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Four ways derivatives can help you manage risk.

#1 Suppose your portfolio has become too heavily weighted in the equities area and you'd like to pull back a little. But you're generally pleased with your portfolio manager's performance and don't want to undercut his efforts. How do you get back on target without upsetting the whole structure?

SOLUTION: An allocation swap fits the bill. Here's how it works:

* You enter into a swap with a swap counterparty, using the equities it wants to allocate to a different asset class.

* You pay the S&P 500 total return (appreciation and dividends) to the counterparty.

* In return, you get a fixed-income or other asset-class return, plus or minus the spread from the counterparty.

BENEFITS

* Simple way to achieve asset-allocation goals without disturbing existing fund management.

* Allows flexibility in fine-tuning allocations without being constrained by manager's actions.

RISKS

* Credit risk of swap counterparty

This scenario is a straightforward allocation swap, a transaction with many applications. Here, an active manager has done well in one area but has thrown the allocation off for the short-term. The allocation swap allows you to readjust by bringing those allocations back into line. As the example demonstrates, the plus or minus on the spread will be a function of the Standard & Poor's total return when the transaction is priced. Don't feel constrained by what an asset manager is doing, nor should you think you're incapable of reallocating. A swap is a simple, straightforward way to retain the active manager's outperformance of the S&P.

You might wonder whether the active manager now has a negative output in the ongoing time period and whether you've potentially added more risk to the portfolio. In fact, you haven't changed what the portfolio manager is doing. What you've done is take some basis risk between the type of portfolio that he or she runs and the index return you're paying away. Suppose the portfolio manager is trying to replicate the S&P plus 100 basis points. When he or she hits that level, you haven't changed those 100 basis points. You're going to earn the S&P plus the 100 basis points and pay only the S&P. The other asset class that you get will retain that 100 basis points generated for you.

This example presumes that you like the manager's performance and style, so instead of taking the money away from the individual, you use the swap. However, if your manager doesn't perform well, you've got a risk whether or not you use derivatives. In other words, derivatives don't change the basic risks in your portfolio -- they just help you manage them differently.

#2 What if you've got the opposite situation? You want to outperform certain investing benchmarks like the S&P 500 index, but your manager has flubbed the job or has turned in an uneven performance. Can derivatives help you correct the problem?

SOLUTION: Use a longer-term derivative instrument, such as a bond-for-equity swap. Below is a typical play-by-play:

* Liquidate your active equity investments and purchase a fixed-income portfolio.

* Then enter into a swap and pay fixed-income coupons to your swap counterparty.

* You get the S&P 500 total return, plus the outperformance spread from the counterparty.

BENEFITS

* Guaranteed outperformance.

* Easy implementation.

* Customized structure with which to construct the portfolio.

* No management or transaction fees, and no tracking error.

RISKS

* Credit risk of fixed-income portfolio.

* Credit risk of swap counterparty.

This situation, outperforming investing benchmarks, is the other side of the coin to the first example. Here, you're seeking to outperform an index, in this case the S&P 500 total return, but you're unhappy with your active management. By using the swap or derivative for a longer period, the fund enters into a bond-for-equity outperformance swap, which will guarantee it, in this example, an S&P outperformance return.

The fund clearly will liquidate its equity strategy by firing its manager, among other things. Then it will purchase, with the advice of its consultants, swap counterparty, investment banker or master trustee, an underlying fixed-income portfolio of the desired credit quality, duration, size and return. Although the fund pays away those fixed-income payments to its counterparty as part of the swap, the yield-curve transaction and credit spread inherent in that coupon is worth something greater, because the fund is further out on the yield curve.

Of course, one of the most significant benefits in an outperformance transaction is your ability to control the duration and the credit quality in constructing your portfolio, and these factors drive the outperformance return that you can expect. On the other hand, you've taken some principal risk to the underlying portfolio, in addition to the credit risk of the portfolio and of the swap counterparty, as shown in the example. There's no such thing as a free lunch.

However, when you're constructing the transaction, you can work with your counterparty to make sure that the duration risk and the coupon flow you get match the swap flows you're going to pay. If you match them perfectly so that you have no basis risk during the life of the transaction, you'll have a par-value portfolio at the end, with the accompanying reinvestment risk. When the transaction matures, you'll have to set those flows so that those bonds, or whatever the underlying fixed incomes are, don't expose you to principal risk at maturity.

That brings up the issue of the transaction's liquidity, a very important consideration. The value of the underlying swap if, for example, you wanted to unload it during the transaction, is exposed to interest rates in the market, because you can get the swap price at any point. The duration of the transaction, your underlying portfolio and the credit quality really determine the transaction's outperformance.

Here's something else to remember. Although all the flows and rates are predetermined before you enter into the swap, which means that the flows will not trade, you could have a liquidity problem. Suppose, in this example, the S&P drops. It's as though you'd be making a net payment to your counterparty for the difference between what you're paying away and the depreciation, and that could pose a liquidity risk.

In most outperformance trades, you're not taking duration risk. Many fund managers will guarantee you the outperformance, and that usually means they're using aggressive cash-management strategies. Some firms use aggressive cash strategies that are designed to outperform LIBOR. All these swaps are generally priced first against LIBOR, so any return above it will give you an outperformance on your index, with little principal or interest-rate risk at maturity. This technique gives you a short-term instrument with little, if any, principal fluctuation.

#3 Let's say your fund has a high concentration of equities, and you'd like to keep it that way. You want to enhance your return, while at the same time maintaining a full investment strategy and keeping an open door to the equities market.

SOLUTION: Try a long-dated put-writing strategy. By using this technique, you can generate premium income while setting a level at which you could be put back into the market. The strategy can be summed up in a few simple steps.

* Write long-dated, out-of-the-money put options on market pull-backs.

* Generate premium income for the puts you are writing.

BENEFITS

* Ability to generate incremental returns on fully invested equity portfolio.

RISKS

* Not a good strategy for minor drops in the market.

* Not appropriate unless the fund's long-term strategy is to be fully invested in the market.

Scenario three is somewhat controversial, but this is a compelling strategy for pension funds unconcerned with inner-period volatility and looking for some incremental returns. This particular kind of sponsor has a very high allocation to equities and an active employee profile. It can improve its yield by writing some long-dated, out-of-the-money puts on the market, giving it the option to put that fund into the market. The strike price that you set on these puts will be a level that you establish as an attractive buying level. That gives you premium income. In the future, on these long-dated puts, if the market takes a significant dip, you might be put into the market. Of course, you could cash-settle the options.

This technique differs substantially from a call overwriting strategy, in which you truncate your return. For a pension fund using this derivatives technique, it's an issue of wanting to remain in the market. That doesn't mean that if the market drops 10 points you should go out and start writing long-dated puts. It's more of a strategy for significant market drops. The closer you write the strikes to the money, the more you're going to get paid.

#4 Like many other pension sponsors, you may be interested in diversifying into international equities, but your fund manager is worried about the country exposure and the currency risk. You can protect yourself with the right structured-note transaction.

SOLUTION: A structured note can help you take a particular market view and avoid certain situations.

* First, get a placement agent that will find a AA-rated bond issuer and will help you and the issuer set up the note.

* You purchase the note in U.S. dollars.

* A protected-equity note pays little or no coupon. At maturity, it pays par, plus a predetermined percentage appreciation of the desired index in U.S. dollars.

BENEFITS

* Guaranteed return of principal, plus a percentage appreciation of the equity index, if any.

* Customized structure.

* No management or transaction fees, and no tracking error.

RISKS

* Credit risk of bond issuer.

* Loss of dividend from equity index.

The last scenario is a good example of structured-note transactions, one of the larger areas for derivatives. This strategy allows you to take a particular market view or to avoid a particular situation. Here a hypothetical fund wants to get into another asset class, but it's concerned about some downside and wants to protect itself. To do that, it uses a placement agent to seek a AA-bond-rated or government agency or, for that matter, any issuer of a note. The note pays par maturity and a percentage appreciation of an underlying index that it selects. In effect, a derivative is embedded in the bond that it buys from this issuer.

A five-year time period for a transaction like this, without any coupon, would probably produce about 113-percent appreciation for an S&P investment. So you get 113 percent of the appreciation, if any, in five years, with no downside. If the index appreciates, you participate and you don't have management transaction fees or tracking error. You do run the risk of the underlying bond issue. And during the transaction, you've lost the dividend on the equity index, which is being used to provide the floor.

With this type of transaction, be sure that the institution has a good handle on credit. There's no credit-quality standard requiring an institution to accept only counterparties of AA or better, but in the last five years, the quality of credit risk that sponsors are willing to accept has risen.

What's the difference in the appreciation among the various indices? It primarily will be a function of the dividends, the volatility of the underlying index, the credit quality of the underlying issue and the maturity. In this example, the S&P's high-dividend yield increases the appreciation. You give away a lot of dividends to buy that embedded floor, but you get back some of it because you've given up some dividend flow. That's why you get 113-percent appreciation.

Some funds can't take a risk profile in domestic equities or international equities, so a structured-note transaction is a great way for them to have an underlying, fixed-income obligation, with equity returns tied to a AA credit risk. With this method, the fund has the exposure to the index for situations in which it can't technically own the underlying equities. You trade some value for the floor that you buy.

In this transaction, you don't technically have a swap. With a swap transaction, contractual obligations flow in two directions. In a structured note, you have a contractual, unsecured-credit obligation with a AA entity. This transaction consists of a note issued by a bond issuer that promises to pay par and a percentage appreciation of some index, if any, in a certain number of years. So you've got the credit risk of that issuer.

Some calls clearly are embedded in that transaction, and that's going to affect the liquidity and the price if you want to get out of it. Theoretically, if the embedded calls are completely worthless, which is unlikely, and you want to pull out, the security is just a zero coupon obligation of the issuer until maturity. Somebody out there will buy the entity's paper, which they know will yield par in four years. Most of the time, however, those calls will always have some time value, so the value will almost always be above the minimum level.
COPYRIGHT 1993 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Publication:Financial Executive
Date:Nov 1, 1993
Words:2153
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