Hedge and Pension Funds Increase Exposure to Derivative Products

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As more conservative funds are investing in derivative products, many are concerned about increase risk of a market meltdown. Yet when used correctly, credit derivatives are an effective risk management tool.

Hedge fund investors show no signs of slowing down their investments in derivatives, despite recent articles in the financial press, as well as naysayers at the Fed, sounding the alarm over the increased exposure of hedge funds, asset and pension fund managers to the volatile world of derivatives products. In fact, even the more conservative mutual fund stalwarts, such as Fidelity Investments and Vanguard, are increasingly frequent investors in derivatives, including such hybrid investments as credit default swaps, collateralized debt obligations (“CDO”s), and total return swaps.

“There is nothing inherently risky about investing in credit derivatives when you understand them”, explains Ellen H. Clark, an attorney in the derivative product group at the DLA Piper law firm. “In fact, they are an important risk management tool that can effectively reduce the credit risk inherent in a fund’s portfolio.” Recent debt rating downgrades at GM and Ford coupled with the unexpected equity sell-off in GM stock has made ripples in the water for portfolios of certain hedge funds with significant exposure to these companies, but there has been nothing of a market meltdown. “The derivatives industry has grown to staggering proportions, but the vast majority of investors are carefully hedged”, concludes Ms. Clark. “We may see a shake-out of small funds, and certainly new products such as ABN-AMRO and AXA’s credit derivatives fund aimed at retail investors look aggressive, but the numbers involved among less sophisticated investors taking significant stakes in credit derivative products are less than 10% of the derivative industry marketplace as a whole.”

Derivative products are investment products that permit the transfer of payment risks or obligations based upon the type of underlying instrument from which the product is derived. Certain credit derivatives can work like a principal return guarantee such that an investor in a specific debt product can enter into a credit default swap and receive a guarantee of full payment on the investment for an upfront premium to the seller of protection under the swap. The seller of protection absorbs the risk of default on the underlying debt or bond obligation from which the swap is derived. Some derivatives are linked to actual debt obligations, others are created synthetically to resemble the risk and return of a debt or equity obligation.

There are three questions a small fund or other end-user investor should consider before investing in credit derivatives. First, what is the risk you are seeking to hedge? Be clear with your counterparty about the economic result you are seeking by entering the hedge. Second, does the product you are investing in provide the hedge protection you are seeking and is your counterparty’s credit rating at least as high or higher than the debt of the entity against which you are hedging? In order to have adequate protection in the event of the bankruptcy or payment default by your hedge counterparty, you should test its creditworthiness before going into the deal by checking its corporate and debt issuance credit ratings. Finally, is the hedge product offered by your counterparty a stand-alone swap or is it, in turn, linked to an underlying transaction involving complex collateral pledges and back-to-back swap arrangements? If so, be sure you understand the underlying transaction and the inherent payment risks that could ripple through the entire structure.

Ellen H. Clark, Esq. is a derivatives and structured finance attorney in New York. She practices at DLA Piper Rudnick Gray Cary US LLP representing international financial organizations and private equity investors. Her offices are at 1251 Avenue of the Americas, New York, New York, 10020. She can be reached by telephone at (212) 835-6205 and by e-mail at ellen.clark@dlapiper.com.

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