Executive Summary

The purpose of this thesis is to study how equity- and index derivatives, i.e. futures

and options, can be used to improve asset management and also how they are used by

Nordic asset managers today. The focus lies primarily on how derivatives can be used

in conjunction with equity portfolios in mutual and pension funds, but also to some

extent at hedge funds and investment companies.

Derivatives are used in asset management for many different purposes. By using

futures and options, an asset manager can change both the return and the risk

characteristics of a portfolio. Derivatives may also enhance the efficiency of

transactions in terms of both time and cost benefits. Traditionally, the most frequent

users have been hedge funds, which usually employ derivatives to generate consistent

absolute returns. However, an increasing number of both mutual and pension fund

managers have begun to implement derivatives in their portfolios. It is therefore

important to investigate how and why asset managers use derivatives, especially for

OMX.

Today, OMX is the leading actor on the Nordic derivatives market and is continuously

working to improve its market offering. In addition, the company works to enlarge the

total derivatives market by educating asset managers on the potentials of derivatives

and encouraging them to employ derivatives in their portfolios. Hence, this thesis may

help explain the benefits of derivatives usage to OMX’ customers. Furthermore, this

thesis should be informative for asset managers who want to understand how

derivatives are used and how they might be used to improve portfolio management.

To fulfil the purpose, numerous interviews have been conducted with asset managers

at mutual and pension funds as well as at hedge funds and investment companies. A

total of 27 interviews were carried out at 26 different institutions within the Nordic

region.1 In addition, a statistical survey has been carried out, which complemented the

interviews with more quantitative and comparable results.

The statistical survey showed that all of the investigated asset managers use

derivatives to some extent. Though, the difference in usage levels is substantial.

According to the survey, roughly 40 percent believe that derivatives are vital or

integral in their asset management, while almost 40 percent define the importance of

derivatives as small. The survey also showed that options are preferred compared to

futures when the underlying is equity, while when the underlying is an index product,

options and futures are approximately equally preferable.

Furthermore, the survey showed that the most commonly used strategies are risk

management and hedging followed by absolute return and overlay. This is in line with

many of the interviews in which risk management often is mentioned as an interesting

strategy. Though, several interviewees have also stated that they use derivatives for

cash management, which has not become apparent in the statistical study. Additionally,

some have described the benefits of using derivatives for return enhancement, such as

the covered-call strategy.

Both the survey and the interviews have shown that there are some major impediments

limiting the development of the derivatives market. According to the survey, the worst

constraint is the costs of trading derivatives. This factor is closely linked to liquidity,

which in the interviews has been stated as the major obstacle. Other significant

problems are the lack of risk-management systems and knowledge in derivatives. The

survey also revealed that the largest risk in the derivatives market is the lack of

understanding of products and the mis-selling of complex products. These risks are

mainly related to the OTC market, which stands for roughly 20 percent of all trading

based on the survey.

In conclusion, it is difficult to make any universal recommendations on how

derivatives should be used. Instead, some general conclusions are drawn and the more

specific recommendations are presented in the final chapter of the thesis. The

conclusion is that there are essentially four major areas in which asset managers

should consider using derivatives:

• Cash management

                          - Capital can be reserved for managing cash flows, but at the same time be

              exposed  to market movements by employing derivatives.

• Overlay (i.e. reallocations in portfolios)

             -Derivatives should be used for temporary rebalancing to avoid inefficiencies.

• Risk management

             -Derivatives should be used to create an accurate risk profile and limit

              the downside of a portfolio when necessary.

• Return enhancement

                          - If used in a professional manner, derivatives can improve returns.

According to both interviews and statistics, the competition amongst asset managers is

increasing. Therefore, it will become increasingly important to have access to all

available instruments when managing an asset portfolio. This is because asset

managers with the possibility to employ derivatives in their portfolios should in

general be able to outperform those that lack this possibility. Furthermore, our

conclusion is that there are no drawbacks in having the possibility of using derivatives

in an asset portfolio, but there are significant obstacles which need to be overcome.

Institutions should invest in both comprehensive risk-management systems and

education if they aspire not to fall behind the competition. At the same time, it is

important that the question of liquidity is given the importance it deserves. Because,

without adequate liquidity; the development of the Nordic derivatives market will be

limited.