Use of Derivatives in Portfolios

Introduction

The paper will centralise on the application of derivatives in the management of the portfolios of the investors. Investors are subjected to many kinds of risks while they invest in the securities of the markets. Some of these risks are currency fluctuations, movements in the market, fluctuations in the interest rates, inflation and exchange rate fluctuations. Derivatives are those financial instruments that are derived from the prices of the underlying securities. They are used as hedging instruments for minimising the market risks of the investors. Derivatives are generally cheaper than their underlying securities, and hence, the investors can easily invest in derivatives and get exposed to a diverse range of asset classes. Through this diversified range of asset classes, the investors can dilute their risks through a strategic asset allocation in their portfolios. The paper would provide deeper insights into this topic through the study of various studies proposed by eminent authors. The paper would also give some substantial evidence of risk reduction of the investors.

Literature review on the use of derivatives in Portfolios

Many studies have been conducted to investigate the usage of derivatives in the portfolio management of investors. According to Venkatesh, Thayumnavar and Anshu, derivatives are considered as ideal instruments for risk-free trading by the investors. The paper also examines a behavioural approach of the investors about investment in derivatives while carrying out trading activities. The sophisticated and modern financial environment has led to the increased usage of derivatives among the investors as compared to other financial instruments. The derivatives market is considered as an integral part of the capital market in the emerging market economies.

Most of the businesses, as well as investors, are benefitted from the derivatives market through useful price signals (Venkatesh and Thayumanavar 2019). These price signals are related to exchange rates, indices, references rates and other asset classes. The investors have realised that they can use derivatives for hedging risks of the securities and taking highly speculative positions in the market. Risk appetite varies from one person to another and in such a situation, derivatives play a vital role in shifting risk from risk-averse people to risk-seeking people. Recently, a large number of stock exchanges have been successful in gaining good turnovers from the derivatives market as compared to the equity market.

The next study conducted by Khan, Arif and Tahir focuses on the extent of the usage of derivatives, especially in the banking sectors of different countries. The application of derivatives in the banking sector has been analysed for ten years. It has been observed that banks are the dynamic users of derivatives, and they use these derivatives for different purposes such as risk management, speculation and other trading purposes. As a result of the global financial crisis, the banks and other financial institutions were severely hit, and it affected their liquidity position.

In such a situation, the banks started using derivatives for investment purposes (Khan et al. 2018). These derivative instruments are considered as financial innovations that have transformed the conventional way of conducting business by the banks. Banks have effectively used derivative instruments for managing bank risks and substantial costs during economic distress. Many authors have argued that derivative instruments also play a vital role in restructuring the dangers of trading into manageable risks. Some other authors have argued that established firms with high capital hedge more than firms having lower capital. Banks have successfully utilised swaps and forward contracts for hedging risks, while options have been used for speculative purposes.

Another study conducted by Marcin Halicki draws attention towards the process of portfolio management as applied by both institutional and individual investors. The study also highlights some of the critical areas of portfolio management as used in real-world scenarios. The utility of derivatives in this process is taken into account in a meaningful manner. The portfolio management process evolved when the organisations shifted to cash investment even during unfavourable internal and external conditions. After the introduction of derivatives in the market, the institutions could quickly reduce their overly high costs of investment and achieve a reasonable rate of return from their investments. Even after the presence of negative constraints of the internal and external environment, the investors can dilute their portfolio of securities through a wide range of asset classes, which are available at cheaper rates.

Under risky situations, derivatives enable investors to make decisions of investment in the market. They help in reducing the investment risk and consequently improve the efficiency of investment funds. Classical portfolio management consists of the development of investment objectives and strategies (Halicki 2017). The portfolio is created following these strategies and catering to these objectives. The portfolio is further monitored and adjusted according to the market conditions. The derivatives play an integral role in this process of portfolio management.

According to the researches conducted by Barro, Canestrelli and Consigli, a comparative study has been made between volatility and downside risk in the dynamic portfolio strategies with derivatives. Many risk control strategies have been prepared based on different market signals, which are combinations of market indices and derivatives. One example of such an approach is S&P500 protective put index, which has been developed by stock exchanges as well as investment banks. There has been an endogenous increase in the systematic risks of the securities due to political events. The global financial markets are affected by the volatile returns, economic turmoil, and reduction of the horizon of investment. These factors can be considered as potential sources for the growth of the derivatives market, which is also referred to as a credit derivative market.

Several portfolio management techniques have been proposed that treat volatility as one of the major asset classes. These approaches have added overlays to the risky portfolios through the use of derivatives (Barro et al. 2019). However, some of the derivative-based strategies suffer from specific challenges such as defensive equity, low-beta alternative investments, and constant-proportion portfolio insurance may prove to be less effective in gaining attractive returns in the bull market. In such cases, a portfolio optimisation model may prove to be effective, which is based on the mean absolute deviation (MAD) approach.

Through the above studies, it can be observed that derivatives play an active role in the development of risk reduction strategies for the portfolio of investors. The derivatives also act as hedging instruments for banks and other institutional investors (Focacci 2019).  Through the application of derivatives, investors can quickly get handsome returns through fewer investment costs.

Evidences of risk reduction

Many financial and non-financial firms have widely accepted derivatives for mitigating the market risks of their invested securities. Chandra, P., 2017.  International evidence has been cited on the use of financial derivatives through the collection of a sample of approximately 7000 firms in 48 countries, including the US. The results suggested that 59% of the firms use global derivatives, 43.6% of the firms use currency derivatives, 32.5% of the firms use interest derivatives, while only 10% of the firms use commodity price derivatives.

Through results, it has been observed that many factors are attached to the use of derivatives in similar firms. One such factor is the size of the derivative market of the local regions (Kim et al. 2017). Firm value is another element associated with the usage of derivatives. Most of the firms use forward contracts for hedging the foreign exchange market risk, and others use swaps. For interest-rate derivatives, the most popular instrument of risk management is the swap contract while there are minimum users of forward contracts. Many anecdotal pieces of evidence have suggested that corporations primarily use derivatives in managing financial risks such as capital market imperfections, bankruptcy costs and convex tax schedules, which might otherwise degrade the value of the firms.

Many other studies conducted by several researchers have examined the relationship between the equity risk and the application of financial derivatives, through the sample of 555 banks in the range of 10 years. From the results, it has been observed that banks, in the beginning, could not use financial derivatives properly, which has increased their risk factors. In the later years, the banks have learnt to use derivatives for speculative purposes. The banks use suboptimal hedging for obtaining hedge accounting status (Gilje and Taillard 2017). Hedging is also used for detecting accounting mismatches of the earnings. Some banks employ a conventional retail banking business model, which is affected by lower idiosyncratic risks. Many instrumental variables have been captured for understanding the use of derivatives with portfolio ranking.

Over the past fifteen years, the over-the-counter (OTC) derivative market has grown substantially touching a revenue figure of US$493 trillion. Banks are the major players of the OTC derivative market. Some of these banks use financial derivatives to bet on the future fluctuations of the prices of the underlying securities (Tessema 2016). Prior literature studies have supported the fact that firms use derivatives for hedging the cash flow and earnings from risk exposures. Banks use derivatives for managing risk and complementing traditional lending activities. Through this way, banks can smoothen their profits and manage equity risks directly and indirectly.

The application of derivatives has also been investigated in the Indonesian non-financial firms. Through evidence, it has been observed that the participation rate of the players is 15.8% lower than that of the developed countries. The results indicate that the use of derivatives is directly related to the firm size, market-to-book value, bank-firm relationship and participation of the firm in foreign businesses (Pérignon and Vallée 2017). At the same time, the use of derivatives is negatively linked with the liquidity of the firms. Due to the impact of the economic crisis, many Indonesian firms have suffered adversely from huge losses. This was triggered by the high volatility of the exchange rates.

The Indonesian firms realised that they had been badly hit due to inadequate hedging opportunities. Through this realisation, the firms introduce derivatives as their hedging instruments for managing and mitigating these financial risks (Pernell et al. 2017). The firms have also suffered from the high volatility of capital and cash flows, exchange rates and other commodity prices. This raised the need for using derivative instruments for hedging the risks of instability. The inauguration of the Jakarta Futures Exchange in Indonesia has facilitated many firms to buy and sell derivatives as hedging instruments against risks (Matukait 2017).  Many companies in Indonesia have been engaged in international business activities. These companies obtain financing sources from foreign capital markets or foreign investments. As a result, they are exposed to various risk sources. This situation has aided the usage of derivatives as hedging instruments.

Evidence has been collected from the hedge fund industry regarding the use of derivatives. A large sample of the hedge funds has been received, and through results, it has been observed that 71% of the funds trade derivatives. These hedge fund companies have been able to lower their fund risks through fund strategies and approaches (Karila et al. 2016). In contrary to this, most of the derivative users have engaged less in risk shifting and more in liquidating the poor market state. Due to the substantial increase of the hedge funds in the past two decades, the use of derivatives has become a significant concern for funding the investors and regulators. Despite the associated challenges, fund investors use derivatives to hedge funds and exploit superior information.

Some authors have stated that the hedge fund managers try to offset their risk-taking incentives and reduce fund risk. This strategy motivates them to use derivatives in managing this fund risk (Chang et al. 2016). Other authors have shown that derivative instruments can manipulate the performance of a portfolio through the change in measures such as the Sharpe ratio. From a sample of 5,000 hedge funds, it has been observed that derivative funds are mostly used in hedge funds and least used in mutual funds (Consiglio et al. 2018). Therefore, the hedge fund industry provides an ideal platform for investigating the relationship between derivatives and risk-taking behaviour of the fund managers.

Conclusion

From the above paper, it can be concluded that derivatives are widely used instruments for hedging and risk reduction in different industries of many countries. The derivative market has observed a good turnover in recent years due to increased use of derivatives among the investors. The derivative has been associated with the management of the portfolio as the investors can optimally allocate assets in their portfolio through the application of derivatives. Various literature studies conducted concerning the utility of derivatives in portfolios have been illustrated. Further, many pieces of evidence have been cited for understanding the efficiency of derivatives in reducing the risks of the investors belonging to institutions all around the world.

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