The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

CHAPTER 15

Using Equity Derivatives in Portfolio Management

Bruce M. Collins, Ph.D. Professor of Finance Western Connecticut State University

 

Frank J. Fabozzi, Ph.D., CFA, CPA Professor in the Practice of Finance Yale School of Management

 

 

 

 

 

In the previous chapter, we described the basic characteristics of the different types of equity derivatives. We identified four primary roles for derivatives: (1) to modify the risk characteristics of an investment portfolio; (2) to enhance the expected return of a portfolio; (3) to reduce transaction costs associated with managing a portfolio; and (4) to circumvent regulatory obstacles. In this chapter, we discuss several basic applications of these instruments to equity portfolio management that reflect a cross section of these four primary roles across passive, active, and semi-active approaches to equity investment management.²⁵⁷ In addition, because options will change the risk reward characteristics of an investment portfolio, we also provide an overview of the relationship between expected returns and risk for strategies employing options.

While forward and futures contracts are time dependent linear derivatives with similar payouts and risk characteristics as the underlying, options are nonlinear derivatives that have fundamentally different risk characteristics than the underlying asset. The real value of options in portfolio management regardless of the motivation for their use is that they allow the investor a means ...