Leverage & Derivatives in Funds

A DERIVATIVE is a contract whose value is DERIVED from an underlying asset, rate or index — a share, a bond, an equity index, a currency, an interest rate or a commodity. The fund does not have to own the underlying to gain economic exposure to it.

The main derivative types a collective investment scheme (CIS) may use are:

• •FUTURES and FORWARDS — an agreement to buy or sell the underlying at a fixed price on a future date (futures are exchange-traded and standardised; forwards are over-the-counter, OTC).
• •OPTIONS — the right (not the obligation) to buy (call) or sell (put) the underlying at a strike price, in exchange for a premium.
• •SWAPS — an exchange of cash flows, e.g. an interest-rate swap (fixed for floating) or a total return swap (the return on an asset for a financing cost).

Derivatives can be EXCHANGE-TRADED (standardised, centrally cleared) or OTC (bilateral, customised). The distinction matters greatly for counterparty risk, discussed below.

Regulators and the industry generally recognise three broad, permitted purposes for derivative use by a mainstream fund:

• •HEDGING — reducing or offsetting an existing risk in the portfolio. Examples: buying index put options or selling index futures to protect against an equity fall; using currency forwards to hedge foreign-currency holdings back to the fund's base currency; using interest-rate swaps or bond futures to reduce duration risk.
• •EFFICIENT PORTFOLIO MANAGEMENT (EPM) — achieving a portfolio aim more cheaply, quickly or flexibly than trading the physical assets. Examples: using index futures to equitise incoming cash so it is not left idle; adjusting asset allocation quickly; reducing transaction costs and market impact.
• •GAINING INVESTMENT EXPOSURE (investment purposes) — taking on exposure to a market, sector or asset that would be costly or impractical to hold directly, e.g. commodity or emerging-market exposure via derivatives.