125 % of the initial deposit.The fund would have been liable for margin calls and would need to have adequate cash in the fund to meet these.John might also have cut the position earlier when it was going against him.

Jupiter Asset Management Limited(JAM) is authorised and regulated by the Financial Services Authority and their registered address is 1 Grosvenor Place London SW1X 7JJ.It is a subsidiary of Jupiter Investment Management Group Limited and the group is collectively known as ""Jupiter”. The above commentary represents the views of the author at the time of preparation and may be subject to change and this is particularly likely during periods of rapidly changing market circumstances. Their views are not necessarily those of Jupiter and should not be interpreted as investment advice. Every effort is made to ensure the accuracy of any information provided but no assurances or warranties are given.