Uses of Derivatives to Address Exposure and Liquidity Needs

Introduction

Have you ever watched a friend try to rearrange their living room by moving a heavy sofa all over the place? Sometimes, you just want to tweak the room’s aesthetics—maybe tilt the couch 15 degrees—without the hassle of carrying it clear across the house. In institutional investing, derivatives can be that “15-degree tilt,” allowing you to adjust a portfolio’s exposures quickly, often more cheaply, and without having to lug around all those large, illiquid assets.

When managing large institutional portfolios, such as endowments, pensions, or insurance funds, derivatives are a mainstay tool for addressing exposure and liquidity needs. They help optimize asset allocations, hedge against undesired risks, and sometimes facilitate compliance with liability-driven objectives. Whether it’s a currency forward to protect overseas donations, an interest rate swap to neutralize unexpected changes in rates, or equity index futures to manage quick inflows and outflows, derivatives can be your best friend in ensuring your portfolio remains agile under a variety of market conditions.

Quick Overview of Common Derivatives

Before diving deep, let’s outline the major types of derivatives that institutions often employ:

• Equity Index Futures: Contracts to buy or sell an underlying equity index. Great for quick exposure adjustments or hedging overall market risk.
• Interest Rate Swaps: Agreements to exchange fixed and floating interest payments, often used to align a portfolio’s duration with its liabilities or reduce interest rate sensitivity.
• Currency Forwards and Futures: Contracts obligating you to exchange one currency for another at a specified future date, used to manage foreign currency exposure and guard against adverse currency movements.
• Credit Default Swaps (CDS): Insurance-like contracts providing protection against default on a reference entity. Allow managers to hedge or gain exposure to credit risk without rearranging the entire bond portfolio.

Hedging and Adjusting Portfolio Exposures

Derivatives are well-suited for rapid hedging or position adjustments: • Equity portfolio managers might use index futures to temporarily reduce or increase market beta.
• Bond managers could turn to interest rate swaps to shorten (or lengthen) duration when they see rates rising (or falling).
• International portfolios often require currency hedges. This is particularly relevant for an endowment receiving donations in foreign currencies. You can lock in a future exchange rate with either forward contracts or currency futures.

It’s not just about blocking out negative exposures. Sometimes, you need to adjust your portfolio’s tilt toward a factor or region. Instead of painstakingly selling underlying holdings, you might overlay a derivative strategy on top of existing positions. That’s what we call a derivative overlay—where we use futures, options, or swaps to shift the portfolio’s exposure on the margin, leaving the “heavy sofa” of the long-term holdings mostly untouched.

Here’s a visual overview of how a derivative overlay can fit into an institutional portfolio:

    flowchart LR
	    A["Core Portfolio<br/>(Stocks, Bonds, Alternatives)"] --> B["Derivative Overlay<br/>Futures, Swaps, Forwards"]
	    B --> C["Adjusted Exposure<br/>(Shifted Beta)"]

In words, the core portfolio remains intact, while the derivative overlay fine-tunes your overall factor exposures or hedges specific risks.

Liquidity Advantages and Transactions Costs

A big selling point of derivatives is their capacity to reduce transaction costs and meet short-term liquidity needs. When you want to raise cash quickly, selling your carefully selected (and maybe less liquid) assets might be the last thing you want to do. Derivatives—particularly exchange-traded futures—let you get or shed exposure fast, with minimal transaction fees compared to trading in the underlying securities themselves.

Suppose an endowment has a near-term cash outflow—maybe a big capital project or scholarship distribution—that requires quick liquidity. Instead of liquidating a swath of lightly traded high-yield bonds, the manager can raise temporary cash in the short term by using a futures overlay. This might involve short-selling equity index futures or negotiating short-duration interest rate products. Once the outflow is met, the position can be unwound—often at lower cost than a full-scale rebalancing would have required.

The typical reasons derivatives can be cheaper than trading underlying securities:

• Lower Commissions and Market Impact: Exchange-traded derivatives often attract minimal per-contract commissions, and large notional exposures can be gained or offset quickly.
• Less Slippage: Because derivatives markets (especially for major indices or widely used instruments) are typically liquid, the bid-ask spreads are often narrower than in thinly traded securities.
• Flexibility in Execution: You can stagger derivative trades over short intervals to mitigate sudden price impacts.

Using Interest Rate Swaps for Liability-Driven Investing

Many institutional portfolios—particularly those of pension funds and insurance companies—are heavily concerned with liabilities that are subject to interest rate risk. But guess what? Endowments might also have inflation-linked spending targets or debt obligations that exhibit sensitivity to interest rate fluctuations.

Imagine a large endowment that issues fixed-rate debt to finance campus expansion and invests in a broad bond portfolio that’s primarily intermediate duration. If interest rates were to spike, the market value of that bond portfolio might decline, leaving fewer resources to service the fixed-rate debt or meet future obligations. One approach is to enter an interest rate swap where the endowment pays fixed and receives floating. By doing so, if interest rates rise, the endowment’s bond portfolio might lose value, but the swap’s value (or the overall effect of paying fixed) becomes more favorable compared to paying floating. So the combined net effect can be a hedge against rising rates.

Alternatively, if the endowment is worried about interest rates dropping (thereby exposing them to reinvestment risk or liability mismatch), they can arrange an opposite swap structure. The beauty is that these changes to the portfolio’s risk profile happen without selling the majority of the existing bond holdings. That’s a big plus, especially if those bond holdings are thinly traded or if the manager believes they offer good value in the long run.

Just be cautious: entering or unwinding a swap generally involves ongoing mark-to-market exposures and margin/collateral posting requirements (depending on your jurisdiction). So keeping an eye on liquidity reserves is critical.

Evaluating Derivatives: Costs, Risks, and Margin Requirements

While derivatives can seem magical at times—“Poof! Adjusted exposure!”—they come with their own set of costs and risks.

• Margin Requirements: Futures contracts typically require an initial margin deposit, plus variation margin with daily mark-to-market. Over-the-counter (OTC) swaps may involve collateral postings and credit support annexes. If markets move against your position, you need to top up margin quickly.
• Counterparty Risk: Especially in OTC derivatives (like certain interest rate swaps or CDS contracts), you face the possibility that your contract partner defaults. Clearinghouses mitigate this risk in exchange-traded formats, but it never fully disappears.
• Basis Risk: The derivative you’re using to hedge might not perfectly track the underlying positions. For instance, your equity portfolio might not exactly match the index used in an equity futures contact, or your bond holdings might have different credit exposures than the interest rate swap suggests.
• Operational Complexity: Policies, procedures, and specialized staff are necessary to handle margin calls, settlement, and monitoring. Mistakes here can be costly.

Personal Reminder

I once saw a mid-sized foundation get caught off guard during a rapid interest rate shift. They had the right idea—use swaps to hedge rising rates—but they forgot to budget for potential margin calls. Short-term rates jumped, the swap’s market value plummeted, and they had to scramble for cash to post collateral. It led to other liquidations at inopportune times. That memory keeps me humble about the importance of liquidity planning.

Overlay Strategies for Tactical Asset Allocation (TAA)

An overlay strategy is basically layering derivatives on top of your existing portfolio. This technique is handy when you need to shift exposures in the short term without changing the underlying Strategic Asset Allocation (SAA). That’s exactly what tactical asset allocation is about: pivoting from your long-run plan to exploit near-term market opportunities—or to mitigate short-term risk.

Let’s say your endowment’s SAA calls for 30% in global equities and 70% in fixed income for liability coverage. But a few times a year, you might want to tilt 5–10% more heavily toward equities if you see a compelling valuation opportunity. Instead of selling part of the bond portfolio, you can purchase equity index futures to ramp up the equity exposure short term. This preserves the underlying bond positions, which may be carefully selected to meet certain liability or yield objectives. Once your TAA view changes, you can unwind the futures.

Governance and Risk Management Framework

Any institution that decides to use derivatives needs a strong governance framework. This includes:

• Established Risk Limits: Identify maximum notional amounts, margin allocations, or Value at Risk (VaR) thresholds.
• Operational Controls: Ensure proper segregation of duties between traders, risk managers, and back-office staff.
• Compliance and Oversight: Adhere to regulatory requirements, reporting obligations, and internal guidelines.
• Board/Committee Approval: Especially for an endowment, the Board may require periodic reviews of derivative usage (e.g., quarterly updates on open positions, realized/unrealized gains, and margin usage).

Beyond that, many institutions create an internal derivatives usage policy that outlines authorized instruments, permissible hedging strategies, maximum position sizes, and procedures for daily margin management.

Scenario Analysis for Best- and Worst-Case Outcomes

So how do you stay ahead of unexpected developments? Scenario analysis (and stress testing) can help ensure you’re prepared if the markets move dramatically against your position. For instance, imagine you’re using equity index futures to hedge a portion of your portfolio. Ask yourself:

• What if the equity market gains 20% in two months?
• What if it plunges 20% in two months?
• What if short-term rates spike, raising the cost of carry for your futures?

By mapping out the potential outcomes (both in standard market conditions and tail-risk scenarios), you’ll get a sense of possible margin calls, rebalancing requirements, and liquidity needs. That way, you won’t be caught off guard by a 2 a.m. phone call from your clearing broker that you’ve got a big margin shortfall.

Here’s a hypothetical scenario table for an endowment using equity index futures:

In practice, each scenario will come with liquidity requirements or collateral calls. For example, a large negative P/L on futures means you owe variation margin to the clearinghouse and must have the cash on hand.

Key Glossary

• Derivative Overlay: A strategy using derivatives to adjust beta exposures without trading the underlying portfolio assets directly.
• Counterparty Risk: The risk that the other party in a derivatives contract fails to meet its obligations.
• Margin Requirement: The collateral that must be posted to enter certain derivative positions, such as futures or swaps.
• Tactical Asset Allocation (TAA): Short-term adjustments made to the strategic asset allocation to exploit opportunities or mitigate risk.

Final Exam Tips

• Be Specific in Your Answers: If a question asks how to hedge currency exposure for an endowment receiving donations in euros, mention currency forwards or currency futures specifically, rather than just saying “use derivatives.”
• Don’t Forget Liquidity and Operational Risk: CFA exam questions often test whether you recognize margin calls, cash flow mismatches, or operational complexities.
• Time Management: In a multi-part essay question, the derivatives component could be just one part of a bigger scenario. Allocate time proportionally and ensure you address each sub-question—especially any sub-question on risk or compliance.
• Illustrate with Simple Math: If you’re asked to show how many futures contracts an endowment might need to hedge interest rate risk, keep your calculations neat and clearly label each step.

References and Additional Reading

• Bhansali, Vineer. “Fixed Income Finance: A Quantitative Approach.”
• CFA Institute: “Derivatives and Risk Management,” Level III Curriculum.
• Das, Satyajit. “Traders, Guns & Money.”

Test Your Knowledge: Institutional Derivative Usage and Liquidity Management