| HOME
|
Don't play with derivatives and don't ignore them
November 19, 2003
Most private and institutional investors in South Africa are be aware that financial derivative instruments, such as futures and options, have a capacity to lead to financial losses if used irresponsibly.
Events such as the much publicised collapse of Barings Bank, as a result of the actions of a single employee, should be enough for an investor to question the use of derivatives.
It may therefore come as a surprise to most people that at any given point in time, an individual investment portfolio or retirement fund is more than likely to be invested in some of these products
'Investors must ensure that asset managers have clear mandates' |
.
Derivative instruments are financial contracts between two parties. The contract will stipulate that there is either a right or an obligation for either the buyer or the seller to transact in an underlying asset at or before a stipulated date and at a predetermined price.
Although the most liquid derivative instruments are regulated by and traded on the SA Futures Exchange, it is possible to trade in over the counter derivatives, which are not regulated.
The most frequently used and the most liquid derivative instruments are index based, such as FTSE/JSE Top40 index futures, which are also traded on the SA Futures Exchange. It is exactly these derivative contracts that investment managers and retirement fund trustees find useful.
The size of the derivatives market in South Africa exceeds that of the JSE Securities Exchange when measured by the value of trades. This should be an indication of the usefulness and liquidity of these investments.
It is usually easier and quicker to deal in a derivative contract than in the underlying asset, and this is one of the main reasons retirement funds normally restrict investment managers on the use of derivatives and allow them to use derivatives only to:
Allocate funds effectively across different asset classes;
Hedge the assets of the fund;
Insure the portfolio against specific events; and
Take advantage of anomalies in derivative market pricing in an attempt to enhance the fund's investment returns.
Investors and trustees of retirement funds need to ensure that they provide their investment and asset managers with very clear instructions concerning the use of derivatives.
They should therefore ensure that they fully understand what potential losses they can suffer from allowing their investment managers to use derivatives.
Trustees of retirement funds should, for example, ensure that they properly mandate their investment managers not to use derivatives to speculate in the market - for example taking uncovered derivative positions.
And they should not use derivatives for gearing - an exposure that may cause the fund's aggregate economic exposure to exceed its market value. This means that for a fairly small investment, an investor can obtain investment exposure as if a much larger amount was invested in the underlying asset or investment index. It is exactly this gearing effect that makes derivatives so risky.
It should, however, be noted that the benefits of using derivative instruments could be far greater than the potential losses if they are managed properly and implemented within a controlled environment. This is the reason the use of derivative instruments forms an integral part of the investment management processes of many investment managers.
These instruments are used in such a way that they are combined with the traditional asset classes to provide investment managers with more flexibility and the ability to manage the assets more defensively.
Bernard Fick is the head of Alexander Forbes Asset Consultants
|
|
|
Social bookmarking allows users to save and categorise a personal collection of bookmarks and share them with others. This is different to using your own browser bookmarks which are available using the menus within your web browser.
Use the links below to share this article on the social bookmarking site of your choice.
Read more about social bookmarking at Wikipedia - Social Bookmarking
|
|
|
News
Markets
Technology News
Company News
International
|
