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

THE ROLE OF DERIVATIVES

Equity derivatives have several properties that provide economic benefits that make them excellent candidates for use in equity portfolio management. These properties are linked to the four roles that derivatives serve in portfolio management:

1. Risk management. Modifying the risk characteristics of a portfolio.

2. Returns management. Enhancing the expected return of a portfolio.

3. Cost management. Reducing transaction costs associated with managing a portfolio.

4. Regulatory management. Achieving efficiency in the presence of legal, tax, or regulatory obstacles.

We can further reduce the role of derivatives to the single purpose of risk management and incorporate the other three roles into this one role. Thus, it can be argued that equity derivatives are used primarily to manage risk or to buy and sell risk at a favorable price.

Risk management is a dynamic process that allows portfolio managers to identify, measure, and assess the current risk attributes of a portfolio and to measure the potential benefits from taking the risk. Moreover, risk management involves understanding and managing the factors that can have an adverse impact on the targeted rate of return. The objective is to attain a desired return for a given level of corresponding risk on an after-cost basis. This is consistent with the Markowitz efficient frontier and modern portfolio theory discussed in Chapter 3.

The role of equity derivatives in this process is to shift the frontier ...