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gumpleon
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Joined: January 8th, 2007, 4:40 pm

which instrument to use, future, option or swap?

September 9th, 2007, 6:55 pm

suppose a fund manager plans to hedge the company's financial portfolio, and various common instruments are out there. the question is how the manager determines which instrument is the right one to use. in other words, what are the pro and cons of these instruments?i know all instruments well (at least in definition), but still can't give an answer which is satisfying to myself. understandably, there are no one-size-fits-all type of answers to this question, and i will appreciate if someone can elaborate on it.
 
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DavidJN
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Joined: July 14th, 2002, 3:00 am

which instrument to use, future, option or swap?

September 10th, 2007, 11:44 am

The major practical tradeoff between exchange-traded products (e.g. futures) and OTC derivatives is cost vs. maintenance. Exchange traded stuff is cheaper (in terms of bid/offer spread) and more liquid (i.e. more visible) but some clients are just not interested in the work involved in maintaining the margin accounts and tailing hedges as time evolves. As well, because of contract standardization (dates, quantities etc.) there may be some basis risk involved in using exchange products. OTC products will usually provide a tighter fit but cost more.The major design tradeoff between linear products (bonds, swaps, forwards & futures) and options is the premium cost of options. By paying the option premium one can retain the upside of a position while removing the downside, much like buying insurance. There is of course no upfront cost in taking a futures position (apart from margin) but a futures position has a symmetrical payoff and thus takes away upside as well as downside.This kind of stuff was well described by Smithson et al in their book(s) "Managing Financial Risk", you know, the one presenting the "Lego" approach to financial engineering.
 
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valmont
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Joined: August 29th, 2007, 4:13 am

which instrument to use, future, option or swap?

September 14th, 2007, 7:09 pm

I would add counter-party and settlement risks to your list of the discrepancies between OTC and exchange-traded products. Quite a few people dive headfirst into the OTC market with being adequately prepared for the added level of risk/complexity. The results of that can be disastrous, as we are witnessing right now in the OTC CDS market.
 
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gumpleon
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Joined: January 8th, 2007, 4:40 pm

which instrument to use, future, option or swap?

September 17th, 2007, 2:36 am

thanks for the replies. it clarifies the issues for me.