Question

Describe how derivatives can be used to more effectively manage an investment portfolio. And why might there be restrictions on the usage of derivative for some funds?

Answer 1

Derivatives are used for efficient asset allocation and enhancing portfolio returns, as they provide great flexibility at lower costs. Derivatives are used for risk management by hedging risks. Derivatives are used for better management of fund inflows and outflows.

Derivatives can be used in risk management to hedge a position, protecting against the risk of an adverse move in an asset. . Hedging is the act of taking an offsetting position in a related security, which helps to mitigate against opposite price movements.Derivatives play an important role in keeping the transaction costs low in the market. The cost of trading derivatives has to be kept low, thereby bringing down the overall transaction costs of the market. Derivatives also offer other benefits like bringing liquidity to the market and encouraging short selling

Derivatives can raise risks for a fund, including risks related to leverage, so it is important to require funds to monitor and manage derivatives-related risks and to provide limits on their use.”

The Problem with Derivatives
There are four fundamental problems that contribute to the negative image of derivatives:

• Bad press. If it isn't bad news, it isn't news. Stories in the press tend to focus on the illegitimate abuse of derivatives rather than how they are used legitimately.
• Investors' misinformed perceptions and uninformed opinions.
• Improper suitability given an investor's resources and temperament.
• Lack of investor education.