Personal Finance: Not such risky business

Ordinary investors tend to shun derivatives but, says Alison Steed, even the most cautious should consider them

Ask most people what they think about derivatives trading and the first name they will come up with is Nick Leeson, the former Barings Bank trader who lost his employer pounds 800m through ill-judged deals in Singapore.

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.

Sport
Alexis Sanchez has completed a £35m move to Arsenal, the club have confirmed
sportGunners complete £35m signing of Barcelona forward
Voices
Poor teachers should be fearful of not getting pay rises or losing their job if they fail to perform, Steve Fairclough, headteacher of Abbotsholme School, suggested
voicesChris Sloggett explains why it has become an impossible career path
Sport
world cup 2014
Sport
Ray Whelan was arrested earlier this week
PROMOTED VIDEO
Have you tried new the Independent Digital Edition apps?
Life and Style
ebookA wonderful selection of salads, starters and mains featuring venison, grouse and other game
Arts and Entertainment
In a minor key: Keira Knightley in the lightweight 'Begin Again'
film
Arts and Entertainment
Celebrated children’s author Allan Ahlberg, best known for Each Peach Pear Plum
books
News
peopleIndian actress known as the 'Grand Old Lady of Bollywood' was 102
News
Wayne’s estate faces a claim for alleged copyright breaches
newsJohn Wayne's heirs duke it out with university over use of the late film star's nickname
Life and Style
It beggars belief: the homeless and hungry are weary, tortured, ghosts of people – with bodies contorted by imperceptible pain
lifeRough sleepers exist in every city. Hear the stories of those whose luck has run out
News
Mick Jagger performing at Glastonbury
people
Life and Style
fashionJ Crew introduces triple zero size to meet the Asia market demand
Sport
Santi Cazorla, Mikel Arteta and Mathieu Flamini of Arsenal launch the new Puma Arsenal kits at the Puma Store on Carnaby Street
sportMassive deal worth £150m over the next five years
Arts and Entertainment
Welsh opera singer Katherine Jenkins
musicHolyrood MPs 'staggered' at lack of Scottish artists performing
Life and Style
beautyBelgian fan lands L'Oreal campaign after being spotted at World Cup
Arts and Entertainment
Currently there is nothing to prevent all-male or all-female couples from competing against mixed sex partners at any of the country’s ballroom dancing events
Potential ban on same-sex partners in ballroom dancing competitions amounts to 'illegal discrimination'
News
business
Independent
Travel Shop
the manor
Up to 70% off luxury travel
on city breaks Find out more
santorini
Up to 70% off luxury travel
on chic beach resorts Find out more
sardina foodie
Up to 70% off luxury travel
on country retreats Find out more
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs General

    Business Analyst Consultant (Financial Services)

    £60000 - £75000 per annum: Harrington Starr: Business Analyst Consultant (Fina...

    Systems Administrator - Linux / Unix / Windows / TCP/IP / SAN

    £60000 per annum: Harrington Starr: A leading provider in investment managemen...

    AVS, JVS Openlink Endur Developer

    £600 - £700 per day: Harrington Starr: AVS, JVS Openlink Endur Developer JVS, ...

    E-Commerce Developer

    £45000 - £60000 per annum + competitive: Progressive Recruitment: Exciting opp...

    Day In a Page

    A History of the First World War in 100 Moments: Peace without magnanimity - the summit in a railway siding that ended the fighting

    A History of the First World War in 100 Moments

    Peace without magnanimity - the summit in a railway siding that ended the fighting
    Scottish independence: How the Commonwealth Games could swing the vote

    Scottish independence: How the Commonwealth Games could swing the vote

    In the final part of our series, Chris Green arrives in Glasgow - a host city struggling to keep the politics out of its celebration of sport
    Out in the cold: A writer spends a night on the streets and hears the stories of the homeless

    A writer spends a night on the streets

    Rough sleepers - the homeless, the destitute and the drunk - exist in every city. Will Nicoll meets those whose luck has run out
    Striking new stations, high-speed links and (whisper it) better services - the UK's railways are entering a new golden age

    UK's railways are entering a new golden age

    New stations are opening across the country and our railways appear to be entering an era not seen in Britain since the early 1950s
    Conchita Wurst becomes a 'bride' on the Paris catwalk - and proves there is life after Eurovision

    Conchita becomes a 'bride' on Paris catwalk

    Alexander Fury salutes the Eurovision Song Contest winner's latest triumph
    Pétanque World Championship in Marseilles hit by

    Pétanque 'world cup' hit by death threats

    This year's most acrimonious sporting event took place in France, not Brazil. How did pétanque get so passionate?
    Whelks are healthy, versatile and sustainable - so why did we stop eating them in the UK?

    Why did we stop eating whelks?

    Whelks were the Victorian equivalent of the donor kebab and our stocks are abundant. So why do we now export them all to the Far East?
    10 best women's sunglasses

    In the shade: 10 best women's sunglasses

    From luxury bespoke eyewear to fun festival sunnies, we round up the shades to be seen in this summer
    Germany vs Argentina World Cup 2014: Lionel Messi? Javier Mascherano is key for Argentina...

    World Cup final: Messi? Mascherano is key for Argentina...

    No 10 is always centre of attention but Barça team-mate is just as crucial to finalists’ hopes
    Siobhan-Marie O’Connor: Swimmer knows she needs Glasgow joy on road to Rio

    Siobhan-Marie O’Connor: Swimmer needs Glasgow joy on road to Rio

    18-year-old says this month’s Commonwealth Games are a key staging post in her career before time slips away
    The true Gaza back-story that the Israelis aren’t telling this week

    The true Gaza back-story that the Israelis aren’t telling this week

    A future Palestine state will have no borders and be an enclave within Israel, surrounded on all sides by Israeli-held territory, says Robert Fisk
    A History of the First World War in 100 Moments: The German people demand an end to the fighting

    A History of the First World War in 100 Moments

    The German people demand an end to the fighting
    New play by Oscar Wilde's grandson reveals what the Irish wit said at his trials

    New play reveals what Oscar Wilde said at trials

    For a century, what Wilde actually said at his trials was a mystery. But the recent discovery of shorthand notes changed that. Now his grandson Merlin Holland has turned them into a play
    Can scientists save the world's sea life from

    Can scientists save our sea life?

    By the end of the century, the only living things left in our oceans could be plankton and jellyfish. Alex Renton meets the scientists who are trying to turn the tide
    Richard III, Trafalgar Studios, review: Martin Freeman gives highly intelligent performance

    Richard III review

    Martin Freeman’s psychotic monarch is big on mockery but wanting in malice