The Fund Industry: How Your Money is Managed, 2nd Edition

APPENDIX to Chapter 7

Funds and Derivatives

Our review of funds' investment strategies wouldn't be complete without a discussion of the role of derivatives. In sum, derivatives are financial instruments that derive their value by referring to an outside source. Specifically, they are contracts between two parties who agree to make payments to each other based on the price of a security or commodity, the valuation of an index, or the level of some other market or economic measure.

Mutual funds often use derivatives to help achieve their investment objectives. Most funds, except money market funds, use derivatives at least occasionally, though some funds deal in them on a daily basis, as an essential component of their investment strategy. Derivatives tend to be most critical to funds that invest in bonds, though they are an important tool for many stock funds as well.

This appendix provides an introduction to the use of derivatives in mutual funds. It reviews:

• How funds use derivatives.
• The regulations governing funds' use of derivatives.

Before you read on, please note that we assume throughout this discussion that you are familiar with derivatives and their terminology. If that's not the case, you might want to read the introduction to derivatives, which is available on this book's website. It contains three articles:

1. Derivatives: The Basics
2. Derivatives: Futures, Forwards, and Swaps
3. Derivatives: Options and Credit Default Swaps

USES OF DERIVATIVES IN FUNDS

Mutual funds use ...