Derivatives can prove their worth in equity protection strategies, thus managing risk without changing asset allocations, says Gareth Derbyshire, executive director of Morgan Stanley’s European pensions group in London.
The most straightforward strategy involves buying put options. These give the holder the right, but not the obligation, to sell the underlying asset – such as an equity index – at a prespecified level. Thus, a put option struck on the FTSE at 4,000 would allow the holder to sell the index if it dropped below that level, placing a floor on their exposure to a falling market.
The cost of such protection tends to rise in falling or volatile markets, making straightforward put option strategies overly expensive. However, Derbyshire says that some institutional investors are turning to collars or, increasingly, put spread collars to reduce the cost of such protection.
“Investors are worried about funding levels, and want to reduce funding risk – they’re concerned about being forced to sell equities at the bottom,” he says. While this is more of a concern to insurers, pension funds are also looking at these strategies, he says.
Collar structures can reduce the cost of protection, because the investor both buys a put at, say, 4000 and sells a call at 4,200. Selling a call effectively caps the investor’s upside – if the FTSE rises beyond 4,200, the seller will be forced to sell the index at 4,200. However, the premium income from the call subsidises the cost of buying the put.
But in falling markets, however, puts become more expensive than calls. The solution, Derbyshire explains, is entering into a put spread, whereby the investor buys a put a 4,000, sells a call at 4,500, and sells another put at 3,500. This second put would force the investor to buy the index at 3,500 if it drops below that level, but the premium income reduces the cost of the structure.

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