Handbook of Finance: Investment Management and Financial Management

Chapter 41. The Use of Derivatives in Managing Equity Portfolios

ROGER G. CLARKE, PhD

Chairman, Analytic Investors, Inc.

HARINDRA DE SILVA, PhD, CFA

Managing Director, Analytic Investors, Inc.

GREG M. MCMURRAN

Chief Investment Officer, Analytic Investors, Inc.

Abstract: The development of derivatives instruments in the form of futures, options and swaps give the investor additional tools in structuring the risk/return characteristics of investment strategies. The impact of using derivatives on an investment portfolio can be complicated. It is helpful to have a methodology to understand the payoff patterns from various combinations of derivatives. Such a framework allows the investor to see the effect of using a derivative as the price of the underlying security changes in order to evaluate the desirability of a particular strategy.

Keywords: swaps, futures, options, linear payoffs, nonlinear payoffs, derivative strategies

The growth of the derivatives markets has given the investment manager an important set of tools to use in managing the risk and return characteristics of equity portfolios. In this chapter we will discuss some of the common strategies available using three different derivatives contracts: index swaps, futures, and options. Each of these derivatives has their own special characteristics which make them useful for adjusting the payoff profile of the portfolio to reflect a manager's expectations or view of the market.

One of the main characteristics of derivatives contracts ...