In this article I will discuss the classification of derivatives when reporting and implications thereon, including the principle of “substance over form” in that context to allow us to see the big picture.
Derivatives
Investopedia defines derivatives as “a type of financial contract whose value is dependent on an underlying asset, a group of assets or a benchmark”. Derivatives may be used to hedge against risk (i.e. mitigate the risk) or speculate (i.e. take on risk with the expectation of commensurate reward). Derivatives thus allow investors to finetune their risk to reward trade-off.
Common examples of derivatives are futures, forwards, swaps and options. Futures and forwards are agreements between two parties to trade an asset at an agreed price at a future date. The difference between the two is that futures are traded on an exchange while forwards are bespoke arrangements. Swaps are used to exchange one kind of cashflow for another. Options give the right to trade an asset at an agreed price at a future date but not an obligation. The key difference between options and futures is that options only have the opportunity to trade but without the obligation inherent in futures.
Pension funds often use derivatives for the following:
- Efficient portfolio management – derivatives offer cost effective ways of accessing some assets.
- Limit downside risk – derivatives allow the retention of upside potential but cap the losses in the event of a crash.
- Tactical switches – derivatives allow temporary exposure to some assets to be executed quickly. This allows nimble exploitation of investment opportunities.
Impact of Regulation 28
Regulation 28 of the Pension Funds Act require pension funds to comply with certain limits for asset classes and individual instruments, principally to safeguard pension funds from poorly diversified investment portfolios. This prevents excessive concentration of risk.
There are set limits on how much funds can invest in major asset classes like equities, bonds, money market, property, commodities and derivatives. Assets thus need to be classified into the above asset classes in order to demonstrate adherence to the limits. Problems arise because derivatives are contractually linked with the other asset classes hence looking at it as a separate asset may miss the connection with the underlying asset. Derivatives exhibit properties of more than one asset class hence classifying it as equity, bond, money market or property would be an oversimplification.
Substance over form
Substance over form is a legal and accounting principle that prioritises the true economic reality of a transaction over its formal or contractual appearance. This is the guiding principle that will allow the correct breakdown of composite assets such as derivatives.
Derivatives are typically valued by identifying a replicating portfolio that gives the same outcomes as the derivatives under all scenarios. Investors are consequently indifferent between the derivative and the replicating portfolio hence the value of the derivative is the same as the replicating portfolio. This is the key insight behind the celebrated Black-Scholes formula that was awarded the Nobel Prize of 1997. For the purpose of classification, the existence of a replication portfolio means that a derivative can be broken down into the following:
Derivative value = Underlying asset portion + Bond related portion
The underlying asset portion represents an investment in a certain specific amount in the underlying asset. The specific amount can be positive or negative depending on the nature of the derivative.
The bond related portion represents an investment in bonds to match the duration of the derivative. The bond related portion can thus be regarded as a money market related portion if the derivative is for a short term. The specific amount of the bonds can be positive or negative depending on the nature of the derivative.
The positive/negative sign and relative size of the underlying asset and bond related portions allows us to see the true economic relationship.
The breakdown of the derivatives allows the underlying asset portion to be aggregated alongside the primary asset and the bond related portion can be aggregated alongside bonds of similar duration. Below is a table demonstrating the insights revealed by breaking down a hypothetical put option on an All-Share Index with a duration of 2 years.
The breakdown of the put option was a negative 167 million into the underlying asset portion and a positive 197 million into the bond related portion. The underlying asset portion is negative because a put option has a right to sell the asset hence its value moves in the opposite direction of the underlying asset.
The look through principle prevents wrong conclusions caused by ignoring the make-up of a composite asset. It requires the disclosure of the underlying assets that are the subject of a derivative asset. It breaks down a composite asset into constituents that can then be classified separately. In this way the portion of a derivative asset that is equity related can be aggregated with equities and the bond related portion aggregated with bonds.
Derivatives are composite assets hence can only be fully understood if broken into parts. The separate parts can be aggregated with more similar assets to see the true economic relationship. This allows investors to better understand the risk to reward trade-off of their investment portfolio.