How Are Derivatives Used? Evidence from the Mutual Fund Industry

Authors

  • Jennifer Lynch Koski,

    1. School of Business Administration, University of Washington
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  • Jeffrey Pontiff

    1. School of Business Administration, University of Washington
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    • * School of Business Administration, University of Washington. We thank Keith Brown, Diane Del Guercio, Roger Edelen, Wayne Ferson, Mark Grinblatt, Avi Kamara, Stanley Kon, Paul Malatesta, Greg Niehaus, Ed Rice, and Catherine Schrand for their comments, and David Myers, Douglas Rolph, Mark Thorpe, and Amanda Westlake for valuable research assistance. We also thank James Curtis, René Stulz (the editor), and an anonymous referee. Helpful comments have been received from seminar participants at Arizona State University, Harvard Business School, Katholieke Universiteit Leuven, Norwegian School of Management, Securities and Exchange Commission, Stockholm School of Economics, University of California—Davis, University of California—Los Angeles, University of Michigan, University of Southern California, University of Texas at Austin, and University of Washington. We also thank participants in the 1996 Wharton Financial Institutions Center Conference on Risk Management in Insurance Firms.

Abstract

We investigate investment managers' use of derivatives by comparing return distributions for equity mutual funds that use and do not use derivatives. In contrast to public perception, derivative users have risk exposure and return performance that are similar to nonusers. We also analyze changes in fund risk in response to prior fund performance. Changes in risk are substantially less severe for funds using derivatives, consistent with the explanation that managers use derivatives to reduce the impact of performance on risk. We provide new evidence regarding the implications of cash flows and managerial gaming for the relation between performance and risk.

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