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Using derivatives to increase and protect returns

Natalie Floate
— 1 minute read

Several asset owners and fund managers have increased the use of derivatives as a way to enhance performance as well as reduce risk and gain tactical or structural exposure to other markets, writes BNP Paribas Securities Services' Natalie Floate.

Tactical derivatives positions are an efficient way to maintain strategic asset allocation during transitions, which have been significant in the period leading up to the MySuper reform.

Also, structural derivatives exposures are an economical and flexible option to gain exposure to foreign markets, currencies or specific sectors.

With the wave of regulatory changes driven globally by the Over the Counter trading (OTC) reform, the complexity and cost of using derivatives has significantly increased.

This may lead to some rationalisation in the use of derivatives compared to other asset classes, but derivatives are also instrumental for risk protection.  

Some 85 per cent of pension funds said derivatives were important to their risk management strategy, according to the International Swaps and Derivatives Association.

In order to maintain their risk strategies, are there opportunities for asset owners to compensate the additional cost of complexity with revenue or return opportunities?

For the sell side, the over-the-counter reform is also driving a higher requirement in collateral in order not to be penalised with regards to capital requirements and to maintain competitive pricing.

As a counter party, the asset owners can access best execution if they can post collateral.

Being able to post securities as collateral, subject to the evolution of the regulation for superannuation funds, allows them to remain fully invested.

As a long-term asset holder, this is also an opportunity for asset owners to provide eligible collateral to the market through securities lending.

Securities lending are among tools increasingly being used by these asset owners to provide their end investors with extra returns or have a stable revenue stream to cover additional costs linked to the increasing complexity of the market.

On the sell side, market participants are looking for high-quality liquid assets (HQLA) to bolster their liquidity ratios. 

This demand from the sell side is creating a unique opportunity for the buy side to generate additional value from their assets.

A typical trade today is to lend HQLA on a term, extendable, and evergreen basis against non-HQLA as collateral.

Risk can also be reduced by derivatives: relatively small investments in derivatives can provide improvements in certainty, in equivalent rates of return and other performance measures.

The other risk protection techniques most commonly used included interest rate and foreign exchange (FX) derivatives, followed by commodity, credit and equity derivatives.

There are also a range of overlays including portable alpha overlays, currency overlays, liability-driven investment (LDI) or duration overlays (generally used to hedge the interest rate risk arising from pension plan liabilities), tail-risk hedging strategies, completion overlays, rebalancing overlays and tactical asset allocation overlays.

Natalie Floate is the head of market and financing services at BNP Paribas Securities Services.

 

Using derivatives to increase and protect returns
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