- 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.
- 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.
- 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.
- There are four
principal investment uses of futures for long term investment institutions
such as pension funds.
- Asset re-allocation
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.
- Strategic
asset re-allocation
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.)
- 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.
- Cash flow
management
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.
- Currency
futures
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.
- 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.
- Options
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.
- 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.
- 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.
- The more technical
details of options are set out in Annex
2.
- 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.
- There are three
principal uses of traded options on individual shares for long term
investment institutions such as pension funds.
- Specific
risk management
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.
- Cash flow
management
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.
- 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.
- Contract for Differences
(or SWAPS)
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.
- Use of Derivatives
By Our Managers
Each
of Oxfordshire’s four managers wishes to use derivatives, but their
proposed use of them is very modest and low risk.
- Alliance
Bernstein
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
- 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.
- 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).
- Legal and
General
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.
- UBS Asset
Management
Manager
of multi-assets £145 million and property £25 million. They would
like to use derivatives in the same way as Alliance Bernstein, namely
- 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.
- 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).
- Baillie Gifford
Manager
UK equities (£105 million). They would like to use derivatives in
two ways
- Stock Index
Futures for cash management in the same way as UBS Asset Management.
(see (c) (i) above);
- 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
- The Committee
is RECOMMENDED to
- 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
- authorise
UBS Global Asset Management and Baillie Gifford to use derivatives
as set out in 4 (c) and (d) above.