The term derivative may make most ordinary investors' palms sweat. Yet this much maligned investment instrument can be - surprisingly enough - as useful a tool for offsetting risk as augmenting it. Ian Morley, the head of derivatives and quantitative funds at AIB GovettAsset Management, says: "The bulk of the use of derivatives is in structuring protected products, guaranteed products, and hedging products. It is only the abuse of them as with abuse of anything, like Nick Leeson trading proprietary capital of the bank without proper controls, that causes a problem."
Guaranteed and protected funds have become popular in the past four years, and options, one form of derivative, are used to offer exposure to stock- market gains while protecting the rest of the fund.
A quarterly rolling fund guarantees, say, 95 per cent of the capital invested over three months. The majority of the investor's capital is placed on deposit with a bank to meet this obligation, and the money left over is used to buy options.
Ewan Smith, a director and derivatives expert at Scottish Life International, says: "If a bank has a three-month interest rate of 2 per cent, then just over pounds 98 needs to be invested at the start of the quarter to return pounds 100 at the end. The higher the interest rate, the lower the amount that needs to be deposited."
With a protected equity fund, the same process is undertaken, but the capital is invested in equities instead of being held on deposit. This type of fund can be managed in a number of ways. Edinburgh Fund Managers' Safety First fund, for example, is actively managed, while other funds are essentially index trackers. AIB Govett in its UK Equity Safeguard buys the entire FTSE 100, and protects 98 per cent of its value with put and call options.
A put option enables the investor to sell an asset at a fixed price in the future. Mr Morley says: "If you bought FTSE 100 stocks at 6,000, and you decided that you would protect yourself at 98 per cent of that value over three months, then you would buy a put at 98 per cent of 6,000 (5,880). If the market fell below there, then the put has value and you are protected. You wouldn't lose more than that 2 per cent over the period, adjusted for costs."
A call option, the opposite of a put, enables the fund manager to buy an asset at a fixed price on a date in the future. Mr Smith says: "If a share was priced at 100p, an investor may have the right to buy that share in three months' time at the same price [by buying a call option]. If the price at the end of three months was 120p, the investor could still buy the stock at 100p."
This facility comes at a premium, and the cost depends on the level of protection, market volatility and the time period of the contract. If the market goes down, call options are not exercised, because the investor can buy the stock more cheaply than the agreed price in the marketplace.
The lower the capital guarantee, the more options that can purchased, and the investor will gain more from a stock market rise. Options can be bought against indices or individual stocks, and some investors use them to insure against share price falls within their share portfolio.
Mark Lengyel, the head of derivatives at stockbroker Capel Cure Sharp, says: "One very sensible way of using them directly is to write a call option against a stock held in a portfolio. If the shares go up, the client may lose out in relative terms, but will still make money in absolute terms. If the shares go down or stay static, the client will be better off by the amount of option premium received. But it is vital to only write calls if you hold the shares to satisfy any obligations you take on."
As market volatility increases, so does demand for options, which increases their price. They are currently quite expensive due to market volatility, but the price of the options can be offset by buying and selling puts and calls to reduce the relative cost.
But Mr Morley says: "It does limit your upside. If you sell a call option above the market level, then any market move above that level you don't get. Call options are generally sold somewhere above the historic average for the market, but when you get incredible market rises like the first quarter of last year, that means that you go through that upside and you are `capped out'. It will occasionally place an upside limitation on your gain."
Over the long term, equities have historically outperformed these types of fund, but with higher risk. If the stock market falls over a year in a quarterly rolling fund the investor can lose a significant amount.
Justin Modray, an investment expert at Chase de Vere, an independent financial advice firm in Bath, says: "If you guarantee that at the end of each quarter you still have 95 per cent of your investment, then the investor could lose 5 per cent each quarter.
"Each quarter the market is falling, then overall you can lose around 18 per cent of the fund over the year. We recommend that a client goes into the stock market. If they take a five-year view, they are likely to do better than a protected product as there are no limitations."
Mr Morley says this is academic. "It is a point often made, but it is hard to find a situation where there have been four consecutive quarters where the stock market has fallen."
Derivatives can be risky, but used in a packaged product they are, according to Nigel Hewett, the investment marketing manager at AIG, relatively safe. "The institution should know what it is doing, and the derivatives are being used as a more efficient form of investment than directly investing in the underlying assets, or they are being used to reduce risk in some way. If someone goes out and buys derivatives directly, then they are very risky."
Alison Steed is assistant features editor at Financial Adviser
DERIVATIVES - WHAT DOES IT ALL MEAN?
Derivative: A financial instrument whose value in whole or in part is determined directly or indirectly by reference to the price of an underlying security or asset.
Option: A form of contract that gives the buyer the right, but not the obligation, to buy or sell a commodity, share or index at a given price on a fixed future date.
Put: An option giving the buyer a right to sell a commodity, share or index at a given price on a fixed future date.
Call: An option giving the buyer the right to buy a commodity, share or index at a given price on a fixed future date.
Future: A cash transaction where a buyer and seller agree upon the price and quantity of a commodity or index on a date in the future. These contracts must be exercised.