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Prudent Investor Update, May 29, 2019

Derivatives:  Leverage vs Hedging
 

The combination of the words “leverage and derivatives” is enough to strike fear in the hearts of many people. After all, we have heard of government bodies, such as Orange County in California, that suffered great harm from using derivatives to increase risk. As well, no less an investment figure than Warren Buffett has referred to derivatives as financial weapons of mass destruction.  

However, derivatives can also be used to reduce risk.  While municipal Treasurers may not use derivatives day to day, ONE Investments (ONE) may use them in specific ways in future investment strategies to manage risk.  

This article is part of ONE’s regular sharing of information that is helpful to better understanding different strategies within the investment industry, and their various risk and potential returns.

What is a derivative?

Derivatives are financial instruments that derive their value from other financial instruments, often stocks and bonds. Their uses are many, ranging from leveraged strategies designed to increase risk to hedging strategies designed to reduce risk.   At ONE Investment, we do not permit external managers to use derivatives in a leveraged way or for speculative purposes.  They may be used only when they are fully covered by a backing asset, e.g., as for currency hedging, discussed below.

Using Derivatives to Increase Risk through Leverage

Leverage involves using funds you don’t actually own to generate returns, which are more extreme than those provided by the markets of the underlying securities (the stocks or bonds).  In the sidebar, we explain how derivatives can be used to leverage portfolios for better or for worse.  When markets are moving in the investor’s favour, leverage enhances those returns; but when markets turn the other way, the downside is significantly worse that it would be without leverage.

One famous example of this is the bankruptcy of Orange County, California in 1994 due to excessive leverage through derivatives.  Orange County lost $1.6 billion on its total portfolio of $7.5 billion.  The Treasurer had been generating above-market returns on County funds for many years by leveraging the portfolio through derivatives.  This worked well until 1994, when a series of increases in interest rates caused bond prices to fall.  At that point, the Treasurer had leveraged the portfolio up to as much as $20.5 billion by pledging the County funds as collateral.  He reinvested the additional amount mostly in 5-year federal government notes because they had higher yields than the short-term County funds he was using as cash collateral:  this would have worked well if interest rates had stayed the same or gone up.  However, when interest rates went up, the value of the longer notes went down more than the short-term collateral, causing a big loss.  The main error was that, by focusing so much on potential returns, the Treasurer did not take into account the size of loss the County could tolerate, causing them to declare bankruptcy.  

As an aside, determining a tolerable amount of downside is an exercise all municipalities should go through before investing and ONE is prepared to help you have those conversations with staff and Council.
 
Using Derivatives to Decrease Risk by Hedging

However, derivatives can also be used to hedge away the risk of certain characteristics in certain strategies and is often used to reduce currency risk. For example, you may hold US stocks because you believe over the long term that they will generate strong returns.  However, you may not want to take on the risk of the currency movements between Canada and the US, as this is an additional source of return volatility.  In that case, you may sell a forward agreement (a forward) on US dollars in the same amount as your stock exposure. A US dollar forward is a derivative whose value is derived from US dollars:  if the US dollar drops relative to the Canadian dollar, the forward rises in value offsetting the foreign exchange loss. Alternatively, if the US dollar appreciates, the forward’s price falls, offsetting the foreign exchange gain. In either case, the impact of any movement in the US dollar is neutralized or hedged.  In order to maintain a neutral (non-leveraged) position, it is important that the amount hedged is equal to the value of the stock portfolio.

In ONE Investment’s future offering of Unconstrained Global Bonds, the investment manager aims to hedge the effect of international currencies using forwards unless it sees value in holding a particular currency exposure.

ONE Investment is offering a range of products and service to help municipal investors maximize returns in the municipal context. The strategies outlined here aim to help you understand how ONE is managing the complexity of investing for you, to deliver better returns and better managed risk.

The Mechanics of Leverage


Leverage is the use of borrowed money (debt) to amplify investment returns. Anyone who has taken out a mortgage to buy a house would understand this. For example, if you buy a $500,000 home with a down payment of $50,000, you have borrowed $450,000 to make the purchase. If the price of your house goes up 10% to $550,000, your equity is now $100,000 which is a 100% return on your investment. (Your original $50,000 has increased by $50,000 to get your new equity of $100,000.)  Unfortunately, leverage also works the same way in reverse, that is, if the price of your home falls by 10% to $450,000, your equity is now $0 or a 100% loss.

Derivatives present another way to obtain leverage. For example, a common derivative is a call option, which gives the owner the right to buy a security at a set price before it expires. Why would someone want this? For the leverage. The following example illustrates how a call option provides leverage.

Let’s say a share of ABC Company costs $100 now and, for $5, you could buy a call option to buy that share at an exercise price of $100 by September.  So, you can buy 100 shares of ABC now for $10,000 (100 * $100). Or you can control 100 shares using a call option that costs $500 (100 * $5 ignoring commissions and fees for simplicity).  

Why spend $10,000 to buy 100 shares when you can get control for $500?  The reason is that, if you finally do buy the shares using the option, their effective cost will be $105 per share so that unless the shares rise to at least $105 you are losing money.  The following scenarios show how this call option leverages returns.

  • By expiry in September, the share price stays at $100
    • The return if you buy the shares now is zero
    • The return if you buy the option is -100% as there is no reason to exercise the option by buying the shares with it and you lose what you paid for the option.
  • By expiry, the share price rises to $105
    • The return if you buy the shares now is ($105 - $100) / $100 = 5%
    • The return if you buy the option and exercise it is ($105 - $100 - $5) / $5 or 0%
  • By expiry, the share price rises to $110
    • The return if you buy the shares now is ($110 - $100) / $100 = 10%
    • The return if you buy the option and excise it is ($110 - $100 - $5) / $5 = 100%

As we can see in our example, the returns for the same 100 shares vary greatly if they are bought outright (0%, 5% and 10%) versus if they are controlled by call option derivatives (-100%, 0% and 100%).  Certain optimistic investors who believe returns are going above the exercise price may be willing to take that risk and leverage potential returns.