Page 137 - Profile's Unit Trusts and Collective Investments 2021 issue 2

Understanding Asset Allocation

The rules governing the exposure limits for different classes of securities are complex.
For the full picture, FSB notice 90 of 2014, which can be found at www.fsca.co.za, is the
best starting point. (This replaced notice 80 of 2012 in August 2014.)

The problem with a simple forward contract is that it is not readily transferable. If the farmer
suffers catastrophic drought and cannot deliver a crop to the cereal manufacturer, he is in default
of contract and may be out of business. By using a standardised futures contract, the farmer can
easily on-sell the contract to someone else and rid himself of his obligations. He may make a loss
on the contract itself, but he will be able to cut his losses much earlier.
The prices of futures contracts in the secondary market change continually depending on
market conditions. Early indications of a coming drought will see prices of maize futures contracts
rising, while good rains, and the promise of a bumper crop, will see futures prices falling. Being
long the futures market when prices are rising means you will make a profit; being short the
futures market when prices are falling also means you will make a profit.
In the same way, futures on financial instruments allow portfolio managers to hedge positions
in the financial markets. A fund manager who feels that the JSE as a whole is in for a major
correction (ie, a general fall in prices) can use a future on the All Share index to hedge his portfolio.
This is particularly valuable because large portfolios are not easy to convert into cash (ie, it is not
easy to protect a large portfolio by quickly selling off shares).
By going short an All Share index future, the fund manager will make a profit on the futures
contract if prices fall. This hedges his position because this profit will compensate for the loss in
the share portfolio.

Options
A futures contract, like a forward contract, is binding on both parties. The party on the short
side is obligated to sell the specified asset on or before a certain future date, and the party on the
long side is obligated to buy the specified asset on or before that date. These contractual
obligations are binding and irrevocable.
An option, by contrast, gives the buyer of the option a right (but not an obligation) to take up
an asset at a defined price on or before a certain date. The seller, or grantor, of the option remains
obligated to deliver the asset.
In return for giving the buyer this right, the seller of the option earns an option “premium”.
This has nothing to do with the contracted price (called the strike price) at which the underlying
asset will change hands if the option is exercised – it is a fee, over and above the strike price,
payable by the buyer to the seller. This, of course, makes options more expensive than futures, but
in return for the higher cost, the option buyer has the luxury of simply being able to walk away
from the option contract if it proves to be unprofitable.
An option to buy an asset on or before a future date is called a call option, and an option to sell an
asset is called a put option. A call option is the equivalent of a long position in the futures market,
andaputoption is theequivalentofashortposition. In either case, the option writer assumes the
obligation of either selling or buying the asset from the option holder if the option is exercised.
From a hedging point of view, options can be used in much the same way as futures. Which
type of instrument a fund manager uses will depend on a variety of technical factors, including the
cost of options and the type of exposure sought.

Warrants
A warrant is a particular type of traded option, usually created with ordinary shares as the
underlying assets. On the JSE, warrants are listed in the same way as ordinary shares and have the
advantage that they can be traded through a stockbroker in the same way as other JSE securities.
The price quoted for a warrant in the paper is the “premium” payable for the rights attached to
the warrant (ie, the right to buy or sell an underlying share on or before a certain date). Like any
other option, the warrant has a strike price, for example, R100 per share.

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Profile’s Unit Trusts & Collective Investments — Understanding Unit Trusts