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CIEBA
Committee on Investment of Employee Benefit Assets

Derivatives Primer

December, 2001

Association for Financial Professionals

www.AFPonline.org
 DERIVATIVES PRIMER

The Committee on the Investment of Employee Benefit Assets (CIEBA) of the Association
for Financial Professionals has published this overview in order to support reasoned
discussion of issues related to derivatives and their use by private pension plans.

CIEBA is a nationally recognized voice for those corporate financial officers who
administer and manage, as fiduciaries, the investment of funds for employee and welfare
benefit plans regulated under the Employee Retirement Income Security Act (ERISA).
CIEBA’s 120 members collectively manage more than $1 trillion in assets for 15 million
participants, including both union and non-union employees and retirees and their
beneficiaries.

The Association for Financial Professionals in Bethesda, Maryland supports more than
14,000 individual members from a wide range of industries throughout all stages of their
careers in various aspects of treasury and financial management. AFP is the preferred
resource for financial professionals for continuing education, financial tools and
publications, career development, certifications, research, representation to legislators
and regulators, and the development of industry standards.

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 Contents

Executive Summary …………………………………………………….. 4

What Is A Derivative …………………………………………………… 5

How Are Derivatives Used?…………………………………………….. 6

• General ……………………………………………………………… 6
• Pension Funds……………………………………………………….. 7

What are the Risks?………………………………………………………. 8

• Sources……………………………………………………………….. 8
• Controls………………………………………………………………. 10

Summary…………………………………………………………………. 11

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EXECUTIVE SUMMARY

The term “derivative” is used to describe any of a number of financial instruments or

contracts whose value “derives” from the value of another asset or market index. Pension
funds, like other investors in global capital markets, have benefited from the rapid
evolution and innovation in financial derivatives.

The Employee Retirement Income Security Act of 1974 (ERISA) established current
standards of conduct for private plans. ERISA requires that plan fiduciaries make
investment decisions that provide the best possible assurance that the pension promise
will be honored; therefore, the overall return on the funds should be maximized subject to
a prudent level of risk. Fiduciaries reduce the risk of the total portfolio by diversifying
investments among and within asset classes. Derivatives are an important tool for
efficient implementation of investment decisions.

The use of derivative instruments has grown rapidly over the last 15-20 years and has
moved into the mainstream of finance. Pension funds and their investment managers use
derivatives to implement asset allocation decisions, manage currency exposure, and
manage the maturity of fixed income portfolios. Through derivatives, the complex risks
that are bound together in traditional instruments can be separated and managed
independently. In short, derivatives are cost-effective tools for implementing investment
strategies and controlling risk. Their prudent use enhances the benefit security of our
private pension system.

A formal survey of CIEBA’s members regarding their use of derivatives was last
conducted in 1994, in the aftermath of a number of companies having problems with
derivatives. At that time, the median private pension fund’s commitment to derivatives
was 7.9% of plan assets. The survey indicated that 85% of the 118 respondents,
(representing 95% of the $613 billion in assets under management at that time) used
derivatives, primarily exchange-traded futures, options and foreign currency forward
contracts. Although no survey update has been made, anecdotal evidence suggests that
derivative usage continues and has likely increased due to the increasing sophistication
and understanding by senior financial management.

The use of derivatives to create highly leveraged positions within portfolios has resulted
in large and highly publicized financial losses by a small number of investors. These
investors ranged from very speculative and sophisticated hedge funds to banks,
governments, corporations and mutual funds. Notable examples are Gibson Greetings,
Sumitomo, Procter & Gamble (1993), Barings (1995), and Long Term Capital
Management (1998). However, CIEBA survey respondents as a group undertook minimal
leverage, both implicit and explicit, in their application. Additionally, the majority of
respondents and their investment managers have policies, procedures, and controls with
respect to the use of derivatives.

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WHAT IS A DERIVATIVE?

A derivative is a financial instrument or agreement whose value is determined (or

derived) from the value of a specified asset, reference rate or index. Derivatives include
futures and options that are actively traded on organized exchanges. In addition,
derivatives include over-the-counter contracts, such as forwards, options, swaps,
swaptions, and structured notes. The term “derivative” has also been used to refer to
privately negotiated, specialized transactions. These include debt instruments that have
payoff characteristics reflecting embedded derivatives, have option characteristics, or are
created by assembling particular components of other instruments such as principal and
interest payments.

Exchange-traded futures and options are the more traditional, highly standardized
contracts that trade on regulated exchanges. These futures and options provide ready
liquidity, daily pricing and minimal credit risk.

A futures contract is a contract in which a buyer and seller agree to purchase or sell a
given asset at a specified price on a stated, future date. Both sides of the trade put up
collateral and any change in the value of an exchange-traded futures contract is settled at
the end of each day. Futures contracts are typically “closed-out” prior to maturity so that
the underlying assets are not delivered.

While financial futures are a relatively modern development, with trading introduced in
1975, commodity futures have been trading since the turn of the country. Forward
markets for future delivery of commodities date back to ancient Greece.

An option gives its owner the right, but not the obligation, to buy or sell an asset,
currency, interest rate or futures contract. The option gives you the right to trade these
underlying securities for a specified price up to a specified time. If an option is not
exercised before the expiration date of the contract, the option simply expires with no
value. Options that give you the right to buy the underlying securities are known as calls.
Options that give you the right to sell the underlying securities are know as puts. Options
can be purchased or sold by the investor.

Over-the-counter (OTC) derivatives are not traded on formal exchanges and are not
standardized; these contracts are high customized to meet the exact needs of the user.
OTC derivatives can be security-based or contractual. Security based derivatives are
instruments that are created from other securities such as mortgages and convertible
bonds. Contractual derivatives are custom designed financial arrangements between two
parties. Instruments in this category include currency forwards, swaps and swaptions.
Both security-based and contractual derivatives can range from predictable instruments
used for hedge or income enhancement purposes to unpredictable instruments.

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A forward contract is a contract in which a buyer and seller agree to complete a
transaction on a given asset on a specified date at a price specified at the origination of
the contract. The contract owner either receives or makes payment, depending on the
price movement of the underlying assets. Payment is conveyed only at the contract’s
maturity date.

A swap contract involves two parties that agree to exchange, or swap, specified returns at
specified intervals for a certain period of time. The most common type is an interest rate
swap in which one party agrees to pay a fixed interest rate on a ‘notional’ principal
amount in return for receiving a floating rate from the counter-party.

A swaption is the right, but not the obligation, to enter a swap on preset terms by some
future date.

A structured note is a customized, structure security created typically with a

combination of derivatives and traditional instruments to meet the specific needs of the
buyer and seller of the note.

HOW ARE DERIVATIVES USED?

General

The use of derivatives has developed in the context of evolving financial markets and
computer technology. Floating exchanges rates and increased volatility of interest rates
are just two examples of evolution in the financial markets. Technology has facilitated
virtually instant global dissemination of information. Powerful computers, using
sophisticated software, are able to analyze large amounts of data. These developments
have created a growing demand for efficient financial products and tools to manage risk.

Derivatives can play an important role in advancing new techniques to manage

investments. They can benefit a wide variety of investors and issuers of securities. In
July 1993, the Group of Thirty published the results of their study entitled “Derivatives:
Practices and Principles”. The study explored who used derivatives and why, and made
recommendations about their usage. Derivatives are used by corporations, governmental
entities, institutional investors, and financial institutions. These participants use
derivatives to:

§ lower funding costs

§ enhance yields
§ diversify sources of funding
§ hedge positions
§ take positions in the market

In addition, derivatives have been used to implement very risky strategies such as
leveraged bets on the direction of changes in interest rates. These leveraged strategies
can result in large gains or losses when the market (interest rates) moves significantly.

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However, the use of derivatives to implement speculative strategies involving excessive
leverage is minimal compared to the more standard uses of these instruments by pension
funds.

HOW ARE DERIVATIVES USED?

Pension Funds

Based on the CIEBA survey results, the three major reasons private pension funds use
derivatives were:

§ Asset allocation / substitute for physical securities

§ Currency exposure management
§ Active fixed income management

Asset allocation / substitute for physical securities

In some cases, derivatives may be more efficient vehicles than the underlying securities.
An example of this is the use of stock index futures rather than individual stocks to
achieve a market position. Index futures provide a quick and cost-effective means for
immediately deploying fund contributions in the stock and bond markets. In a single
transaction, an investor can gain instant participation in the performance of a diversified
basket of stocks, such as the S&P 500 index, without incurring the transaction costs
associated with the purchase of each of the underlying securities. The ability to gain
instant market exposure largely eliminates the potential opportunity cost of the market
advancing while the fund is still carrying out its equity deployment.

Pension funds may shift the asset mix of their portfolios in response to changing patterns
of opportunity in the market. A shift in asset mix can be accomplished either through the
purchase and/or sale of underlying assets in the portfolio or through the purchase and/or
sale of futures contracts. Trading the underlying assets can incur significant commission
and execution costs, whereas the vast size and liquidity of the futures market generally
results in very low transaction costs. This is also used effectively in portfolio transitions
when changing investment managers.

Currency exposure management

There is a continuous trend toward international diversification by pension funds. In

addition to the price exposure implicit in any security portfolio, pension funds with
international investments are also exposed to currency volatility. Derivatives can help to
control the risk or even exploit the opportunities associated with foreign exchange rate
movements. The simplest and most commonly used form of hedging foreign currency is
through the forward market. For example, an investment manager of a US pension fund
portfolio who is holding Japanese equities might sell yen forward against dollars. Any
adverse movement in the yen that reduces the value of the equity holding would be offset
by a gain in the dollar value of the forward contract. Thus the manager captures the

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Japanese equity market return while avoiding the volatility, or risk of foreign exchange.
The portfolio manager can also hedge currency risk by using currency futures contracts
or the currency option market.

Active fixed income management

Fixed income managers of US pension funds use derivatives in a number of ways

including managing portfolio duration (maturities and yields), enhancing portfolio yield
and, in general, implementing strategies in a more efficient manner. Interest rate
derivative instruments have become important components of fixed income portfolio
management. Interest rate derivatives are used to alter the interest rate sensitivity of
fixed income portfolios; to exchange a fixed rate payment stream of interest for a floating
rate payment stream or vice versa; or to create unique rate structures to meet a specific
portfolio objective. In addition, fixed income managers invest in mortgage and asset-
backed securities which derive their values from cash flows associated with underlying
pools of home mortgages, credit card debt, and other types of receivables.

WHAT ARE THE RISKS?

Sources

For most derivatives applications, the associated risks are not much greater than those
associated with investment in the securities markets. However, the character and degree
of risk undertaken with derivatives varies with the type of instrument used and the way in
which it is implemented. Some of the more common sources of risk are summarized
below.

Credit Risk - Credit risk is the risk that a party will fail to meet its financial obligations
under a contract. To mitigate this risk, exchange-traded futures are marked-to-market on
a daily basis; in addition, investors are required to maintain sufficient collateral (known
as margin in this context) to cover the estimated maximum daily loss. These
requirements, in combination with a clearinghouse guarantee on every transaction, reduce
the credit risk associated with exchange-traded futures. In the 1994 CIEBA survey,
approximately 36% of private pension fund derivative holdings were in exchange-traded
futures and 4% in exchange-traded options.

Derivative instruments that are traded over the counter as opposed to on public exchanges
may entail greater credit risk because such contracts are not always subject to daily mark-
to-market valuation. Moreover, counterparties may not be as well capitalized as
exchanges. Managing the credit risks associated with these instruments is not inherently
different from managing a corporate bond portfolio. Credit risk for both derivatives and
corporate bonds can be minimized by selecting only those counterparties/issuers that are
deemed to be highly creditworthy. In addition, diversifying this exposure can reduce
overall portfolio risk. An important difference between derivatives and bonds is that with
most derivatives the basis of the counterparty risk is not the principal amount of the

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security; rather, it is the change in the market price of the underlying instrument. The
CIEBA survey indicated that approximately 33% of private pension funds’ use of
derivatives was in non-publicly traded currency forwards, which trade through the major
global banks, and 2% were in swap agreements.

Leverage - Leverage can take the form of either explicit borrowings or implicit leverage
in the payout pattern of a derivative’s investment return. In the case of explicit
borrowings, more capital is at risk than the amount funded by the investor (e.g. futures
purchased on margin), and the performance of the derivative will magnify the return of
the underlying security in a proportionate fashion. Implicit leverage results from the
characteristics of the derivative itself, which may have a magnified return under certain
market conditions, but not in others. For example, stock options and certain types of
structured notes are designed to produce higher returns than do the underlying securities
when markets move in a particular direction; the degree to which the return is leveraged
when markets move in the opposite direction is dependent on the characteristics of the
specific derivative instrument.

Both explicit and implicit leverage in the context of unanticipated interest rate moves led
to substantial losses for some investors in the 1990s. However, based on the CIEBA
survey results, leveraged positions accounted for only 0.2% of private pension fund assets
and, as a result, have not posed a meaningful risk to the funded status of these private
pension plans or the benefit security of participants in these plans.

Liquidity - Liquidity risk arises when an investor is unable to sell or offset a derivative
position at or near the previous market price due to a dearth of buyers or a disruption in
the market. Market depth is usually a greater concern in the over-the-counter derivatives
transaction because is may be either more complicated in structure or customized to the
needs of the original investor. However, some over-the-counter markets are well
established and highly liquid. For example, forward currency contracts are traded on the
“interbank market” which is the most active, liquid market in the world.

Liquidity risk due to disruptions in the market for exchange-traded derivatives was
addressed as a result of the severe imbalance in supply and demand for index futures in
the market crash of October 19, 1987. Since that time, the implementation of financial
linkages across exchanges and “circuit breakers” to halt trading temporarily when prices
move more than a specified amount have proven successful in providing market stability
and liquidity.

Another type of liquidity risk is the uncertainty of the availability of funds to meet
payment obligations on settlement dates or to meet margin calls. Because most pension
funds invest the majority of their assets in highly marketable securities and use minimal
leverage, liquidity is generally readily available and has not posed a problem for pension
fund investors.

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Other Risks – Market risks of various sorts must be considered when entering into
derivatives transactions. In addition to risks such as equity, currency, and interest rate
risk, which affect the underlying securities and derivatives markets alike, there are
characteristics that are unique to some derivatives. For example:

The price of an option is determined by its strike price, the time to expiration, and other
elements that are the source of opportunity and of risk.

The risk of a mismatch in the variables that affect a derivative and the security that
underlies it could result in an imperfect hedge.

Deficiencies in information systems or internal controls could result in an unexpected

loss. For example, the foreign exchange (FX) market trades 24 hours a day. If FX
derivatives are used to take market risks, the investment manager must have the systems
and staffing to manage continuous price movements.

Not fully understanding a complex derivative could create operational and related risks.

It is the responsibility of the investor and user of derivatives to be fully informed and
understand the risks associated with derivative instruments and the investment strategies
employed.

Controls

The moderate use of derivatives by the private retirement plans in the survey, the focus
on exchange-traded futures and foreign currency forwards, and the minimal use of
leverage have enabled plan sponsors to minimize risks unique to derivatives. In addition,
most plan sponsors maintain guidelines that incorporate risk constraints and review their
derivatives exposures regularly.

Survey results show that portfolio managers to whom investment authority is delegated
also maintain tight controls on their use of derivatives. In 1994, over 94% maintained
guidelines on permitted derivative applications and risk, and 85% used stress testing,
simulation, or sensitivity analysis to ensure that they adequately assessed the risk of loss
under a wide range of scenarios. The introduction of FAS 133 in 2000, which governs
corporate derivatives’ disclosure has introduced greater scrutiny in this area, and
presumably, greater awareness of the risks in and prudence of their usage.

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SUMMARY

Derivatives include a broad array of financial instruments that are used by investors,
including pension funds, to efficiently achieve investment objectives. Derivative
instruments are integral to portfolio strategies and are used to reduce risk, enhance return,
replicate physical securities or achieve a combination of these objectives. The risk
characteristics of individual derivative holdings cannot be evaluated in isolation, but must
be viewed in the context of the entire portfolio. While derivatives are an important tool
for efficient implementation of investment decisions, sufficient understanding of the
instruments being used and adequate oversight are necessary.

Plan sponsors have been proactive in developing guidelines and risk constraints for
management of plan assets, and their derivative exposures are primarily in the more
liquid, standardized and regulated instruments. In addition, CIEBA supports the Group
of Thirty Global Derivatives Study Group recommendations. These actions demonstrate
plan sponsors’ commitment to the responsibilities placed on fiduciaries by ERISA to
manage plan assets prudently and in the best interest of the plan participants.

Group of Thirty − Global Derivatives Study

Group Recommendations
In summary, the recommendations suggest that each dealer and end-user of derivatives
should:

Determine at the highest level of policy and decision making the scope of its
involvement in derivatives activities and policies to be applied.
Value derivatives positions at market, at least for risk management purposes.
Quantify its market risk under adverse market conditions against limits, perform stress
simulations, and forecast cash investing and funding needs.
Assess the credit risk arising from derivatives activities based on frequent measures of
current and potential exposure against credit limits.
Reduce credit risk by broadening the use of multi-product master agreements with
closeout netting provisions, and by working with other participants to ensure legal
enforceability of derivatives transactions within and across jurisdictions.
Establish market and credit risk management functions with clear authority, and
independent dealing function.
Authorize only professionals with the requisite skills and experience to transact and
manage the risks, as well as to process, report, control, and audit derivatives activities.
Establish management information systems sophisticated enough to measure, manage,
and report the risks of derivatives activities in a timely and precise manner.
Voluntarily adopt accounting and disclosure practices for international harmonization
and greater transparency, pending the arrival of international standards.

Source: Derivatives: Practices and Principles, published by the Group of Thirty, Washington, D. C.., July 1993. The Group of
Thirty is a not-for-profit, Washington, DC-based research group specializing in international finance.

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