Use of Derivatives

Similar to asset-only management frameworks, derivatives can be used to further expand the efficient frontier to help manage risk or seek additional return.  More aggressive solutions tend to rely more on the use of derivatives. 

Collateral Management

The efficient allocation and monitoring of collateral lies at the heart of any well implemented derivative overlay program. Collateral is typically tiered into three buckets intended to cover variation margin requirements over different horizons and risk levels.

• Cash → Daily/weekly variation margin
• Liquid Securities (i.e.  T-Bills and Treasuries) → Medium term variation margin
• Less Liquid Securities (i.e. Corporates)  → Outlier event

To identify collateral requirements, we analyze historical moves of underlying assets to determine expected moves at different percentile levels.

Performance Impact

In setting up any overlay program it is critical to isolate the performance of the derivative overlay from that of an actively managed portfolio, with clearly defined benchmarks.  This may allow for continued measurement of a manager's alpha contribution.