Meeting documents

Pension Fund Committee
Friday, 29 August 2003

PF290803-12

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ITEM PF12

PENSION FUND COMMITTEE – 29 AUGUST 2003

DERIVATIVES

FUTURES, OPTIONS AND SWAPS

Joint Report by the Head of Finance and the Independent Financial Adviser

Futures

  1. A financial future is a contract to buy or sell a security on a specified future date at a price fixed at the outset. It is similar to a forward deal, the price reflecting the value of the underlying security adjusted for the financing cost to the future settlement date. The security covered by the normal range of futures contracts is usually a ‘synthetic’ security; it does not actually exist in a form that can be traded in the cash or spot market. The two most popular futures contracts in London are the FTSE contract (The Financial Times/Stock Exchange Index of the shares of the 100 leading UK companies) and the long gilt contract (a future on long-dated government securities). There are also futures contracts in a short dated gilt, in interest rates of various maturities and in the major foreign currencies.
  2. Futures began in the early 19th century in North America where they were used for the purchase and sale of grain, thereby giving a certainty of price to the farmer for his crop and to the corn merchant/miller for his commodity in-put. Financial futures were first developed in the Chicago markets – The Chicago Board of Trade and the Chicago Mercantile Exchange, but it is only more recently that they have been used by long term investment institutions such as pension funds, partly encouraged by the growing integration of world financial markets and the increased volatility within markets.
  3. Futures do not enable institutional investors to do things which they could not previously do, but they do make investment processes considerably more efficient especially when it comes to controlling risk.
  4. There are four principal investment uses of futures for long term investment institutions such as pension funds.
    1. Asset re-allocation
    2. When an institutional investor wishes to change the principal asset allocation of a fund such as between equities and cash or equities and fixed interest it may be done rapidly and cheaply by means of future contracts. There are two categories of asset re-allocation, depending on whether it is a long term or short term move.

      1. Strategic asset re-allocation
      2. This is when a long term change in the asset allocation is to be effected. A futures contract will be entered into immediately and then over time the necessary transactions will be effected in the cash market to support this deal. Thus, if it is wished to increase the proportion in UK equities, the FTSE Stock Index Future would be bought immediately and then over the next two to three months shares in actual companies will be bought before the expiry of the futures contract. If the market rises during that period the higher price of the shares will be offset by the rise in the value of the FTSE contract held. (Most principal overseas stockmarkets also have their own futures contracts. A switch therefore between UK and overseas equities or between two overseas markets can be facilitated through the use of futures.)

      3. Tactical asset re-allocation

      This is when it is wished to effect a short term re-allocation of assets such as when a temporary fall in prices is expected. A futures contract will be effected but the underlying portfolio will be left undisturbed. (This is particularly useful when shares in medium or smaller companies can be difficult to sell or accumulate.) This is also known as an ‘overlay strategy’. Thus if a temporary fall in the UK equity market is expected the FTSE Stock Index Future contract may be sold, but there will be no associated transactions in the cash share market. If the market does in fact fall the profit on the futures contract will offset the under performance on the shares held in the portfolio during that period. This type of transaction may be regarded as a form of hedging or risk insurance.

      Some institutions have so developed the use of futures whereby the futures covering a portfolio are managed totally independently from the underlying portfolio of securities in what may be regarded as a permanent overlay strategy, the theory being this leaves portfolio managers free to concentrate on share selection and so not be disturbed by changes in asset allocation. However, continually extending futures contracts can become costly.

    3. Cash flow management
    4. If there are large scheduled receipts or payments of cash at known dates in the future, the asset performance of the fund may be protected by the use of futures contracts. Thus if cash is to be received in a few months time, but in the meantime it is thought the UK equity market may rise, a FTSE Stock Index Future contract may be bought and when the cash is actually received shares are bought in the cash market to match the maturing futures contract.

      Futures can also be used for trading purposes but these are not normally regarded as a regular or legitimate use for a pension fund such as that of Oxfordshire County Council. Such trading purposes include arbitraging between the FTSE futures contract and the cash share market to profit from price anomalies and buying futures to leverage the fund, i.e. to increase the exposure of the fund to a particular category of assets without having the cash or other free assets to support the move.

      Strict limits are normally set on investment managers permitted exposure to futures.

      The 1990 Finance Act removed a number of tax and regulatory obstacles to pension funds operating in futures and so, subject to any restrictions in their trust deed, funds are in general free to use futures.

      The more technical details of Stock Index Futures are set out in Annex I.

    5. Currency futures
    6. These are more commonly known as forwards, which are contracts giving the right to buy or sell another currency at a fixed price at some future date. Again the price of the forward is based upon the current spot or present rate for the currency, plus the financing cost. For the UK based investor sterling is frequently the matching currency against the foreign currency in a forward deal, but often one foreign currency is matched against another foreign currency in a forward deal; these are cross trades which give rise to cross rates. Currency forwards are normally used in institutional investment to hedge the currency risk in holding overseas assets back into sterling, particularly where the liabilities are expressed in sterling, such as with UK pension funds. The currency risk in foreign bonds is frequently hedged, but that in foreign shares to a lesser extent.

    7. Interest rate futures (or swaps)

    These involve swapping the rate of interest on one currency with that on another currency and are frequently used in complex bond deals.

  5. Options
  6. An option is the right (but not the obligation as with a futures contract) to buy or sell an asset within a set period of time at a price fixed at the outset, for which a premium is paid. Unlike a future, an option need not be exercised, and so the buyer’s loss is limited to the premium. A ‘call’ option confers on the buyer the right to buy and a ‘put’ option the right to sell.

  7. Call or put options have been available in the London market for many years, but these ‘traditional options’, as they are now called, cannot be exercised before their expiry date nor sold to another investor. As a result they are somewhat inflexible instruments and are little used now.
  8. In 1978 the first traded options were introduced. These may be exercised at anytime before their expiry date, or sold (traded) to another investor, or the position closed by buying an exactly opposite matching option (viz if one is holding a ‘call’ one closes by buying a ‘put’). Traded options are now available on most leading UK shares. There are also traded options on the FTSE index, short and long gilt options, interest rate options and currency options. However, the most common options are those on individual shares.
  9. The more technical details of options are set out in Annex 2.
  10. As with futures, traded options do not provide an alternative to sound investment judgement arrived at by the application of normal investment criteria, but they can provide a useful aid to portfolio management. As a result institutions are making increasing use of traded options.
  11. There are three principal uses of traded options on individual shares for long term investment institutions such as pension funds.
    1. Specific risk management
    2. Where an institution has a mildly bullish or bearish view on a share it holds, particularly where the holding is under or over weight (against the FTSE All Share Index weighting) the institution can write (i.e. issue) or buy traded options to cover part of its holding. Currency options can also be used to hedge the exchange rate risk of holdings of shares and bonds in specific overseas markets.

    3. Cash flow management
    4. Where an institution will receive cash for investment on a known date in the future and it wishes to use the cash to buy a particular share, it can buy a call option to protect its position. Equally, when there are payments to be made in the future, a ‘put’ option can be bought to cover sales of specific shares.

    5. To earn extra income on its portfolio

    Where an institution has a relatively neutral view on certain shares it holds, not minding if it adds or sells some, it can write (i.e. issue) traded options on a portion of each such holding provided the premia it earns are sufficiently wide to justify the operation. (The extra income thus earnt can be used to reduce the book cost of each holding instead of being taken to the revenue account.)

    Where an institution such as a pension fund is firmly bullish or bearish on a share, it should buy or sell the share respectively and not write options on it. Further it should not write traded options ‘naked’, i.e. on shares it does not hold, since this increases the scope for loss. Strict limits are normally set on investment managers permitted exposure to traded options. When writing options a limit of 25% of the holding of the particular share being written is usual. When buying calls for cash flow management a limit may be set on the proportion of cash that may be applied to options.

    The 1984 Finance Act clarified the tax position on traded options, but each pension fund still needs to ensure its trust deed permits it to deal in traded options.

  12. Contract for Differences (or SWAPS)
  13. A contract for differences or swap enables the investor to buy or sell the economic interest in a security without actually acquiring it or disposing of it, but unlike a cash purchase of a security an investor does not acquire other benefits such as dividends, the right to vote etc. The purchaser of shares in a contract for differences pays interest at LIBOR (London inter bank offered rate) plus a margin of 1% - 2% on the total value of the security and puts up collateral which is adjusted regularly for price movements (marked to market). Conversely, a seller of shares in a contract for differences will receive interest at LIBOR less a margin of 1% - 2% on the total value of the security and put up collateral which is regularly marked to market. The counter party house offering contracts for differences will cover itself by actually buying or selling the particular security involved. Contracts for differences are not normally used by long term investment institutions such as pension funds, but tend to be more the province of shorter term operators, such as arbitrageurs or hedge funds.

  14. Use of Derivatives By Our Managers
  15. Each of Oxfordshire’s four managers wishes to use derivatives, but their proposed use of them is very modest and low risk.

    1. Alliance Bernstein
    2. It was agreed, following consultation with the Chairman, Deputy Chair and Third Group Spokesperson following a letter to them dated 5 June to allow Alliance Bernstein, who manage the Global Equities Portfolio (£145 million) to use two forms of derivatives

      1. Stock Index Futures for cash flow management (see 1 Futures (2) above) to enable the portfolio to be fully invested when appropriate. They may have sold securities, but not completed research on a new purchase, so may buy a Stock Index Future to cover the unemployed cash in the meantime. They would not buy a future to leverage or gear the portfolio, i.e. to have more than 100% exposure to the market.
      2. Currency Forwards

      They would use currency futures or forwards to hedge the currency risk in holding overseas shares back to the base currency sterling on occasions. (See 1 Futures (3) above).

    3. Legal and General
    4. Manager of £75 million fixed interest portfolio.

      It was also agreed with the Chairman, Vice Chairman and third party spokesperson to allow Legal and General to use currency forwards (see 1 Futures (3) above) to hedge all overseas bond holdings back to sterling.

    5. UBS Asset Management
    6. Manager of multi-assets £145 million and property £25 million. They would like to use derivatives in the same way as Alliance Bernstein, namely

      1. Stock Index Futures for cash management (see 1 Futures (2) above). If they have cash from sales or cash inflow and decided to invest the money quickly, they would like to be able to buy Stock Index Futures immediately and then more gradually acquire the actual stocks for the portfolio. Similarly, a sudden decision to raise liquidity or to meet a cash outflow might initially be covered by a sale of Stock Index Futures followed by cash sales of stock.
      2. Currency Forwards

      They would use currency forwards or futures to hedge the currency risk in holding overseas shares and bonds back to the base currency sterling on occasions (see 1 Futures (3) above).

    7. Baillie Gifford
    8. Manager UK equities (£105 million). They would like to use derivatives in two ways

      1. Stock Index Futures for cash management in the same way as UBS Asset Management. (see (c) (i) above);
      2. Traded Options where it would be easier to buy or sell the option than the actual share itself. They visualise rarely if ever using traded options in this way, but would like to have the authorisation to do so.

    RECOMMENDATIONS

  16. The Committee is RECOMMENDED to
          1. endorse the action taken by the officers following consultation the Chairman/Deputy Chair and Third Group Spokesperson, to allow Alliance Bernstein’s and Legal and General’s use of derivatives as set out in 4 (a) and (b) above; and
          2. authorise UBS Global Asset Management and Baillie Gifford to use derivatives as set out in 4 (c) and (d) above.

CHRIS GRAY
Head of Finance

A F BUSHELL
Head of Finance Independent Financial Adviser

Background Paper: Nil

Contact Officer: Tony Wheeler, Pension Fund Investments Manager. Tel (01865) 815287

August 2003

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