The Building Blocks: Exchange-Based Contracts

Abstract

There can be no doubt that one of the main reasons for using derivative securities is to protect the value of an underlying portfolio. Often ignored or simply overlooked, however, is the fact that portfolios can, with the aid of derivatives, be modified to gain enhanced participation in market upswings. The portfolio in question might be a long position in an equity index-tracking portfolio, for example, or a short position in interest rates payable on a loan, a bond portfolio, a currency position or a commodity. Whatever the character of the portfolio and whoever the manager of the portfolio is — a fund manager, trader or corporate treasurer — there will be an expectation of the way in which the market value of the portfolio under their management is likely to be affected given the driving influences in the market at that point in time. Managers may seek to protect the value of their portfolio by selecting from a palette of derivative securities. It may be that they wish to hedge for a short, single time period or it may be that their horizon may spread over a longer period of time with several important, intermediate investment horizons. This chapter will focus on exchange-based contracts and will discuss how such contracts might be used to create and utilise a variety of risk hedging or value enhancing strategies.