Companion Advisor: Techniques
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Derivatives: Not so scary
If you limited your reading to reports about boating
and swimming accidents just before going to the cottage, your holiday
would be ruined. Likewise, recent press attention has focussed on isolated
cases of large investment losses through the mismanagement of leveraged
derivatives. This has created a common perception of derivatives as scary
and dangerous, a perception which contains more fancy than fact.
Derivatives are financial instruments that derive their value from stocks,
bonds, currency, commodities, or a market
index such as the TSE 300. The first kind of derivative is called
a "forward" or "futures
contract". It is an obligation to buy or sell a specific instrument
at a specific price on a specific date. An example of a futures contract
is your offer to buy a house at a specific price. If accepted, you make
a downpayment today even though the closing may be months in the future.
The second kind of derivative is an "option",
which gives you the right, but not the obligation, to buy or sell an instrument
at a specific price before a specific date. A "call" option
is the right to buy; a "put" option is the right to sell. The
buyer of the option pays the seller a premium for the right to decide
later. Let's say you closed the deal on that house and now you need renovations.
You might pay a small amount to have a carpenter come over, take some
measurements, draw up a rough plan, and give you a quote that is good
for 90 days. You've just bought a call option on that carpentry job.
Mutual funds use derivatives
in four basic ways:
1) To decrease risk. An international fund may use forward currency contracts
to lock in an exchange rate and reduce the risk of currency fluctuations.
This is called hedging,
locking in a future buying or selling price in times of volatility, and
is an important component of sound portfolio
2) As a substitute for direct investments. Stock
index futures may be purchased instead of buying all the stocks the
index represents. For the TSE
300, for example, it is more convenient to buy a future on the whole
index than buying all 300 stocks. International RRSP funds buy index futures
or futures on a selected basket of stocks in foreign countries while holding
the equivalent amount in Canadian T-bills. Because the T-bills
are in Canadian dollars, the investment is 100% RRSP-eligible
while the fund gains international investment exposure.
3) To back up a belief in the direction of prices. A bond fund
manager who believes interest rates are going to decline may buy an
interest rate future or option
directly, rather than bonds.
4) To provide liquidity
and enhance returns. A futures contract requires a small down payment,
freeing up cash for other uses. There may be lower custodial
and transaction costs which enhance returns.
The use of derivatives by Canadian
mutual funds is strictly regulated, both by type of derivative and
by the manner in which derivatives are used. Mutual funds may use only
certain derivatives with an approved credit rating that trade over-the-counter
or on permitted exchanges, and no more than 10% of the net assets of a
mutual fund may be invested in derivatives.
As well, mutual funds cannot use leverage
or borrow money to buy derivatives. They can only use derivatives for
hedging purposes or where sufficient cash or securities
are set aside to meet the fund's obligations under the derivative security.
All investments carry risks. There are three risk factors when derivatives
are used by mutual funds:
1) Liquidity risks. If a fund cannot "close out" or "sell
out" its position, it may not be able to realize profits or limit
losses. Or, if trading in the underlying security is halted, the prices
of the derivatives may be distorted.
2) Credit risks. The fund's counterparties in the derivative, whether
clearing corporations in the case of exchange-traded securities or other
third parties in the case of over-the-counter obligations, may be unable
to meet their obligations. This is minimized by dealing with only the
most reputable firms and by increasing the frequency of payments.
3) Safekeeping risks. In certain circumstances, investment dealers and
futures brokers will have possession of some assets belonging to the Fund
in connection with the derivative positions.
You can learn if and how your mutual fund is using derivatives by reading
the simplified prospectus
and the footnote section of your mutual fund's financial
statements or calling a Fiscal Agents
- Investment Advisor.
Derivatives are very useful when used properly and, like insurance, can
hedge against losses. Don't be misled by the horror stories produced when
derivatives are misused, or you may end up sitting on the investment beach
while everyone else is having fun in the water.
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