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Absolute Return Bonds Guide

Derivatives

Derivative instruments available to fund managers
Most absolute return bond funds make use of derivatives, a term used to describe a variety of futures and options contracts.
A wide range of bond market derivatives is available and the market is growing very rapidly, with new instruments continually being developed. Derivatives tend to be the preserve of highly experienced, professional investors and in the past it has been difficult for ordinary investors to gain exposure to this type of investment. However, the new UCITS III regulations have made it possible to launch funds for private clients that include investments in derivatives.
We have detailed below some of the types of derivatives that can be used by managers of absolute return bond funds and their potential applications.
Bond market derivatives
Futures
Bond futures contracts are employed as a method to speculate on interest rate changes. A view that interest rates will fall (and bond prices will rise) will be expressed by buying bond futures contracts. Conversely a view that interest rates will rise will be expressed by selling bond futures contracts. A fund manager may also use bond futures contracts to hedge interest rate risk by selling a bond future against a specific asset, or to express a view on the relationship between interest rates of different maturities or currencies.
For example, a view that 5 year interest rates would rise by more that 30 year interest rates could be expressed by selling 5 year bond futures and buying 30 year bond futures. A view that US interest rates would rise by more than UK interest rates could be expressed by selling Treasury (US) bond futures and buying gilt (UK) bond futures.

Options
Options allow for more refined views on how much the market might move in either direction. The effect (negative or positive) of the market moving in the manager's favour or against him, can be greater than it would have been if he owned the underlying security.
For example, if the manager feels that the US dollar is going to weaken against the yen, he could buy a 'put' option, ie an option to sell the US dollar at a specified price in the future (a 'call' option would confer the right to buy). If the dollar did indeed weaken and the manager had an option to sell it at a higher level, then he would be 'in the money' and could sell the option for a much greater price than he had paid for it. If the dollar did not weaken by the time the option expired, then the option would be worthless and the manager could simply take the loss of the price paid for that option, known as the premium.
It should be noted that whilst the above example shows an unlimited gain and a limited loss, there are also cases of futures and options trades where the loss can be unlimited.
Currency Risk and Currency Derivatives
The forward market allows the manager to take a view on what the relative value of a particular currency will be versus sterling in the future, by agreeing a price today at which he will buy that currency at a later date. In this way, the manager can use this contract to hedge a fund's foreign currency exposure back to the base currency. In addition, currency derivatives can be used to take advantage of expected changes in exchange rates between currencies other than the fund's base currency.
For example, the manager could take a long position in the Chinese renminbi if he felt that China's currency was likely to strengthen further, or a long position in the Canadian dollar, if he felt that interest rates could rise against the backdrop of a booming economy. In contrast, the manager could take a short position in a currency that he expects to weaken.
Credit Derivatives
Credit default swaps / iTraxx indices
A credit default swap (CDS) is essentially a transaction that allows the transference of credit exposure to an issuing entity between two parties. Put at its simplest, one party is insuring the other against the risk that the issuing entity defaults. In this way, the buyer of that insurance is taking a view on the creditworthiness of the issuer.
An iTraxx index takes a group of these CDSs and so creates an index that can be bought or sold. This will therefore allow the manager to take a view on how an entire section of the fixed income credit market will perform, without actually owning the underlying securities.
For example, if the manager believes that high yield is likely to outperform other sections of the market, he can trade the high yield index. This allows him to take a view on whether the spread between high yield and other credit markets will narrow or widen. By buying this basket, he is taking a view on the performance of the underlying credits.
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