Lesson 6 of 6 · All lessons in this module
- Benefit 1: transferring risk and creating new exposures
- Benefits 2–4: price discovery, operational and market efficiency
- Risks 1: implicit leverage and lack of transparency
- Risks 2: basis, liquidity, counterparty credit and systemic risk
- How issuers use derivatives: hedging and hedge accounting
- How investors use derivatives, and issuers versus investors
Lesson 6 of 6 · 12 min
How investors use derivatives, and issuers versus investors
Investors use derivatives to replicate cash market strategies, to hedge a portfolio's value, and to add or reshape exposures; unlike issuers, they care little about hedge accounting and trade more on exchanges.
In short
- Replicate: greater liquidity and lower capital make a derivative an efficient substitute for a cash position.
- Hedge: isolate some exposures while keeping others, e.g. FX hedges on foreign investments to cut currency-driven return volatility.
- Modify or add exposure: go short, add leverage or duration, or create payoff profiles not available in the cash market.
- A fund's prospectus typically says which derivatives it may use and for what purpose.
- Fund positions are marked to market daily in NAV, so investors care less about hedge accounting and use standardised, liquid exchange-traded contracts more than issuers do.
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