When you use this feature, you will leave Vanguard and go to a third-party website.
Many investors think of derivatives as modern, complex instruments conjured up by today's financial wizards. Although it's true that innovation keeps pushing derivatives forward, their history goes back centuries, even millennia. Early forms of derivatives were used in medieval Europe, the Roman Empire, ancient Greece, even as far back as the Sumerians around 4000 B.C.
Broadly speaking, a derivative is a financial instrument whose value is based on, or "derived" from, an underlying security (such as a stock or bond), an asset (such as a commodity or currency), or a market index (such as the Standard & Poor's 500 Index).
Although the instruments have evolved over time, the fundamental reasons for using derivatives have stayed the same. Derivatives facilitate the transfer of risk—for example, from one party that seeks to minimize or hedge risk to another that is willing to bear the risk in the hope of earning a return.
Vanguard employs derivatives as part of our prudent portfolio management strategies to improve investor outcomes by hedging risk, managing cash flows, and minimizing transaction costs. Regulated derivatives markets effectively serve investment needs, and Vanguard has worked closely with regulatory bodies around the world to encourage prudent, workable rules to enhance the resiliency of the derivatives markets.
The basics of derivatives
Derivatives are typically contracts to exchange payments based on the changing value of the underlying security, asset, or index. Because of global regulatory reform, the most liquid, standardised derivatives are cleared through an exchange or execution venue, with the risk managed by a central clearinghouse, which mitigates default risk by mandating that appropriate margin is held to address market and volatility risk. The three basic types of derivatives are futures, options, and swaps.
A physically settled futures contract refers to an exchange-traded obligation to buy (or sell) a specific amount of the underlying security, asset, or index at a specified price on a specific future date. For example, a business that has to make a payment in a foreign currency next year can use currency futures to offset the risk of changes in the exchange rate before the obligation comes due.
Options contracts give one party the option—but not the obligation—to buy or sell a specified underlying security, asset, or index at a specified price on a specific future date. Unlike futures, options give investors the flexibility to exercise the contract only if it is advantageous or "in the money."
A swap is an arrangement in which two parties agree to exchange future cash flows, often involving one cash flow at a fixed rate of interest and one at a variable rate. Common types of swaps include interest rates swaps, currency swaps, commodity swaps, and total return swaps.
How derivatives can improve investor outcomes
"The use of derivatives by most mutual fund companies, including Vanguard," notes William Thum, head of the capital markets team in Vanguard's Office of the General Counsel, "falls into three buckets: hedging exposures, managing cash, or synthetically investing when derivatives markets are more liquid, less volatile, or price-competitive relative to the cash markets for the underlying security."
Vanguard funds enter into derivatives contracts, including swaps and futures, to achieve a number of benefits for our clients. Such benefits include hedging currency exchange risk in certain portfolios, lowering transaction costs, managing cash, and achieving economic exposure that is generally equivalent to traditional investments when the derivatives markets are more liquid, less volatile, or price-competitive with the cash market for the underlying security.
For example, Vanguard commonly uses derivatives to "equitise" cash. That is, we buy highly liquid futures to help our funds stay fully invested, while having cash on hand to manage fund inflows and outflows. That gives the portfolio managers and traders the flexibility to invest in underlying securities opportunistically, while helping minimize tracking error versus their benchmarks and maintaining cash buffers for redemption requests. All of this is done while respecting internal fund parameters on the use of derivatives that are much more conservative than the limits set by regulators.
"These are all basic, prudent portfolio management strategies." Mr. Thum said. "And the risks associated with these derivatives are closely managed by Vanguard's experienced portfolio management teams."
Vanguard also uses derivatives in our actively managed bond funds to generate alpha, said Sam Priyadarshi, head of portfolio risk and derivatives in Vanguard's Fixed Income Group. "Our portfolio managers take strategic and tactical views on interest rates, yield curves, inflation, and levels of volatility," Mr. Priyadarshi said. "Derivatives provide a prudent, risk-controlled way to act on those views, with the aim of adding to our active funds' returns."
Four ways Vanguard uses derivatives
How Vanguard advocates for derivatives—and investors
Since the global financial crisis, derivatives use and regulations have come under much greater scrutiny. Given our commitment to achieving efficient investment and risk-mitigation methodologies through innovative strategies executed on electronic derivatives trading platforms, Vanguard has been actively engaged in advocating for workable derivatives regulation. To date, we have written 30 comment letters to prudential regulators around the world, weighing in on better regulatory controls for these financial instruments, with the goal of improving outcomes for all investors.
For example, in an early comment letter to the Commodity Futures Trading Commission, Vanguard advocated for a margin segregation model applicable to centrally cleared derivatives that aimed to mitigate "fellow-customer" risk—the risk that margin posted by nondefaulting investors could be used to address losses from unrelated defaulting investors. And in 2015 we worked with other market leaders to encourage the international Financial Stability Board, the Bank of England, and the U.S. Federal Reserve to develop consistent regulatory requirements regarding the timing for exercising insolvency-related derivative termination rights.
"Advocacy on this issue is an ongoing, iterative process," Mr. Thum said. "We're committed to staying engaged in this advocacy because we believe derivatives, when used prudently to mitigate risk and achieve investment objectives, can help give investors a better chance for investment success."
All investing is subject to risk, including the possible loss of the money you invest. Investments in bonds are subject to interest rate, credit, and inflation risk.
Futures trading is speculative in nature and involves substantial risk of loss. Futures are not suitable for all investors.
Options are a leveraged investment and are not suitable for every investor. Options involve risk, including the possibility that you could lose more money than you invest. Prior to buying or selling options, you must receive a copy of Characteristics and Risks of Standardized Options issued by the OCC. A copy of this booklet is available at http://www.theocc.com. It may also be obtained from your broker, any exchange on which options are traded, or by contacting The Options Clearing Corporation, 125 S. Franklin Street, Suite 1200, Chicago, IL 60606 (888-678-4667 or 888-OPTIONS). The booklet contains information on options issued by the OCC. It is intended for educational purposes. No statement in the booklet should be construed as a recommendation to buy or sell a security or to provide investment advice. For further assistance, please call the Options Industry Council ("OIC") Helpline at 888-PTIONS or view the website at www.optionseducation.org. The OIC can provide you with balanced options education and tools to assist you with your options questions and trading.