Derivative Strategies for Managing Portfolio Risk-Keith C. Brown-1932495568

7/29/2019 Derivative Strategies for Managing Portfolio Risk-Keith C. Brown-1932495568

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ForewordThe concept of derivative instruments is at least asold as paper money, and organized futures exchanges predate the present century. Nevertheless,derivatives are still regarded with suspicion in somequarters, particularlynow that theycome in complexforms based on mere paper and far removed fromsuch "real" underlying assets such ashog bellies andcom. As this proceedings testifies, however, thesecomplex forms are turning out to be useful portfoliomanagement tools-for those who know how to usethem. The exchange-traded derivatives, which arefairly straightforward and standardized, have longbeen used to hedge various types of risks. The OTCcontracts areanother matter. They come in a myriadof forms designed to meet specific, individual portfolio needs; moreover, these forms are in a state ofconstant metamorphosis. No wonder investmentcommittees, some regulatory bodies, andmany portfolio managers are leery of testing these particularwaters.The presentations at AIMR's seminar on Deriva-tive Strategies for Managing Portfolio Risk, collected inthis proceedings, all address the issues of why andhow to use derivative instruments. No longer confined to their risk-hedging roles, derivatives are nowalso used, among other things, to match asset andliability duration and convexity; to mimic the returncharacteristics of assets that are not even in the portfolio; to add or protect liquidity; to arbitrage one'sway around tax, regulatory, or investment policyconstraints; and to enhance yields. New uses surfaceconstantly, reflecting the flexibility and virtuosity ofthese instruments. As new forms evolve, however,

Katrina F. Sherrerd, CFASeniorVice PresidentPublications and Research

the requirements for information and 'experience todeal with them profitably increase exponentially.The authors represented in this proceedings havedone an outstanding job of sharing their informationabout and experience with various forms of derivatives used for a variety of purposes. Perhaps theirgreatest collective contribution is helping to demystify this arcane world.AIMR wishes to thank the participants in thisseminar for assisting in the preparation of the proceedings. Specia l thanks are in order for DonChance, the able and knowledgeable seminar moderator, and Keith Brown, who contributed the overview and self-examination test as well as his ownpresentation.The speakers participating in this "derivatives"seminar were Keith C. Brown, CFA, University ofTexas; Don M. Chance, CFA, Virginia PolytechnicInstitute and State University; RogerG. Clarke, TSACapital Management; David F. DeRosa, Swiss BankCorporation; Gary L. Gastineau, Swiss Bank Corporation; JoanneM. Hill, Goldman,Sachs & Company;Ira G. Kawaller, ChicagoMercantile Exchange; Robert W. Kopprasch, CFA, Alliance Capital Management; Donald L. Luskin, Wells Fargo Nikko Investment Advisors, Americas Group; Lloyd McAdams,CFA, Pacific Income Advisers; Henry M. McMillan,Transamerica Occidental Life Insurance Company;Maarten L. Nederlof, TSA Capital Management;Murali Ramaswami, Salomon Brothers; Eric S.Reiner, UBS Securities; and Matthew R. Smith,Amoco Corporation.

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Derivative Strategies for Managing PortfolioRisk: An OverviewKeith C. Brown, CFAAlliedBancshares FellowandAssociate Professorof FinanceUniversity of TexasThe basic premiseof a derivative security, such as anoption, futures contract, or financial swap, is hardlya new one. We know, for example, that derivativesin some form have been exchanged for hundreds ofyears. It is somewhat ironic, then, that in the latterpart ofthe 20thcentury,we stillfind ourselves struggling to figure ou t the vas t number of ways theseinstruments are being packaged and sold in today'smarkets. Of course, we have made considerableprogress in ou r efforts to comprehendthe fundamental nature and purpose ofderivative contracts,whichare by now regarded as the building blocks in thefinancial engineer's tool kit. Each announcement ofa new structure involving the latest derivative innovation or acronym reminds us, however, that thislearning process is never really complete.For most money managers and corporate treasurers, derivatives represent solutions to problemsmanifest in an underlying portfolio or balance sheetrather than stand-alone investment opportunities.Whether the exact solution requires repackaging aset of cash flows or mitigating a risk exposure, thefinancial services industry has been quite adept a tcreating inventive and affordable derivative-basedstructures that address these problems. The presentations that compose this proceedings reflect thatfocus. Although the various topics discussed rangefrom managing currency exposure to restructuringbond coupon payments to altering a global assetallocation, an emphasis all of the speakers share isthatthe derivativemarkets truly can add value. Nevertheless, an important caveat that always lingersbetween lines of any discussion extolling their virtues is that futures, options, and swaps also requirea substantialcommitment to continuingeducation inorder to understand and use them properly. In theworld of derivatives, one manager's solution is another manager 's problem, and the difference between them is no t always transparent.

If Derivatives Are So Great,Why Don't MorePeople Use Them?A provocative way to begin is to consider the question Luskin poses. In fact, he argues that investors

are actually using derivatives all the time whetherthey realize it or not. What, for instance, is equity ifno t a call option on the underlying firm in tha t itallows the holder the possibility of unlimited gainswith limited losses while bearing none of the decision-making responsibilities for the company? Indeed, a dollar bill i tselfis nothing more than a pieceof paper with a value derived from the productivecapacityofthe economy. Why,then,is there asmuchapparent reluctance for investors to use securitiesthat are packaged somewhat more obviously in theform of derivatives?A fundamental problem in get ting clients totrade more traditional derivative instruments is thatthese products are often erroneously viewed as belonging to a separate asset class. What options andfutures really do, Luskin argues, is permit portfoliomanagers to unbundle or otherwise repackage therisk of an underlying position. An example of thiswould be the use of currency forward contracts toremove the foreign exchangeexposure from a collection of international equity positions. Many u.s.-based managers who have done this during the pastfew years, however, have been criticized for losingmoney on their derivative positions while the dollarweakened without being given credit for the appreciation in the "forex" component of the equitiesthemselves. The author suggests that viewing thederivative in tandem with the equity, rather than asa separate position, is a preferable approach.Luskin also considers several other factors thatinhibit the use of derivative markets. Chief amongthese is the adversarial relationship that often existsbetween client and broker; the former oftenassumesthat any deals the latter offers are too good to be true.Two factors exacerbate this distrust. First, many ofthe more innovative derivative products that haveemerged in recent years have transacted in over-thecounter (OTC) markets, which are largely unregulated. Although this situation has allowed for anexplosion of complicated, creative products andstrategies, it has also-rightly or wrongly-fosteredthe impression amongmany clients that brokers aremaking toomuch money at their expense. A relatedfactor is that derivatives markets are populated on

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the sell side by young people who often speak whatamounts to a different languagethan theircustomersdo. Luskinconcludes that the only solution to theseproblems may be having enough time pass to allowthe conventional wisdom of the client to catch upwith the market's existingstoreof new products andstrategies.

Risk and Return Characteristics of DerivativeSecurities: Beyond the BasicsOne of themain themes that emerges from this collection ofpresentations is that,whenused as hedgingvehicles, derivatives can provide effective and lowcost insuranceagainst deleteriousprice or ratemovements. Once a customer decides to hedge an exposure, however,many important questions remain tobe addressed. These include the amount of the underlying position to be hedged, thetype ofthe derivativecontract involved, the number of contracts (i.e.,the hedge ratio), and the length of the hedging period. Although derivatives traded through commercial and investmentbanks often allowclients to tailoranswers to eachof these questions, solutionsmoldedaround derivatives traded on an organized exchangerequire more care, because these instruments typically comewith standardized terms.Exchange-Traded DerivativesKawaller analyzes several dimensions of settingup an objective, systematic approach to hedgingwithexchange-traded futures and options. Of particularinterest, he notes that the practice of hedging withderivatives often puts financial managers a t oddswith accountants. Accountants do not recognize thedistinction between present and future value, whichis crucial to the managers in constructing optimalhedges. Furthermore, long-term futures-basedhedging strategies require customers to select a sequence of contract maturi ties . Kawaller suggeststwodifferent approaches: stackingcontracts in a single month or spreading a "strip" of them over time.He points out that both of these procedures requirejudgment calls on the part of users, especially whenthe optimal hedge ratio is not a whole, evenly divisible number orwhen the price relationshipsbetweendifferent contractmonths change.Kawaller observes that the main difference between hedging with futures and hedging with options is one ofcost. Although both contracttypes canbedesigned to offer the same protection against, say,rising interest rates, only an option allows the holderto keep the benefit thatwould accrue to the underlying position if rates fall. Of course, this benefitmustbe paid for in the form of the option's front-end2

premium, whichwill be a function of, among otherthings, the option's strikeprice. This lastpoint raisesanother question: If a particularcustomer decides onan option-based hedging solution, how can heor shechoose the appropriate set of option characteristics?Kawaller provides an interesting way of selecting anoptimal strike price based on a compari son of theoption's premium with the rate protection it offers.He concludes by describing the advantages and disadvantagesof using various combinationsof options(e.g., collars and spreads) as alternative hedging solutions.Over-the-Counter Derivatives

Another unifying theme connecting these discussions is that intelligent application of derivativesecurities demands thattheuser understand both thebenefits and costs of such products. Although thepotential rewards and nominal (i.e., front-end monetary) expensesare typicallydisclosedat origination,derivatives involve a number of other lesser knownrisks that candramatically increase the eventual costof any deal. An appreciation of these "hidden" costsis particularly important in the OTC markets,wherepublicly available information is less plentiful thanin the exchanges.

In his presentation on the risks associated withthe OTC market for interest rate swaps, Brown focuses on two of these lesser known exposures. First,the issue of default, or credit, risk is addressed. Henotes that default risk on a swap is always bilateralin naturebecause eachof the counterpartiesdependson the other to perform according to the terms ofthecontract. An actual loss becauseof default, however,will depend on two factors: the financial distress ofthe counterparty and an adversemovement in interest rates since the inceptionof the agreement. Browndescribes several methods for mitigating this exposure, including collateralization and enhanced nett ing agreements , special-purpose vehicles, andmark-to-market contracts. An example of the lastmethod shows it to be somewhere between a traditional swap agreement and a fully margined futurescontract.

The second type of swap-related exposureBrown discusses is basis risk. Basis risk exists whenever the price volatility of a derivative contract doesnot exactly offset that of the underlyingposition. Forcertain types of deal structures (particularly thosewith longer maturit ies) , this exposure can be substantial. A more thorough grasp of the nature ofbasis risk in the swap market can be achieved byunderstanding what causes swap prices to changeover time. Brown describes the results of an empirical investigation of how swap spreads-the main


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pricing var iable in a swap-interact w it h m yr ia dother financial variables, including the slope of theyield curve, theanticipated differencebetween Eurodollar an d Treasury bill rates, repurchase agreementyields, a nd b on d credit spreads. The model alsoleaves a lot of swap spread volatility unexplained,however, suggesting that basis risk in the swap market remains a problem.

Derivative Applications: Fixed-Income InvestingInterest rate s wa p s w e re w ith o ut a doubt on e of thepremier financial innovations of the past decade.From the time of the first swap agreement in 1982 tothe present, the swap ma rk e th a s g ro wn to the pointthat its outstanding notional principal is no w measured in trillions ofdollars. Further, thebasic interestrate swap concept ha s been replicated for a numberother underlying exposures, including equity indexes, currencies, an d commodities.Using Swaps in Fixed-Income PortfoliosKopprasch analyzes the mechanics of severalne w derivative structures from the point ofview ofa fixed-incomemanager. Among the several reasonshe cites as to wh y such investors find these swapsattractive are their potential for achieving enhancedreturns, their flexibility in tailoring unique solutionsto portfolioproblems, an d the fact that they allow themanager to acquire asset exposures th at migh t otherwise be prohibited by portfolio policy guidelines.After reviewing the dynamics an d risk profile ofthe s ta nd ar d " pl ai n vanilla" i nt er es t r at e swap,Kopprasch focuses his discussion o n h ow fixed-income investors can exploit variations on the basictheme. He first considers index swaps, in which acash flow linked to the return on an equity o r d eb tindexis exchanged periodicallywith a cash flow tiedto a floating interest rate. Kopprasch explains thatthe primary advantage of this s tructure is that itallows managers to assemble an actual portfolio ofsecuritiesof one asset class an d theneffectivelytransform part or all of it into an indexed posit ion inanother. He illustrates this concept with an exampleofa moneymanagerholding a portfolio ofmortgagebacked securitieswh o isable to use an index swap totransform the position into o ne t ha t p ay s accordingto the returns to a traditional bond index. Thus, themanager in this case is able to ad d value by tciking aphysical position in his or he r area of relative expertise (i.e., mortgage-backed debt) an d then swappingit into the desired exposure.Kopprasch also outlines other innovative fixedincome swap structures. As he explains, a constantmaturity (or yield curve) swap involves an exchange

of tw o rates thatboth float bu t are taken from differen t point s of the yield curve. A variation on thisnotion of a yield curve play is the arrears swap,which exchanges tw o floating rates of the same maturity; one isset at the beginning an d the other at theen d of a settlement period. An index-amortizationswap is structured like a plainvanilla rate swap thatha s its notional principal amount adjust according tochanges in the prevail ing level of the floating rate.The author notes that, because the usual adjustmentisfor the amortization schedule toslowdown (speedup) whenever the floating rate rises (falls), this typeof swap structureha s an interest rate sensitivity similar to that of a mortgage security. An advantage ofthe index-amortization swap, however, is that itcanno t be prepaid for reasons other than interest ratem ov em en ts . K op pr as ch also consider s a "di ff "swap, which trades tw o floating rates denominatedin different currencies, as a wa y of gaining foreignexchange exposure without holding actual currencypositions.Using Derivatives in Asset'LiabilityManagementAlthough money managers often have the luxur y of considering nothing more than ho w derivatives ca n enhance the return of an asset portfolio orreduce the funding cost of a collection of liabilities,many corporations do not. For instance, financialinstitutions such as insurance companies must constantly coordinate the interest rate sensitivi ties ofboth their asset an d their liability positions to protectagainst adverse economic events. As McMillan explains in his presentation, asset/liability management is tantamount tomanagingthe firm's ne t worthin an effort to influence the extant risk-return tradeoff in a favorable way. Derivatives can help a manager accomplish this goalby providing, amongotherthings, a more efficient wa y to transform cash flowsin order to reduce the ne t interest rate exposure.McMillan provides an example by showing ho w ashort position in a bond futures contract can successfully reduce the natural d u ra tio n g a p between aninsurer's assets an d liabilities.Amoresubtle wa y insurance companiesbecomeinvolved with derivative securities results from theinherent nature of the assets an d liabilities themselves. McMillan argues that securities on both sidesof an insurer's balance sheet contain embedded options with risk exposures that must be managed. Onthe asset side, many of the bonds a company investsin can be called by the issuer an d its mortgagebacked security positions will be subject to prepayment risk. Conversely, the insurer's basic liabilitiesgrant policyholdersoptions on the right towithdraw

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surplus funds or "dump in" new funds. McMillanstresses the importance of recognizing that these embedded derivatives essentially leave the insurancecompany with a short straddle position, meaningthat it will be adversely affectedwhichever directioninterest rates move. Thus, he argues, a modem approach to asset/liability management for an insurance firm must integrate the traditional goal ofhedging the interest rate risk of fixed-cash-flow liabilitieswith the design of an effective hedge for this embedded straddle.McMillan next addresses the issue of how sucha hedge should be structured; that is, which derivatives and how many of them should the managerbuy? He notes that answering these questions fullyrequires the use of simulation models to forecast thecompany's asset and liability cash flows under several different rate and competitive environments. Inthese simulations, it is useful to separate non-interest-sensitive and interest-sensitive cash flows and tocalculate their present values tak ing all relevantproduct options into account. To help clarify thisprocess, McMillan presents an example of hedgingthe interest rate spread for a universal life insuranceproduct. The main result of this exercise is that theoptimal hedge, which in the example involves thepurchase of a series of interest rate floors struck atdifferent rate levels, depends critically on the user'sassumptions aboutthe investmentand rate-creditingpolicies of the firm and its competitors. He summarizes this exercise by once aga in noting that, forinsurance companies, the appropriate derivativeshedge requires joint consideration of the asset andliability exposures.Embedded OptionsThe previous two presentations offered cogentanalyses of how derivative products could be usedto alter the cash flow patterns of an existing set offixed-income securities. McAdams extends thistheme in a more technical fashion. Specifically, echoing MacMillan's conclusion, he argues that the preeminent use of derivatives in active bond management is to alter a position's volatility resulting frominterest rate movements. Interest rate futures, henotes, can produce this result by allowing a managera way of synthetically adjusting the duration andconvexityof a fixed-income instrument. Further, forlarge trades in either the Treasury or the corporatemarket, performing these transformations with futures is likely to be more cost-efficient than exchanging the physicals because of the relatively illiquidnature of the cashmarket for bonds.

How does the manager's problem change if theunderlying bond positions themselves contain em-4

bedded options? In addition to being harder tohedge, these securities are more difficult to value,given that the derivative typically cannot be separated from the underlying security. Stressing theimportance of this issue, McAdams points out that,becausemost bonds in the market are callable-andsome mortgage-backed instruments are unpredictably so-a manager's entire value added from a particular position could be dissipated by paying toohigh a price for, say, an embedded pu t feature. Hesuggests that calculating a callable or putable bond'soption-adjusted spread over the relevant Treasurysecurity provides the manager with an accurate, ifcomputationally complex, way of comparing thesebonds with their nonoptionable counterparts.Toillustratethe challenge ofmanaging a callablebond portfolio, McAdams provides an example ofhow the option creates negative convexity: Wheninterest rates fall, the bond is called away from itsholder before i ts price can rise commensurately.Technically, the call feature effectively shortens theduration of the underlying bond in bull markets,which is one of the most significant factors for underperformance during a period when bond pricesare generally rising. McAdams concludes this analysiswith a detailed example ofhow an investor witha long posit ion in an adjustable-rate mortgagebacked security might hedge the prepayment riskwith exchange-traded Eurodollar futures and options contracts.

Derivative Applications: Equity InvestingHistorically, equity managers havebeen theprimaryusers of derivatives because of these instruments 'versatility, relatively low cost, and adaptability to awide variety of investment problems and purposes.Adding Value with Equity Derivatives

One of the barriers potential users of any newfinancial instrument must overcome is the sometimes arcane terminologyassociatedwith that product or the markets in which it trades. This barrier isperhaps as great in derivativemarkets as anywhere.Accordingly, Gastineau begins the first of his twopresentations by disabusing us of the notion that allderivative applications are "strategies." A more appropriate way of viewing these instruments is tothink of them as having both strategic and tacticaluses. Strategic decisions involving derivatives arethose concerned with an investor's broad mission:arbitrage trading,marketmaking, and the creationofasymmetric payoff distributions, for example. Gastineau defines tactical derivative decisions as thoseinvolving specific purposes such as hedged divi-


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dend-capture plans, hedged tax and regulatory arbitrage schemes, or year-end "indexing" to preserveaccumulated performance. He notes that yield enhancement, a tactical decision that typically involvesthe sale of an option against a long position in anunderlying portfolio, is probably the most popularderivative application.Gastineau closes with a discussion of how toevaluate properly the performance of an optionlinked investment. He frames his basic argument byciting separate studies concluding that schemes thatinvolve writ ing covered calls have both underperformed and outperformed the market on arisk-adjusted basis. Of course, both of these conclusions cannot be true at the same time, and Gastineausuggests that, in fact, neither iscorrect. The problemis that these studies rely on standard deviation,which is an inappropriate measure of risk when options are involved. After demonstrating how an option effectively truncates the returndistribution for asecurity to which it is attached, Gastineau stressesthat asymmetric risk measures (e.g., the semivariance, lower partial moments, shortfall risk) areneeded to capture this fundamental characteristic.Gastineau concludes by predicting that refining therisk measurement dimension of the option performance question will be an important considerationof the investment industry in the future.Hill focuses her discussion onthe benefits of andspecificapplications for exchange-traded derivativesin managing equity portfolios. In particular, as analternative to buying equities directly, an investorcan a lways purchase a cash equivalent supplemented by a long posit ion in an index futures contract. Continuing with the distinction that the cashmarkets for stocks are primarily for individual investors and active managers while the futures markets facilitate portfolio trades, Hill cites several interesting statistics about how wide spread futures trading has become. First, more than 95 percent of theworld's equity capitalization is covered by eitheractual or synthetic index futures. Second, in most ofthe countries Hill examined, the volume of futurestradingis equal to or exceeds that in the stockmarket.Finally, one of the major benefits of index futurestrading is that the transaction costs are cheaper thanfor direct trading; in fact, the ratio of cash markettransaction costs to those in futures markets can begreater than ten to one in some countries.Hill argues that managers need to understandmany of the practical realities involved with usingindex futures markets. For example, they must becomfortable with the way these contracts are valuedin their various markets. She lists five reasons whyindex futures might be mispriced: stock borrowing

costs, dividend treatment, taxes and commissions,settlement procedures, and liquidity differentials.Tracking error-deviations between the price of thefutures and the underlying index-is one consequence of this mispricing and averages about 3 percent pe r contract around the wor ld . Beyond this,managerswith long-term investment problemsmustbe prepared to roll over their futures positions asthose positions mature; in lieu of roll ing over a futures position, they could also execute an exchangefor-physical settlement if the rules of the particularexchange permit it.Hill continues her presentation with an analysisof how the use of index options canbenefit an equitymanager. Exchange-listed index options can differfrom OTC contracts in several ways, including therange of available maturities, trading procedures, orsettlement and exercise terms. Hill describes threeapplications for indexoptions inU.s. equitymarkets.Although the problems involved in these case studies are interesting in their own right, the real value ofthis discussion is the detailed evaluation of the various solutions. In this analysis, Hill compares hedging approaches using futures, calls, puts, zero-premium collars, and zero-premium pu t spread collars.Her discussion ends with the observation that option-based solutions are particularly useful for riskmanagement purposes but that their use requirescareful monitoring of time decay and volatility effects.Equity Swaps and PortfolioManagementIn the second of his two presentations,Gastineauconcludes the discussion of how equity managersuse derivatives by considering the use of equityswaps. Like the interest rate swap agreement, anequity swap defines a periodic exchange of cashflows between two counterparties, one of whommakes a payment t ied to the return to a stock indexwhile receiving a LIBOR-based cash flow. Gastineaucontends that, although liabilitymanagers tend to bethe predominant users of interest rate swaps, equityswaps are used primarily in asset management, especially in situations requiring cross-border investing. The reason is that these contracts allow a manager to obtain foreign equity exposure without owning the physical securities, which is often either impossible or prohibitively expensive.Gastineau lists several other factors about themarket for equity swaps that are relevant to assetmanagers. First, as an OTC market, pricing in theindustry is not standardized; two quotes from differen t dealers may not be comparable because of possible adjustments for dividends or withholding tax.Second, until recently, rulings by the Internal Reve-

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nue Service severely limited the participation of taxexempt institutions in this market. With theremovalof these adverse interpretations in July 1992, the IRShas now paved the way for considerable growth inoutstanding notional principal in the coming years.Third, equity swaps provide an efficient way tobenchmark a portfo lio, which means that a plansponsor no longer has to hire a multitude of equitymanagers to obtain a diversified asset mix. Gastineau also suggests that this trend will give rise to aneed for sponsors to hire competent managers forthese new swap positions. Fourth, aswith anyswapposition, the credit quality of the counterpartymustbe evaluated carefully. Gastineau predicts that, asthe market grows, swap credit risk may be handledthrough the creation of central clearinghouse. Finally, Gastineau notes that eventually equity swapsmay be a central component in "regulatory arbitrage" strategies linked to the new risk-based capitaladequacy standards for certain institutions.

Derivative Applications: Global InvestingAs noted in several of the preceding discussions onfixed-income and equity management, derivativesoften provide investors with the most cost-effectivemeans of transforming the basic character of theirportfolios. This facility isperhapseven more importan t to a global investment manager because of themany restrictions and logisticdifficulties involved inassembling a diversified collection of internationalsecurities.Managing Global Equity PortfoliosClarke exploresmany of the issues that need tobe addressed when using swaps, futures, and options to alter the underlying exposures of an international equity portfolio. He begins by mentioningthree basic facts that global managers must under-stand about derivative markets. First, the managermust recognize that these contracts have finitematu-rities, even if the underlying assets do not. Second,the manager must understand the nature of the intended derivative position and have the discipline totake that position. Finally, the manager must constantly be aware that derivatives trade in differentmarkets than the underlying securities and may notalways be priced efficiently.The primary futures-related strategy thatClarkeanalyzes involves converting the country exposureof a portfol io of international stocks. Suppose, forinstance, that a manager holds a portfolio of U.s.stocks, u.s. cash equivalents, and Japanese stocks.Clarke argues that this manager has two ways toincrease his or her Japanese investment. The first,6

and likely the mostly costly to implement, would beto sell some of the U.s. securities and increase theportfolio's directinvestment in the Japanese market.Alternatively, the manager could affect this conversion synthetically by taking a long posit ion in a Japanese index swap or futures contract. This derivativeposition will typically convert theU.s. cash positioninto a currency-hedged Japanese equity fund; to recover the currency exposure, a separate position in acurrency derivativewould also have to be adopted.Themanagermust consider at least four caveatswithusing foreign index futures, however: the trackingerror between the futures index and the underlyingportfolio, the level of liquidity in foreign markets forfutures contracts, mispricing in those markets, andthe need to roll over the futures pos it ion as it approaches maturity.Clarke next turns his attention to how optionscan be used in global allocation decisions. Becauseof the asymmetric nature of the payoff structures,option-based strategies are far more flexible thanthose involving futures. Building on this intuition,Clarke outlines three different strategies. First , heagain showshow the countryallocation ofa portfoliocan be altered through the purchase of either a calloption or an option spread in which one call optionis bought while another with a different strike priceis sold. Second, any given market exposure can be"insured" by buying puts, pu t spreads, or optioncollars consisting of longpu t and short call positions.Finally, selling options can enhance the portfolio'sincome-generation potential bu t only at the expenseof increasing downside risk after some point.The choice ofwhich option to sell in an incomeenhancement strategy often comes down to pickingthe one tha t the market appears to overvalue themost. Given tha t an overvalued option is synonymous with one having a relatively high implied volatili ty, Clarke concludes his presentation with ananalysis of this dimension of an opt ion's price. Inparticular, he shows that the implied volatilities forsome of the major market indexes throughout theworld follow patterns that depend on such characteristics as the option's strike price, its time tomatu-rity, and the month in which it matures. For thecountries in his sample, he also shows that impliedvolatilities are mean reverting and tend to movecontemporaneouslywith changes in actualvolatility.He cautions, however, that portfolio managers needto recognize that implied volatilities areby no meansperfect predictors of futuremarket direction.Managing Currency RiskBeyond the natural price exposures implicit inany security portfolio, themanager of a global port-


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folio must also be concerned about currency risk.Not surprisingly, derivative-based solutions canhelp to control,or evenexploit, the problems createdby potentially adverse foreign exchange rate movements. In the first of two discussions on this topic,DeRosa considers many of the practical aspects ofmanaging currency risk. He begins by noting that,contrary towhat some believe, foreign exchange hasnotbeen a zero-sum gameoverthe lastdecade. Whathas masked this risk from most unhedged U.S.moneymanagers is that the dollar weakened relativeto most world currencies during this t ime, whichincreased the translated value of their foreign holdings. Ofcourse, oncethe dollar begins to riseagainas it certainly will at some point-these same managers will come to realize that risk t ruly is a twoedged sword.

An interesting aspect of DeRosa's analysis is hisconcise, yet insightful, description of how foreignexchange markets operate throughout the world. Inparticular, he outlines the conditions under whichthe forward exchange rate between two currencieswill be higher or lower than the spot rate. At thepresent time, the U.s. dollar is trading at a forwardpremium to most other major currencies becauseU.s. interest rates are among the lowest in the world.This becomes an important consideration for a U.s.portfolio manager who periodically must sell theproceeds of foreign investments back into dollars. I fsuch an exposure is hedged by rolling over a seriesof forward positions, the manager will be forced topay forward discount points. DeRosa also arguesthat another unsavory aspect of this sort of hedge isthat, as one contract is closed out and another iscreated, the firm's foreign exchange gain or loss willhave to be realized, even if theexposure on itsunderlying asset remains accrued. DeRosa concludes witha brief description of how baskets of pu t optionscould provide a comparable hedging solution.The second treatment offoreign exchangerisk isby Ramaswami, who presents thedetails ofhis studyon active currency management. He begins with atime-series analysis of currency returns to sevenmajor countries and demonstrates that, althoughpossessing a risk level similar to that of the S&P 500,returns to the average cur rency position underperformed equities. Further, Ramaswami documents that these returns showed evidenceof movingin trends-an exchange ratemovement in oneperiodtended to be followed in the next period by a movement in the same direction. Using a sophisticatedvariance ratio methodology, he shows that thesetrends were often statistically significant, althoughthe dependenciesappeared to be both nonlinear andcomplex. The presence of statistically significant

trends does not, however, ensure profitable tradingopportunities . In fact, citing previous literature,Ramaswami notes tha t the consensus view of theprofession holds that currency returns cannot beforecasted accurately. Indeed, his own study of currency return behavior following large exchange ratemovements suggests tha t the currency market iseven more efficient than the stock market.Ramaswami contends that investors could takeadvantage ofthe trends in the foreign exchange market once they understand the trends' inherently nonlinear nature. He uses h-\'o different trading strategies to demonstrate this point. First, he specifies asimple filter rule that buys (sells) a foreign currencyafter it has increased (decreased) in value relative tothe U.s. dollar by a predetermined percentage. Thesimulated profits from this strategy, which were significant for four of the seven currencies in the study,revealed a payoff structure similar to that of an option (i.e., convex). Thus, his second trading strategyinvolves the synthetic recreation of a currency pu toption in which the amount and frequency of theadjustments are governed by a similar filter process.This strategy also proves to be profitable relative toholding an unhedged basket of currencies.The Valuation and Evaluation of Derivative

StructuresA final theme that to some extent pervadeseachofthe presentations in this proceedingsis that investment managers must be able to value properly thederivative products they use and also evaluate howthese instruments alter the fundamental risk-returntrade-offof their underlying positions. Several of thepanelists noted that the Black-Scholes valuationmodel, which was the first closed-form option pricing equat ion to gain wide acceptance, is now twodecades old. The primary advantage of age in thiscase is that most participants in the derivative markets have had enough time to become comfortablewith the way basic optioncontractswork. Nevertheless, althoughmost of us have spent thepast 20 yearsschooling ourselves in these basics, the market hasmoved on to create newer and more sophisticatedderivativestructures that areeven more complicatedto price. Naturally, this progress puts quite a fewpotential users back at the base ofthe learningcurve.To help fill this knowledge gap, Reiner offers acomprehensive summary of how many of the mostpopular nonstandard (i.e., "exotic") options are valued. Before taking up the valuation question, however, he first provides a useful taxonomy for thesenew products. In particular, he categorizes exoticoptions into four different classes by the number ofassets and critical dates (or "tenors") the contract

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---"----------------------------------------involves. A binary option, as a single-asset/singletenor contract thatmakes one of two discrete payoffsat its expiration date, is an example of the first category. Single-asset/multiple-tenor contracts, including compound options and barrier options, must bevalued as the price of the underlying asset changesover a sequence ofdates; for this reason, these instruments are often called path-dependent options. Athird class ofexotics, multiple-asset /single-tenoroptions, are typically structured to give the investor achoice between the payoffs to two or more assets.Reiner notes that these derivatives are becomingquite popular, especially with managers of globalasset allocation funds. Finally, he briefly describesthe industry's l at es t ext ension into mul ti pl easset/multiple-tenor contracts.Reiner begins his valuation analysis with a briefreview of the Black-Scholes model. He stresses that,under any circumstances, investorsmustconsider therisk characteristics of a derivative position, includinghow an opt ion' s price changes with asset pricechanges (delta and gamma) and the passage of time(theta). Reiner then turns his attention to how thestandard pricing process needs to be adapted for twotypes of exotics: average-price contracts and basketoptions. Although a formal mathematical development is beyond the scope his presentat ion, Reinerexplains that average-price options are path dependent in a way that reduces volatility and hence thevalue of the contract. The reason is that the ultimatepayoff to the most popular form of this instrumentwill be based on the difference between a geometricaverage ofthe asset's price during the holding periodand the strike price; this averaging process is whatreduces risk. Similarly, the basket option, which canbe structured as the right to either purchase or sell aportfolio of assets or currencies, will be cheaper thana collection of options on the individual positions,although Reiner notes that the two structures do nothave exactly comparable payoffs.Once a manager settles the valuation question,the next issue to confront is how an optionwill alterthe investment characteristics of an existing portfolio. Nederlof addresses this point two ways. First,picking up where Gastineau left off, he argues that,when options are involved, standard deviation is animproper measure of investment risk. Starting withan empirical analysis ofthe riskand return dynamicsof standard stock and bond portfolios, hedemonstrates that adding options into themix altersthese characteristics in ways that the standard deviation is incapable of detecting. As an example, hecompares the risk-return trade-off created by a protective pu t strategy wi th tha t of a covered callscheme. Although the covered call strategy gener-8

ates a higher expected return with a lower standarddeviation, it is actually riskier in that it has a muchgreater potential for losses than the protective put,which can be created to permit no loss at all. Thus,it is the inherent asymmetry of an option's payoffthat renders meaningless comparisons based onstandard deviation.

If traditional portfolio analysis does not work,how then does an investor evaluate the appropriateness ofany given option strategy? Nederlofsuggeststhat options should be viewed as a financial "prism"that al lows a manager to focus a set of potentialinvestment outcomes to a particulardesirable range.An example ofthisis the creationof a range-forwardpos it ion whereby an equi ty investor can insureagainst losses (after some level) by buying an out-ofthe-money pu t option, which in tum is paid for byselling an out-of-the-money call. In this case, anindependent assessment of standard deviationwould not capture the fact that the investor has beenable to eliminate most of the downside risk at theexpense of most of t he ups ide gain potential.Nederlof further demonstrates this conceptwith examples ofhow an international equityportfoliomanager can use derivatives to emphasize a countryexposurewhile eliminating the currencyrisk and theway options can help an investor with a broadlydiversified portfolio isolate the exposure to a particular industry group.Managing Derivatives: The Plan Sponsor's

ViewEven the most casual observer of the financialscene can recall stories of new products that lookgood on paper but fail to produce the desired resultsin practice. Because much of the previous analysiscentered on derivative-based strategies proposed bythe industry's "sell side," it is perhaps fitting to conclude with a discussion of how one pension plansponsor actually uses these instruments in the management of his portfolio. Smith, who is involvedwith Amoco's pension and endowment funds, describes fourways the funds' managers apply derivative strategies: to adjust the risk and return characteristics of an underlying risk-neutral portfolioformed by taking long and short positions, respectively, in thebestandworst stocksavailable; tocreatesynthetic equity funds from cash management portfolios; to adjust the duration of fixed-income portfolios; and to hedge currencies.Smith also addresses several important issuesinvolved with managing Amoco's participation inthe derivatives market. He first notes several majoradministrative challenges, ranging from educatingthe plan's trustees to finding an accounting system


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that canproperlymark thepositions tomarket. Also,after accounting for broker's commissions,custodianfees, and market impact costs, futures are not ascheap and liquid as often advertised. Beyond thesechallenges, using options in a port folio creates aproblem ofthe appropriate performance benchmarkto use.Smithcloseswith thesame pointLuskinmade toopen the discussion: namely, the derivatives market-and derivative traders, in particular-face asubstantial image problem. This distrust runs sufficiently deep that Smith questionswhether some tra-

ditional "truths" about the indus try, such as tha texchange-traded futures are highly liquid and aTecontracts can be customized to the customer's satisfaction, are really true. Despite these caveats, heconcludes with the observation that Amoco intendsto increase its use of the derivative markets, particularly international swaps. In fact, given recent courtrulings, Smith cautions that, in the future, corporation fund managers may be imprudent not to usethese products, at least to hedge the price risk of anunderlying position.

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If Derivatives Are So Great, Why Don't MorePeople Use Them?Donald L. LuskinManaging Director andChiefExecutive OfficerWells Fargo Nikko InvestmentAdvisors, Americas Group

Managers sometimes have difficulty persuading clients to try using derivatives. Someof the reasons are reluctance to try a new "asset class," greater awareness of risk, failureto understand how derivativeswork, lackofstandardization, and the complexityofmostderivative trades.

The title question makesme think of the evenmorecosmicquestion: Ifyou're sosmart, how come you'renot rich? Perhaps the first question can be answeredby startingwith the second question. Maybe you arenot rich because you do not t rade enough derivatives. According to Forbes magazine, all those whotrade derivatives are rich. Its cover story said: "Welcome to the action-filled world of derivative securities, where people in their 30s are pulling downincomes of $10 million and more a year."l

The Derivatives ConceptDerivatives are extremely popular and profitable. Infact, they havebeenwidely used throughout history.What are corporate securities if not derivatives?They are much like collateralized mortgage obligations. They are tranches excreted from an earningasset called a company. Today, if you want to ownan interestin a company, you buy a derivative security-a tranche called equity. Owning equity is notlike owning a real company. You do not need to beinvolved in running it, and you do not take anypersonal liability. You just own a certificate. Thiscertificate looks like a call option. Its upside is unlimited, and its downside is limited. The upside isonly restrictedby the fact thatyoumust payoff somepeople who own different tranches, pCJ.rticularlybondholders. They get first call, bu t an element oftheir derivative securities is that theymust be shorta put on the value of the firm. If anything goeswrong, they end up with all the operating responsibilities, and the strike price paid is the value of the

lLisa Coleman,"Jackpot," Forbes (January 4,1993):151.10

bonds.Derivative securities are more common thanthat. For example, say a $50 bill and a $50 I-ouncegold coin are derivative securities. The total value ofthe $50 bill comes from it s derivative nature . Thepaper is not worth much. It is a derivat ive claim oneach other's production. When traded for production, people accept it because they plan to t rade itlater for somebody else's production. Itmay be therootof all evil, bu t this derivative securityallows theworld to work.The $50 I-ounce gold coin ismore complex, anditisworthmuchmore for that reason. It has an exoticoption embedded in it. It is an option on the betterperforming of two asset classes. If the money valueof the coin ($50) is greater than the commodityvalueof an ounce of gold, you can spend it in the UnitedStates on $50 worth of goods and services. If thecommodity value of the gold is greater than $50, youcan exercise the option-you can melt it down anduse it for fillings, i f you want to.Mycharacterizationof stocks, bonds,andmoneyas derivative securities is not really a remote metaphor just to make a point. It is a proof of concept.The notion of derivative securities is powerful. It isso widely accepted that, in these cases at least, it isinvisible. Countless social conventions and covenants are based on these derivative securities. Whenthe contract terms of these derivatives are changed,the social fabric gets ripped and rearranged. Whenthe government, for example, forgets that money isa derivative security on production and prints moreof it th an is backed by production, the bonds ofconvergence in this derivative security are broken,


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and it is just paper again.If you do not think stocks are really derivatives,think aboutwhat happenswhen institutional investors treat their equity holdings as anything but derivative securities. If they call corporate management

and try vigorously to assert the power of the proxy,they are treated as radicals and are reminded thatthey are not owners but mere investors. In fact,tax-exempt investors can only participate in corporate ownership through derivative securities. If atax-exempt pension plan tried toown a company,theInternal Revenue Servicewould treat the gains fromthat ownership as unrelated business taxable income, which could potentially threaten the entiretax-exempt status of the pension plan.Stocks are derivative securities, and the worldwants to keep themthought ofthatway. I fyou grantthat stocks, bonds, and money are derivative securities, the title question has been answered: Derivatives are so great that everybody is using them.

Options, Futures, Swaps . ..Not only are derivatives in the broad sense of theword widely used, but so are options, futures, andswaps. Opt ions and futures exchanges are busyplaces. They are now expanding their reach fromChicago and New York to every corner of theworldthrough Globex. Swaps and other structured OTeinvestments are a multitrillion dollar industry. Youcannotmake a deposit in a moneymarket fund without a swap being behind i t one level beneath thesurface.Most managers have had a frustrating experience trying to persuade a client or colleague to become interested in derivatives. Somemay have triedto seduce them by explaining the gamma characteristics of $50 bills, but they still will not buy in. Various derivative tools-ranging from PAC (plannedamortization class) bonds to equity index link swapsto costlesscollars-havebeen devised for restructuringuncertaintyin our investmentlives. Thewonderful benefits can be explained to potential users. If allpotential derivative userswould listen to reason,weall could bemaking $10 million a year. Theywill no tlisten, however, for a number of important fundamental reasons.First,many investorswhodo not use derivativesmake a fundamental conceptual error. They think ofderivatives as an asset class unto themselves. Theydo not accept derivatives as derivative, so the choiceto use them is fraught with all the weight that normally attends a decision about whether to enter anentirely new asset class.During thepastseveralyears,many institutional

investors have ramped up their holdings ofnon-U.S.stocks to where the decision to hedge currency riskis decidedly nontrivial. Many have decided that, ata certain size, hedged foreign equities are a betterdiversifier in a global portfolio than unhedged equities. Institutional investors who believe that haveimplementedhedgingprogramsby selling currencyforwards.During the past couple of years, the dollar hasbeen weak. The implicit foreign currency exposurethrough the stocks has incrementally boosted theirperformance, even though the stock markets themselves have been poor performers. For hedgers, theincremental boost from currency exposure is reflected as mark-to-market losses in their currencyforward position. Of course, this mark-to-marketloss must be physically paid for when the contractsare rolled over. Writing that check can be a very biginstitutional problem, because suddenly the currency hedge is seen as a separate asset class thatgenerated a big loss.

An article in the Wall Street Journal said it best:"As a result of the dollar's plunge, a number ofinstitutional investors have incurred sizable lossesfrom currency hedging. Pacific Telesis Corporation,for example, incurred a loss between $40 and $50million on a hedge on its $1.1 billion internationalstock portfolio. California's big public pension planhad a $70 million loss on a currency hedge. Someinvestment professionals questioned whether thehedging effort ever made sense. Some investors aresticking with the hedging strategy despite losses.,,2Never mind they were offsetting incrementalgains in theequity portfolioor thatthe goalofoverallportfolio risk reduction was perfectly achieved; thelosses were sizable.Derivatives are mistaken for an asset class because they allow investors to unbundle risk. Therisks have always been embedded in ordinary securities. Derivatives let investors choose whether tohold the risk or detach it, but many investors do notlike to choose.By offering the option of unbundling risk, derivatives make investors very aware of risk. That issomething they like to ignore. The only way to continue ignoring it is to ignore derivatives by mentallyturning theminto a risky asset class, the riskof whichcanbe avoided simplyby not holding it. Derivativesmake investors uncomfortably awarenot only of riskbu t also of the adversarial, zero-sumnature of investing. Gone is the role of the broker-dealer as thefriendlymiddleman, charginghisor her commission

2"Pension Fund Managers Find Currency Hedging Is RiskyBusiness," Wall Street Journal (August 1992).11


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The Age BarrierUse of derivatives requires an investor to at leastthink young. Consider the developments in derivatives and other dimensions of modem investmentpractice that are turning 20 years young in 1993-theBlack-Scholes model, the Chicago Board OptionsExchange,Financial Futures, and the first index fundat Wells Fargo. These were all born in 1973.Derivative sales/traders are usually youngerthan their potential customers. There is a massiveculture gap between them. The faith of the childrenis not the same as the faith of the fathers. The youngderivative enthusiasts are comfortable operating inthe virtual reality of derivatives. In this cyberspace,liquidity is an island in the network, not a specialiston the floor. There isno exchange, no published time

days of the equity-index-linked swaps. I persuadedone ofour large international index clients to substitute with attractively priced equity-index-linkedswaps in three of its EAFE countries. The clientwasconcerned with the hassle factor. I promised a trouble-free, perfectlymanaged solution from the desireto trade to the actual implementation of the trade.Then four lawyers got involved. The broker-dealerhad a lawyer, we had a lawyer, and the client hadtwo lawyers-an internal counsel and an outsidecounsel. By the time the client's outside counselwasdone manhandling the contracts, two months hadgone by, pricing had changed to the point that wewere only able to execute in one country, and two ofthe deals had to be canceled. Then the lawyer sentmy client a bill for $33,000.Next, the clientmust analyze thecreditexposurein the derivatives trade. How much exposure doesan equity-index-linked swap generate? Certainlynothing as large as the notional principal involved.Half of the time, there is no exposure at all becausetheclient owes the broker-dealera flow. What abouttheotherhalf? To assess the average value,youmustgo into the volatility-forecasting business. Most clients are not set up to do that.Once you have estimated the credit exposure,you must analyze the creditworthiness of a particularcounterparty. Which counterparty? The brokerdealer, theparent company, an offshore sub, theAaaSwapco, or what? Cross-default provisions, collateral, how much, when, and what triggers it?Derivative securities must add value in a substantive andmeasurableway to justify the economicand social costs of overcoming these obstacles.Takenone at a time,eachis trivial,but taken together,they have the power to kill a deal and make derivatives useless in the real world.

for being the honest agent connecting an investor toan anonymous marketplace. Brokers today pay fortheir yachts by trading gains earned as principal.Derivatives rub clients' noses in the fact that theirgains or losses are exactly equal to the losses or gainsof their counterparty. Clients become suspicious ofeven the most attractively priced d e r i v a t i v ~ securities. In some sense, the better their price the moresuspicious the clients become.In 1989, equity-index-linked swaps on severalEAFE country indexes were first being shown toinstitutional investors by a number of brokers. Thebrokers showed seemingly irresistible pricing, insomecases offering to pay the index total return plusmore than 200 basis points. What indexer couldresist sellinghis or her physical securitiesand replacing them with this free lunch? Oddly, most of ourclients would not pu t on their buying shoes becausethey could not stand not knowing how the brokerswere generating the enhancement. "What are theydoing on the other side? If they are payingme indexplus 200, they must be earning evenmore and keeping the difference. Well, I am going to find outwhatthey are doing and take their side of the trade."As it turned out, brokers were taking advantageof dividend withholding taxes, which must be paidbyeven tax-exempt U.s. holders offoreign securities,by creating various means of avoiding the taxesthemselves and paying out some fraction of the difference. Whena broker creates an enhanced after-taxreturn for a U.s.-based indexer, itis a good deal. Theclients who engaged in these swaps in the beginningdid well. They did not mind that the broker-dealercounterparty was making a profit too, as long as theindex fund investor got an enhanced return. Thosewhowaited to figure ou t the brokers' various gamesfound they were not in a position toplay themselves.They had no comparative advantage. By the time _they were ready to capitulate and actually do theswap, it was gone.The adversarial nature of derivatives becomesevident before the trade even begins. Beforeone cangetstarted, the lawyers becomeinvolved. For example, with l isted futures contracts, there is an uglybattle over an endless number of contractual minutiaein the customer account agreement. I have yet tointroducea client tofutures tradingwho accepted thestandard documents that have been agreed to afteralready bruising negotiation between us and ourbrokers. For swaps, it is far worse. There is nostandard. The pension world has never heard of it.Every deal is an original masterpiece presided overby an ERISA lawyer who wants to leave a mark onthe history of trust law.I went through an example of this in the early12


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an d tape, an d no daily record of closing prices.This situation can create an adversarial relation-shipbetweena portfolio manager an d his or he r ow nback office. Master custodians d o n ot know ho w tobook derivatives, price them, or settle their paymentstreams. Consultants ' performance analytical sys-tems do n o t k n o w ho w to measure them or to merget hem w i th the underlying investments that they areintended to enhance or substitute for. Of course, theOTC portion of the derivat ives market is virtuallyunregulated. As a textbook study, derivatives mightbe cited as a great example of h ow m u ch innovationcan occur in a very s hor t time period when there issubstantial freedom from regulation. On t he o th erhand, if yo u are interested in expanding t he use ofderivatives, do no t forget that some potential userswill no t be comfortable about using them as long asthey are unregulated. The market ma y ultimately beexpanded by regulations simply by creating a senseof comfort in the minds of these potential users ,irrational though it might be. The trick for the deriv-atives industry will be to seek to be regulated at therightpoint,when thevalueofinnovationstartsgoinginto diminishing returns. We m ay b e there now.Young derivative specialists an d their older po-tent ial clients speak different languages. For a so-phisticated young op tions trader, the price of theoption is no t a dol lar price at all in a convent ionalsense. It is an implied volatil ity quotation, an inputto a s ta nd ar d m od el t ha t p ro du ce s a dollar pricealmost as a formality. For t he o ld er customer, thelanguage difference is a real risk itself an d a legiti-mate barrier to using derivatives. For example, thetypical costless collar trade offered to customers asfree in dollar price terms is no t free at all. In fact, itis quite expensive in implied volatil ity price terms.Its characterization as costless by sales traders wh oknow better appears to be a deliberate exploitationof the language barrier an d the misunderstanding ofthemeaning ofprice in derivatives. Itis condescend-ing an d deceptive an d gives t he w hol e field of deriv-atives a ba d name.

The Complexity FactorThe final reason derivatives are no t used more is thecomplexity of derivatives an d the structured tradesin which they are used . Young der ivative t raders

ma y think that complexity is a form of performanceart. Many potential users of derivatives feel thatcomplexity is a formofinvestment riskto be avoided.In conversations, even with very sophisticated cli-ents, extremely complex s tr uc tu re d t ra de s c an b eelegantly diagrammed an d articulately explained,ye t the client cannot shake an intuition that there issomething risky about them. Even when the clientunderstands each individual step in the elaboratechain of structure an d ca n see the beautiful inevita-bility of the resulting payoff pattern, when he looksup from the diagram with that spark of delight in hisey e that indicatesyo u arethe most persuasiveinvest-ment visionary he ha s ever talked to, it will no thappen. The client will look down, shake his head,a n d d r aw his breathe signaling that the matter is toocomplex. The very complexity of it seems a risk.Each additional piece cleverly built in to reduce riskis perceived as increasing risk. It increases the riskthat yo u h av e n o t t ho ug ht of something. The moreth e client understands about the trade, the more heis convinced there must be something he does no tunderstand.

ConclusionPerhaps for everyone to use derivatives, we advo-cates must wait until ou r vision, style, language,conceptionof risk, an d complexity become thenorm.We will probably wait for a generat ion to pass forthat to happen. Until then, we must accept thatsomepeople do no t get it an d never will. If y ou h av e a nydoubts about that, letme quote formerMerrill Lynchchairman, U.s. Treasury Secretary, an d White HouseChief of Staff Donald T. Regan in Senate testimonyin 1988 on the subject of stock index futures: "Theseinstruments (stock index futures) have combinedtheworst features of stocks an d commodities . Theyhave low margin requirements, practically nonexis-tent in some cases such as with options on options.There are those wh o a rg ue t ha t options an d indexfutures are just like commodities. This statementdoes no t w as h w it h me. Soybeans, wheat , cot ton,an d gold are real. On e cannot eat o r w ea r a stockindex."Do no t despair , however . A ne w generation ofclients is coming, an d for those of us still in ou r 30s,for $10 million a year, we can afford to wait.

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Hedging Strategies Using DerivativesIraG. KawallerVice Presidentand Directorof the New York OfficeChicago Mercantile Exchange

Is knowing when, how, and how much to hedge an ar t or a science? A systematicapproach provides discipline and control, and i t prevents a manager from avoiding theissue entirely.

I have several objectives for this presentation. First,Iwill examinethe anticipated outcomes thathedgingmanagers hope to achieveby using futures contracts.That is, accepting that futures contracts are price-fixing (or rate-fixing) mechanisms, what is the targetrate that we can reasonably expect to realize whenimplementing a futures hedge-and how can weachieve this rate (i.e., what is the methodology fordetermining the appropriate hedge ratio)? Second, Iwill t ry to clarify the distinction between hedgingimminent exposures as opposed to deferred exposures. Third, I will discuss the tactical considerationsregarding the choice of the futures expiration monthfor a given (set of) exposure(s). And finally, I willexplore hedge goals other than those associatedwiththe use of futures. Specifically, I will address alternative option hedge structures.

Objectives of HedgingWhenhedgingwith futures, do you expect to lockuptoday's spot price (rate) or today's future spot price(rate)? In fact, either goal can be pursued, bu t eachrequires a differentmethodology for determining thehedge ratio.To try tolockin the current spot price, the hedgeratio will be determined with the aid of regressionanalysis, which compares the price movement of agiven exposure with the price movement of the selected hedge vehicle. Ideally, one would hope tocreate a balance, whereby losing X dollars on theexposure will be compensated by an offset of X dollars gained on the hedge, or vice versa. The problemwith this approach is simply that historical relationships may not be robus t over time. This lack ofconsistency, depending on its severity, could beproblematic. Its consequence is that the desired ob-14

jective of locking in the spot rate may prove to beelusive.An alternative to the regression-based approachis one that str ives to lock in today's futures pricerather than today's spot price. For interestrateproblems, this alternative relies on equat ing the basispoint value of the exposure to the basis point valueof the futures hedge. For example, consider the caseof an exposure of a money market instrument forwhich interestis determined on thebasis ofprincipaltimes rate times time, with time being expressed as afraction of a 360-day year. In this case, thebasis pointvalue (bpv) is calculated as follows:

_ daysbpv - exposure x 0.0001 x 360 .Assuming that this exposure is to be hedged with aChicago Mercantile Exchange (CME) interest ratefutures contract,which generates $25 per basis pointmove, the hedge ratio would be found s imply bydividing bpv by $25. Using this methodology, thehedger receives compensation for movements of thefutures price, and as a consequence, the effect is torealize the initial futures rate, rather than the initialspotmarket rate.1

Now versus LaterSomemight takeissuewith theclaimthatwe canlockin the futures rate, because when constructing a futures hedge , the hedge effects are realized coincidently with the market move, bu t the effects on theexposure are not realized until the maturity date of

IPor a concrete demonstra tion of this point , see Ira G.KawaHer, "Choosing theBest InterestRateHedge Ratio,"FinancialAnalysts Journal (September IOctober 1992):74-77.


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the money market instrument in question. From aneconomics perspective, a preferred hedge construction would offset changes in the present value of abasis point value. This adjustment, however, is trivial. To determine the correct hedge ratio taking thisconcern into consideration, one would discount thenotional exposure, using the appropriate zero-coupon rate (the rate associatedwith the length of timeup to the maturity date of the exposure).Importantly, this revised approach is at oddswith current practices by accountants. Specifically,accountants do not recognize the difference betweenpresent value and future value. They allow for thedeferring of notional hedge results-not an adjustedamount to reflect t iming differences. As a consequence, hedge managers ultimately have to choosebetweencreatingthe appropriatehedge from an economics perspective and violating the accountants'sensibilities, or vice versa. In practice, this dilemmais likely to be inconsequential for nearby risks, but itcould be considerable for longer term exposures,especially exposures involving rate resets scheduledmany quarters or years later.

Placement StrategiesGiven that the prevalentmoney market futures pertain to three-month instruments, when longer termmaturit ies are of concern, the problem arises as towhich contract expirations to use. Should you useMarch, June, or September contracts? This is wherediscretion comes into play. The alternatives arestacking 'the contracts using a single expirat ionmonth, stripping the contracts into different expirations, or selecting specific expirations based on relative price considerations.The stacking approach typically places all thecontracts in the contractmonth most closely following the rate-setting date of the exposure. Althoughsimple, this strategymay introduce yield curve risk.Hedging a one-year piece of paper with a singleEurodollar futures contract, for example, creates thepotential for a mismatch in the performance in thehedge with respect to the exposure, if one-year ratesmove differentially from three-month rates.The stripping approach involves placing thecontracts across different expirations. Ideally, thehedge instrument should have a similar maturitystructure to the instrument being hedged, bu t eventhis generalization can be satisfied in a number ofways. For instance, the strip length could be as longas the matur ity of the security being hedged, or i tcould be as long as the exposure's duration. Toillustrate these alternatives, suppose Eurodollar futures contacts are selected to hedge a $10 million,

four-year piece ofpaperwith a durationof 3.4 years,or almost 14 quarters. The modified duration is 3.1,which is used to determine the value ofa basis pointand hedge ratio, as follows:

$10 million x 3.1 x 0.0001- ' - - - - - ~ - - - - = 124 contracts.$25Using the maturity approach, these 124 contractswould be spread over four years, or 16 quarters;using the durationapproach, this stripwould extendover only 14 expirations. Under both cases, the division required fails to result in an integer value, sosome judgment is still required. For example, 124contractsdivided by 16 quartersequals 7.75 contractsper quarter. Simply rounding off to 8 contracts ineach expiration results in a total of8 times 16, or 128contracts, whichwould foster overhedgingby 4contracts. To correct this excess, four expirationswouldhave to be selected, where 7 contractswould be used(rather than 8), bringing the total hedge back downto 124contracts. Similarly, 124 divided by 14 equals8.86 contracts, so the same problem arises with theduration length approach.Thechoicebetweenstackingas opposed to stripping ultimatelyrelates to a judgment asto the spreadpricesbetweenMarch and June,June and September,September and December, and so forth. Are thesespreadslikely towiden or narrow? This expectation,in turn, is driven by the manager's view of prospective adjustments to the yield curve: The shorthedger(concerned about rising interest rates) generallywould find stacking in the nearby contract month tobe appeal ing if the yield curve were judged to beparticularly upward sloping and unlikely to remainthat way. Otherwise, strippingwould be preferred.For the longhedger, the opposite preferenceswouldapply.

Option HedgesThus far in the discussion, attentionhas been focusedsolely on the use of futures as the hedge vehicle.Futures have the drawback, however, that they necessarily force thehedger to forego thepossible attractive outcomes accruing on the exposure that are associated with beneficial price (rate) moves. Conceptually at least, the ideaof insurance to protect againstadversity alone, without foregoing the beneficialmarket effects, has considerable appeal. This resultis exactlywhat follows from the purchase of an option contract o r a long option hedge. Buying anoptionas a hedgevehicleprotects against an adverseprice move beyond the strike price and retains theadvantage of a beneficialmove-for a cost equal tothe price of the option.

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Theselection of the"right" option is complicatedby the fact that a whole host of s tr ike pr ices areavailable, ranging from very cheap options (out-ofthe-money options) to very expensive (in-themoney) ones. Which is the r ight one to buy? Nosingle answer is right for all,bu t there is an approachthatmight help in the selection process.The methodology starts by conceptualizing aspectrumofrisk potential, running from oneextremeof virtually no risk of an adverse price move to theother extreme of virtual certainty that an adversemove will occur. The managermust evaluate whichpoint on the spectrum applies. Solutions for the twoends ofthe spectrum are easy. I f the possibilityof anadverse move is assessed to be zero, using no hedgeat all makes themost sense. If , on theotherhand, theprobability of an adverse market is a v irtual certainty, the hedge instrument that will payoff themost is a futures (or forward) contract.The more interesting part is the gray area inbetween, and in this range, buying an option maymake the most sense. Selection of a point on thespectrum closer to the "no risk" end would justify

purchasing a cheaper (out-of-the-money) option,while moving to the other extreme would justify amore expensive choice. Some greaterdegree of analytics, however, might be appreciated. One suchapproach for choosing between the various optionstrike prices that are available involves comparingmarginal costs to marginal benefits. Table 1illustratesthe marginal cost/marginalbenefitsmethodology for a hedge constructed using Eurodollarcalls, which ultimately provides the same protectionas over-the-counter interest rate floors.Table 1. Marginal Costs and Benefits for a callStrike Marginal Effective MarginalPrice Call Price Cost Floor Benefit92.25 0.51 0.19 92.76 (7.24%) 0.0692.50 0.32 0.14 92.82 (7.18%) 0.1192.75 0.18 0.09 92.93 (7.07%) 0.1693.00 0.09 0.05 93.09 (6.91%) 0.2093.25 0.04 93.29 (6.71%)Source: Ira G. Kawaller.In Table I, the strike prices range from 92.25 to93.25, corresponding to fl oors of 7.75 percent

through 6.75 percent, respectively. The effective floor,however, must incorporate the price of the opt ion.This f igure is generated by subtracting the strikeprice from 100.00 and then deducting the price paidfor this option. Referring to Table I, paying 51 basispointsfor the right tobuy at 92.25 guarantees a worstcase interest income, or effective floor, of 7.24percent(100.00 - 92.25 - 0.51). At the other extreme, paying16

4 basis points for the r ight to buy at 93.25 translatesto an effective floor of 6.71 percent (100.00 - 93.25 0.04). Note that when moving to better and betterfloors (reading up from the bottom of the table), themarginal cost increases and the marginal benefitfalls.We start with the cheapest (and worst) opt ionavailable and, in a step-wise fashion, pay up for an

improved floor as long as the marginal cost remainslower than the marginal benefit. Based on this criter ion-and this is not the onlyway to make the judgment-the preferred option in this example wouldbethe 92.75 strikeprice call,with an effective floor of7.07 percent. Of course, if a higher floor is required,say, 7.18 percent , the manager does not have anydiscretion. The hedgermust pay upandbuyan evenmore expensive option.

An analogous treatment is offered inTable 2 forexposures to risinginterestrates, solved by usingpu toption contracts. In this case, the effective ceiling isfound by adding the price of the opt ion to the str ikeyield (100minus the strike price).Table 2. Marginal Costs and Benefits for a PutStrike Marginal Effective MarginalPrice Put Price Cost Ceiling Benefit92.25 0.07 92.18 (7.82%)92.50 0.13 0.06 92.37 (7.63%) 0.1992.75 0.24 0.11 92.51 (7.49%) 0.1493.00 0.40 0.16 92.60 (7.40%) 0.0993.25 0.60 0.20 92.65 (7.35%) 0.05Source: Ira G. Kawaller.

Alternative Hedge GoalsLong option hedges are attractive because they protect against adverse price moves while at the sametime allowing for the opportunity to enjoy beneficialmarketmoves. The consensus, however, is that buying options can bevery expensive. Oneway of dealing with this concern is to sell options.

When selling an opt ion, the premium is collected, which potentially provides a maximum income equal to the initial option price. At the sametime, a short option position also offers the potentialof a loss thatmay be virtually unlimited. Whenusedfor hedging, short options should be pai red withexposures such that income from the short optionoffsets the losses on the exposures. Thus, the shortoption leaves the hedgerwith the prospect ofprotection only for a finite amount ofmarket risk and withthe corollary that beneficial market moves beyondthe threshold dictated by theoption's strikepricewillbe offset by hedge losses. Not surprisingly, this prospectmakes theshort optionhedge, by itself, less than


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Spot Interest Rates

wholly desirable. Using short options in conjunctionwith long options, however, ca n generatethe desiredprotection with a more attractivecash outlay requirement. Two common structures designed to achievethis objective are described more fully below:Fix a price outside of a potential range. Whether labeled collars, cylinders, or range forwards, allof these terms refer to the same thing: the combinat ion of a long call with a short put, or vice versa. Ineither case, the combination establishes both a flooran d a ceiling. The long option provides the desiredinsurance against the adverse price move, bu t toreduce the outlay of cash, the second option is sold.The short option potentially would generate a losscommensurate with a beneficial price move of theexposure beyond the secondary option's strike price.The net resul t of this combination is that the hedgeavoids the effects of price (rate) extremes---eitherhigher or lower. Within the range dictated by therespective strikeprices, however, the outcome issensitive to market movements.Fix a price within a potential range. Whereas acollar involves buying a callan d selling a pu t (or viceversa) this alternative strategy requires buying an dselling the same option. That is, buying an d sellingdifferent strike price puts or buying an d selling different strike price calls. These combinations arecalled "vertical spreads." The long option providesprotection beyond some initial threshold defined byitsstrikeprice; theshort option, in essence, eliminatesthat protection if the market moves beyond the secon d strike price threshold. For example, suppose amanager is concerned about a decline in prices. Theprimary option to bu y would be a pu t option. I f theprice decl ine is expected to be l imited to, say, lessthan 3 percent, a secondary (cheaper) pu t would besold. This option would have a strike price 3 percentbelow today's market price. The effect of selling thissecond pu t wo uld b e to negate the original longoption if prices were to fall below that 3 percentthreshold. If a beneficial price rise were to occur, themanagerwould enjoy thatentire pricemove, less theinitial price paid for establishing the options spreadposition. This strategy is the opposite of the collar.A collar eliminates price risk at prices outside of therange of the tw o relevant strike prices an d leavesexposure between. In contrast, vertical spreads fixprices within the strike price range an d accept theexposure for prices outside of this range.

Evaluating Hedge StrategiesThe availability offutures an d optionsallows managers to solve exposure problems in a wide variety ofways: using futures contracts, buying options, selling

options, or combining these strategies. Futures givethe same outcome no matter where interest rates go,bu t all other solutions to a riskmanagement problemwill have a path-dependent result . That is, the effective interest rate that yo u will realize (post-hedge)will d e pe n d o n whether interest rates rise or fall.

H ow do hedgers choose the best strategy? On eapproach is to create a spread sheet, such as thehedge choice matrix shown in Exhibit I, to help toevaluate the alternatives. For th is procedure, theexchange-traded instrumentshavea tremendous advantage over over-the-counter (OTC) products. Ex-changes disseminate all prices daily, making it easyto evaluate a large number of different solutions foran y given problem. An OTC dealer, on the otherhand, is very likely to select three or four strategiesan d present only those alternatives for consideration.Exhibit 1. Hedge Choice MatrixAlternativeStrategies ~ L ~ o ~ w : , , : o ( ~ : ; : : = = = = = = = = = = ~ . ~ H ~ i g ~ hFuturesLong OptionsShort OptionsCombinationsSOl/fee: Ira G. Kawaller.Note: The information in the cells should reflect effective rates(net interests, inclusive of hedge results expressed as annualinterest rates).

To use the accompanying matrix, start with aforecast for interest rates or prices, which woulddictate a particular column. Then select the preferred hedge strategy-the one tha t genera tes theoptimal result. For an y given strategy, however,achieving that optimal result only occurs if the forecast (column choice) is correct. If the forecast iswrong, theoutcomeis dictatedby the strategychoice(Le., along the horizontal line). Discomfort with thepotential ext remes of any s trategy would justifygoing to the originalcolumn an d choosing a strategythat mightappear to be suboptimal bu t thathas morep a l at a bl e p o t en t ia l o u t co mes u n d e r th e nonforecasted scenarios. The advantage of this exerciseis that the choice is made with full information an d"surprise" outcomes are virtually eliminated. Creation of this matrix provides a document that showswhat to expect in virtually an y potential market contingency.

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ConclusionIn some cases, hedging is automatic, because that isthe nature of the business, but in many other cases,people can exercise a great deal of discretion abouthedging. Sometimes this discretion relies almost entirely on subjective judgments. Other times, it usesrigorous, objective indicators that signal when toinitiate (or add to) a hedge position or when to remain exposed (or reduce a hedge position).Personally, I favor an objective, systematic approach. Aside from the obvious control advantagesofsuch a system, the downside ofnot having such amechanism to determine when to (or how much to)

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hedge is that, without the discipline, too frequentlymanagers elect to do nothing. A hedging plan enforces the discipline that movesan organization frombeing at the mercy ofthemarket tobeing in a positionofmanaging exposures responsibly. Given theavailability of the various risk management tools andstrategies, a manager who chronically chooses toremain exposed to the vagaries of the market is amanager who is abrogating his or her professionalresponsibility. Increasingly, as use of these toolsbecomesmore widespread,facility with these instruments is becoming a required qualification for the"up-to-speed" treasury professional.


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Question and Answer sessionIraG. Kawaller

Question: To determine thespot/futures hedge ratio in the regression equation, i f you introduced the difference between thefair value of the futures and spotas an explanatory variable,wouldthe problem of an incorrect hedgeratio go away?Kawaller: No. I do not carewhat the futures price is. When Idecide to hedge, I lock in whatever the market allows. If themarket allowsme to lock in 11 asopposed to 12, in either case, thenumber of contracts I use shouldnot be affected by a mispricing.Question: When the probability of adverse outcome is 100 percent, you suggest the use of futures to hedge. What is the riskofa long horizon? Will there be a

rollover risk in the futures hedgestrategy? How does your investment horizon affect hedge strategy and selection, rollover risk,and transaction costs?Kawaller: My comments aboutwhen to use futures were mostlyconceptual. When I am at that100 percent extreme, I want someprice-fixing mechanism as a solution-a futures contract, a longdated forward contract, or swaps.Ifwe use a futures contract, thetypical approachwould be to useone thatmay not extend to thedate desirable for us, the contractwould have to be rolled over.The rollover cost presents somerisk, which translates to the riskof an unattractive spread price betweenMarch and June or Juneand September, and so forth.

You must make some assumptions aboutwhat those spreadsmay be. Nothing I can suggestcan overcome that kind ofexposure.Question: Regarding yourmarginal cost-benefit analysis of different strike options, the marginalcosts are 100 percent certain butshould the marginal benefitbe adjusted by the probability of receiving that increased benefit?Kawaller: Your pointmay bewell taken. I do not see marginalcost-benefit as being the only wayto make this decision. I onlysuggest it as a perspective, but therecould easily be mitigating or alternative considerations. The probability that this will work for youshould be considered.

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Credit RiskSwap agreements, like futures contracts, create bilateral credit r isk in that each party depends on theother to perform according to the terms of the agreement. In contrast , options create unilateral creditrisk. The owner of a cap or a floor, for instance,depends on the counterparty topayoffon that agreement, bu t the seller of the opt ion does not need to

Default risk. To some degree, all users ofderivativecontracts are exposed to the potential economic losses that could occur if a counterparty defaults at an inopportune time. Credit risk is particularly important when considering OTC derivativesbecause, unlike their exchange-traded equivalents,these instruments often dispense with a transfer ofcollateral between the participants.Basis risk. As mentioned earlier, sometimeswhen implementing a hedging strategy, the volatili ty of the deriva tive instrument will not exactlymatch that of the underlying position. The termbasis risk is often used in derivatives markets (especially in connection with futures and swaps) to describe the extent of this imprecision in price movements.In this discussion, Iwill consider the problemsofdefault risk and basis risk-two of the lesser-knownderivative-related risks. My intention is to provide aframework for recognizing that a complete and balanced evaluation of any derivative strategy mustinvolve an examination of both the benefits and thecosts. In particular, I wil l focus on how these risksare measured and managed in the market for interestrate swaps.

Understanding the Risks in Over-the-CounterDerivative StructuresKeith C. Brown, CFAAllied Bancshares FellowandAssociate ProfessorofFinanceUniversity of Te

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Derivative Strategies for Managing Portfolio Risk-Keith C. Brown-1932495568