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Frances Cowell has worked in the investment management industry since 1983 starting as an equity analyst for Aetna Investment Management in Australia. Since then she has managed domestic and international equity and fixed interest portfolios, and asset allocation. In each case the focus has been applying quantitative techniques, with an emphasis on combining derivatives and physical investments, to construct and manage investment portfolios with predefined risk targets to meet specified investment objectives. In 1998, she moved to the UK to work for QUANTEC, a major provider of portfolio risk management systems, and in 2002 took up duties as Interim Head of Portfolio Risk at Morley Fund Management. She now works in the Portfolio Risk team, specialising in risk management for derivatives and hedge funds.

Practical applications This paper — describes how derivatives are used in portfolio management; — explains how to measure the effective economic value of the investment achieved by a derivative transaction and the role of collateral; — discusses the different types of risk associated with derivatives, the interaction between derivatives and conventional instruments and, from this, — addresses the question of how derivatives risk can be measured, managed and, where necessary, controlled. Abstract For conjuring fear, few aspects of investments rival derivatives. This is not surprising given the history of august institutions humbled or even demolished as a result of poor risk management of their derivatives exposures. While some types of derivatives strategies certainly demand a very specific approach to risk management, it cannot be said that derivatives defy risk management. Derivatives Use, Trading & Regulation (2006) 12, 228–243. doi:10.1057/palgrave.dutr.1850044 INTRODUCTION The main reason that derivatives are perceived as being more risky than physical investment

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instruments is because they facilitate gearing and short selling. Gearing results from the ability to gain exposure to risky assets with a value much greater than the initial sum paid to effect the position. A sharp adverse market move can result in losses far exceeding the initial ‘investment’. Short selling allows the investor to sell things he or she does not own, again with only a small initial payment, which can be dwarfed by the losses resulting from a sharp price appreciation. While these characteristics certainly can give rise to extreme outcomes, most derivatives held in investment portfolios (hedge funds are the notable exception) are managed in a way that

Derivatives Use, Trading & Regulation Volume 12 Number 3 2006 www.palgrave-journals.com/dutr

Derivatives Use, Trading & Regulation, Vol. 12 No. 3, 2006, pp. 228–243 r 2006 Palgrave Macmillan Ltd 1357-0927/06 $30.00

avoids the risks of gearing and short selling. In fact, in many cases derivatives significantly reduce the risk of the overall portfolio.

WHAT ARE THE OBJECTIVES OF INVESTING IN DERIVATIVES? Nearly all investment portfolios can benefit from using derivatives, either as