The Use of Derivative Securities for Hedging: A Case Study of AustralianSuper

Summary

Risk management is an important undertaking for each corporation to consider for the purpose of sustainable performance and business excellence culminating from the day to day operations in every business corporation. As stipulated below, this begins by first developing a risk profile which basically incorporates the outlining of all risks exposed to a firm, and estimating the magnitude of their exposure. In this report, AustralianSuper is used for the purpose of clear exhibition of this process. The risks facing the operations of this corporation are underlined. Afterwards, the most suitable strategies based on derivative securities are proposed for the most effective combat of the underlined risks. In addition, the outstanding advantages as well as the limitations of the proposed hedging strategies are brought to discussion.

AustralianSuper: Background

As aforementioned, for the purpose of perfect understanding of the above aspects of risk management, AustralianSuper is used. This is a corporation operating in Australia. With its headquarters in Melbourne, its operations are widespread with state offices in Victoria, Queensland, South Australia, Northern Territory, and Western Australia. Essentially, this corporation works in the superannuation sector. This basically means that its operations are majorly based on making arrangements for the citizens in Australia to be able to acquire funds once they retire. Notably, superannuation is encouraged and supported by the government of Australia, with its minimum provisions being required for all employees.

AustralianSuper is well known for exchange traded funds (ETFs). Basically, ETFs provide a wide exposure towards a wide range of both Australian and international shares, either in emerging or in developing markets, and in specific market sectors including healthcare and telecommunications. For the purpose of investing in exchange traded funds, AustralianSuper offers special access to firstly the Australian Stock Exchange (ASX) as well as international iShare exchange markets through its AustralianSuper Member Direct plan. Under this plan, members are able to select and transact with shares and ETFs from the main menu, choose whether to buy or sell, enter the ETF’s ASX code or name, enter their trade details and confirm the correctness of the entered details to place their trade (AustralianSuper, 2012). With respect to the provisions of superannuation, AustralianSuper basically offers a fund suitable for almost every Australian citizen, regardless of their industrial backgrounds or insurance need. Basically, the AustralianSuper fund embarks upon investments, insurance, pension, and super savings (AustralianSuper, 2014).

AustralianSuper: Operating Risks

With respect to operating in the superannuation field, AustralianSuper is faced by a number of risks. The first risk is associated with its bonds portfolio. The bond market is no exception to the rule that in order to earn higher returns, greater risks must be withheld (Gitman et al., 2013). The bonds portfolio of AustralianSuper includes risks such as the interest rate risk which increases with increase in the bond’s maturity period. It also includes the reinvestment risk, which comes from the fact that with declining interest rates, investors reinvest their interest incomes at the prevailing lower rates. There is the market risk as well which is based upon the fact that should the bond market as a whole fall; the value of the individual securities will be brought down. Other risks in associated with the bond’s portfolio include timing risk, selection risk, and duration risk.

The other broad risk category for AustralianSuper is associated its share portfolios. This corporation holds shares in other businesses both in Australia as well as internationally. Ideally, of all the risks associated with various categories of assets such as bonds above, cash, gold, real estate and stock, shares are the most risky (Garner & Brittain, 2009). As stipulated under AustralianSuper, shares bear volatility risk which basically refers to the tendency of share prices to unpredictably fluctuate over a period of time. In addition, shares also impose a permanent risk to capital with respect to investing in companies that end up in continuous decline trends.

The third risk comes as a result of capital guarantee portfolio. Essentially, AustralianSuper must have this under operations since it operates in the superannuation sector. Basically, this portfolio incorporates the transfer of some part of assets in the preretirement periods of individuals. The returns in this kind of portfolio take time to smoothen, usually through holding back and supplementing them during strong and weak market performances, respectively.

The use of Derivatives in a Portfolio

In the context of risk management, a couple of aspects arise. The first is hedging, which basically refers to the process applied to offset the prevailing risks of price movement in the market, particularly by locking in the same commodity’s price with respect to the future market (Alexander, 2008). The other aspect is the use of derivatives in hedging. In this case, derivatives basically refer to some financial tools used in the pursuit of allowing investors to have a clear theoretical exposure to a portfolio, without having it in reality (Brigham & Houston, 2009) . The operations of AustralianSuper calls for the application of a number of strategies as well as financial tools with respect to the provision of positive returns regardless of the prevailing market conditions. In this case, derivatives come in for the purpose of speculation, leveraging, or increasing the exposure to specific assets so as to reduce risk, or without actually having it.

It is worth noting that AustralianSuper has a wide range of investments available, especially for its Member Direct investment plan. With reference to the most recent list, this list composes of shares, Australian share ETFS, international share ETFs (in the developed markets across the globe), International share ETFs (in developed markets regionally), International share ETFs (in emerging markets), and Term deposits (which are basically bonds). All the shares are traded in the Australian Stock Exchange Market (ASX) while the term deposits, or the bonds, are traded in the Australian Securities Market, which is a secondary exchange market (AustralianSuper, 2013).

Derivative Strategies Applicable By AustralianSuper for the Above Risks

AustralianSuper is licensed and regulated as an APRA superannuation entity which means that it must comply with the Superannuation Industry Regulations Act 1994 and the Superannuation Act 1993, both of which require the development, implementation and maintenance of a prudent and forthcoming framework as far as risk management is concerned. In light of this, AustralianSuper could use derivatives for risk control in the pursuit of implementing investment strategies aimed at enhancing the returns in the corporation’s investment options. With respect to the fact that AustralianSuper has an internal Derivatives Risk Statement as well as another from its board of external managers, coming up with specific strategies to counter the aforementioned risks should not be a problem.

In the case of the risks associated with the bonds portfolio, the most appropriate strategy is to apply the two most suitable derivatives whose provisions agree comfortably with the nature of bonds. The first is the application of futures. Futures are basically exchange traded contracts that provide for assets to be bought or otherwise be sold a specific point in time and at specific prices (Scheidler, 2007). So as to combat the duration risk as faced by AustralianSuper due to their bond portfolio, futures are valued daily and can bear a range of specific settlement dates. Importantly, futures bring forth the ability to speculate on the direction of and asset’s price, and are often cancelled or closed before their maturity dates. The use of futures by AustralianSuper would result to both the security and liquidity of their bond portfolio.

The other strategy would be the use of options and warrants. Basically, options are secure contracts for selling or buying underlying securities at given prices (Garner & Brittain, 2009). In light of this, AustralianSuper can engage the acquisition of bond portfolio through this strategy since it is possible to set a price that best fits the prospects of the corporation. On the other hand, the strategy to apply warrants is suitable in combating risks associated with share portfolios. Ideally, warrants bestow upon their holders the right to acquire various securities from their issuers at a predetermined price as well as within a given time frame (Stowell, 2010). Even though warrants are issued by a company while options are issued on exchange terms, these two derivatives could also be of importance with respect to reducing or eliminating various portfolio risks faced by AustralianSuper as highlighted above. In light of this, in the case of both bond and share portfolios (including all Shares, iShare ETFs, and Term deposits), the strategy of using either futures or options would enable AustralianSuper in effectively hedging against generally all the underlying risks, especially as volatility is concerned.

Advantages and Limitations of the Above Derivative Strategies

With reference to the above content, a derivative stands out as financial contract that clearly derives its value from a given liability or asset, where the underlying assets incorporates shares, commodities, currencies or fixed income securities (Scalcione, 2011). Notably, the extent of applying security derivatives in solving financial problems has both the positive and the negative sides as stipulated by the advantages and the limitations underlined below.

Starting on the positive side, the use of derivatives in the above strategies used for combating financial risk is of advantage mainly due to a couple of reasons. To start with, the derivatives stipulate the best way to hedge or insure against the prevailing risks, thus reducing the potential losses facing the portfolios due to instances of movements both in currency or interest rates (AustralianSuper, 2011). Secondly, the derivatives as used in the strategies above help AustralianSuper in gaining exposure to any class of asset, especially with reference to holding cash (AustralianSuper, 2011). This stands out perfectly for example while indulging in full investments of a portfolio such as in shares, while at the same time managing to hold a cash balance on the same portfolio. Thirdly, derivatives are good for speculative purposes. In this respect, they help in enabling traders to magnify the potential gains as well as losses through certain securities, for example in the application of options. Consequently, the investors are able to gain ample access to a relatively large amount of assets with only a relatively little initial outlay, allowing for greater potential gains, tough at times there may be losses (AustralianSuper, 2011).

On the other hand, the negative side which represents the limitations surfaces as a result of a number of reasons. To start with is the structure of the derivative contract in application. Essentially, some derivatives tend to involve relatively significant payments especially with prevalence of certain market events such as large market movements, interest rate changes, or credit rating (Chance & Brooks, 2009). The other limitation occurs due to the volatility of the asset in question. Basically, the rationale behind this limitation is based on the fact that a derivative contract safeguarding a more volatile asset will end up more risky in comparison to the same type of derivative security safeguarding a less volatile asset. For example, currency is viewed as a relatively highly volatile asset since it incorporates quite significantly daily movements with reference to exchange rates (AustralianSuper, 2011).

Conclusion

Risk management is an important aspect the management of each corporation should consider in the pursuit of attaining its goals of business excellence and performance. However, as highlighted in the sections above, to successively manage risk, it is important to first understand the nature and the extent of risks affecting the corporation. Successful development of a risk profile, especially with respect to financial risks affecting key company portfolios consequently helps to come up with the most suitable strategies of combating the identified risks, either through the use of one or a combination of a number of derivative securities.

References

  • Alexander, C., 2008. Market Risk Analysis, Pricing, Hedging and Trading Financial Instruments. New York: John Wiley & Sons.
  • AustralianSuper, 2011. Derivatives – An Overview. Fact Sheet. Melbourne: AustralianSuper AustralianSuper.
  • AustralianSuper, 2012. Exchange Traded Funds (ETFs). Fact Sheet. Melbourne: AustralianSuper AustralianSupa.
  • AustralianSuper, 2013. Investment Menu. Fact Sheet. Melbourne: AustralianSuper AustralianSuper.
  • AustralianSuper, 2014. Superannuation. [Online] Available at: http://www.australiansuper.com/superannuation.aspx.
  • Brigham, E.F. & Houston, J.F., 2009. Fundamentals of Financial Management. London: Cengage Learning.
  • Chance, D.M. & Brooks, R., 2009. Introduction to Derivatives and Risk Management. London: Cengage Learning.
  • Garner, C. & Brittain, P., 2009. Commodity Options: Trading and Hedging Volatility in the World’s Most Lucrative Market. New Jersey: FT Press.
  • Gitman, L., Joehnk, M. & Billingsley, R., 2013. Personal Financial Planning. London: Cengage Learning.
  • Scalcione, R., 2011. The Derivatives Revolution: A Trapped Innovation and a Blueprint for Regulatory Reform. Bedfirdshire: Kluwer Law International.
  • Scheidler, M., 2007. Hedging a Portfolio with Futures. Berlin: GRIN Verlag.
  • Stowell, D., 2010. An Introduction to Investment Banks, Hedge Funds, and Private Equity. London: Academic Press.
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