The Use of Derivatives by Investment Managers and Implications for Portfolio Performance and Risk

Authors


  • *The authors gratefully acknowledge the helpful comments and suggestions from an anonymous referee, Bruce Grundy (the Editor), Anthony Asher, and seminar participants at the 2004 Australasian Finance and Banking Conference.

Aaron Ng
School of Banking and Finance
The University of New South Wales
Sydney NSW 2052
Australia

ABSTRACT

This study provides an empirical examination of derivative instruments used by institutional investors. Our analysis provides a unique insight into the role and benefits of derivative securities in active equity portfolio management. We contribute to the literature by using a database that comprises the periodic portfolio holdings and daily trades of institutional fund managers. The consequence of derivative use is analyzed using a number of performance and risk measures. Overall, we find the use of derivatives have a negligible impact on fund returns, and is primarily attributed to low levels of derivative exposure relative to total fund size. We also evaluate how derivatives are used by considering the trading strategies executed by active investment managers. Specifically, option trading patterns are consistent with the execution of momentum trading strategies. This study also documents that active investment managers prefer not to use options markets to engage in informed trading.

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