loss, it is still worth £56 250. The speculator, therefore, wants to
assume risk for potentially much higher rewards.
The reason why the fund manager might buy options, or futures, is
to gain an immediate exposure to the market. Having achieved this
the fund manager can now actually take the exposure in the relevant
stock or bonds or currencies by buying the underlying and then
simultaneously closing out the derivatives. The big advantage is par-
ticipation in any immediate market move, but also if the anticipated
move does not happen the fund manager can easily and quickly close
out the derivative positions and whilst a loss may occur, the fund
had not had the expense associated with buying and then selling the
underlying.
Looking at the settlement issues, they are once again about funding
and recording, valuing and accounting for the derivatives in the port-
folio so the overall value of the portfolio is complete.
Use of OTC derivatives
Until fairly recently most funds have been restricted in their use of
OTC derivatives, many only being able to use currency forwards to
manage currency exposures. That has changed with the latest Euro-
pean Directive (see appendices) and greater use of IRS, equity and
total return swaps and credit derivatives is not being made where the
fund’s mandate allows.
From a settlement point of view, the key issues are to understand
the product, how to account for these products and the need to
manage negotiated terms and conditions rather than a standardised
product. A key issue here can be the valuation of the OTC position as
no exchange or public price may be available.
In this case the fund management must determine a fair and
consistent valuation approach that may include using other parties
to verify internal pricing methodology and or that of the counterparty
bank.
Given the bespoke nature of OTC products it is not easy to set
out standard procedures; however, many common OTC products like
IRS do have fairly standard settlement procedures as we have seen
earlier.
The OTC settlement is usually, but not always, under the terms of
the documentation provided by ISDA and these can be obtained from
the ISDA website (see appendices).
Using derivatives in investment management 121
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