Episode 301: Derivatives Applications in Investment Management

 

The content of this podcast is provided for educational and informational purposes only and should not be construed as financial or investment advice. Listeners should consult with qualified financial professionals before making any investment decisions based on the information discussed.

Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name's Stewart Foley, I'll be your host. Hey, welcome back and thanks for joining us. We've got a great podcast for you today on a topic that we don't spend a lot of time on. Before we get going though, I want to tell you that the registration is currently open for our insurance investment executives annual meeting, which is taking place in Chicago on July 16th and 17th. Registration is open to insurance asset owners and allocators, CIO, CRO, and direct reports of CIOs and CROs. Please email us at events@insuranceaum.com. We are already without much advertising, we're already two thirds of the way full, so please go ahead and register as soon as you can. We'd certainly appreciate that. We want to accommodate as many people as we can.

Today's topic is derivatives in action applications and insurance investment management, and we're joined today by Kamesh Chilukuri, who's the managing director and head of derivatives at Symetra Investment Management. Kamesh, welcome. Welcome to the program. We're thrilled to have you.

Kamesh: Very happy to be on the podcast, Stewart. Thank you for having me.

Stewart: We are thrilled. And you know what, this is such an important topic and something that we don't often have a chance to talk about. So just to start off, where did you grow up and what was your first job? Not the fancy one.

Kamesh: Before I answer the question, I want to start by clarifying that all opinions expressed in this podcast are solely my own. And now to answer your question, Stewart, I grew up in India and went to college at the Indian Institute of Technology, Madras, where I majored in electrical engineering, and I minored in linguistics. I then moved to the US to do my master's at Massachusetts Institute of Technology, where I got my first paid job as a graduate researcher. And as part of my research at MIT, I used Monte Carlo simulation to build out the first monolithically integrated light emitting device on silicon material. So essentially, we were bombarding silicon material with hydrogen ions and using Monte Carlo simulation to optimize the energy of the hydrogen ions to determine the optimal depth of penetration into the silicon material.

Stewart: That's so cool.

Kamesh: And I mention that because I still use Monte Carlo techniques today in my finance job and as a factoid, Monte Carlo simulation was also used in the Manhattan Project during World War II as referenced in the movie Oppenheimer.

Stewart: That's really cool. I've actually used Monte Carlo simulation techniques myself, and so that's certainly a cool topic, but let's just start with the basics for folks who may not be familiar, can you talk a little bit about how you classify the different types of derivatives? What is a derivative, first of all, and how do you classify the different types, and why is that distinction important from a portfolio management perspective?

Kamesh: So I'll motivate derivatives using a couple of practical examples that you will be able to relate to. Stewart, I think it is beneficial to classify derivatives into two categories. One is linear derivatives, and the other are nonlinear, and both have applications, as you will see through the examples I discuss. So, for linear derivatives, let's say in your personal account you have $50 and you want to invest $100 in US large cap stocks. So, you could open a margin account at a discount broker, and since you can't invest directly in the S&P 500 index, you have three alternatives. First is you can go and buy each individual stock of the S&P 500, which as you can imagine is pretty cumbersome. The second alternative is to invest the $100 by buying an ETF, like the SPY, and the third alternative is to buy a derivative called S&P 500 futures. Futures are linear derivatives because their payoff is linear in the performance of the underlying S&P 500.

So, if S&P 500 goes up, you make a proportional gain and if it goes down, you make a symmetric proportional loss. The other thing about futures contracts, Stewart, is that there is no cashflow during the life of the contract. In fact, the market's best estimate of the cash flows of the underlying S&P 500 index like financing costs and dividends are forecasted by the market participants and already embedded into the price of the futures contract. So, let's take the example and continue it forward. So, if you had say $50 in your personal account and you were to buy the ETF, you would borrow another $50 from your broker and take the $100 and you would invest it in the ETF. Now, the interest the brokerage firm will charge you on the loan will be at the broker's discretion. However, if you were to invest in $100 notional of S&P futures, the financing cost that is embedded in the futures price is determined by the market supply and demand forces, and not at the discretion of your brokerage firm. So even as a retail investor, you are able to access institutional level financing costs using the futures market. Also, the S&P 500 futures are more liquid than the ETF and there is no management fee either. And if you look at dividends as well, when you buy the future's contract, you are locking in the dividends over the term of the future's contract, let's say it's three months, which is based on the market's expectation determined by the supply and demand forces and is reflected within the future's price.

Stewart: Lemme just ask a question real quick. So the dividends are priced in and that's a very efficient pricing mechanism, and then what you're saying is that at least help me understand this. So there is an embedded time value of money in that futures contract, which is closely tied to the risk-free rate. So you're effectively as a buyer of a futures contract or a derivatives contract, not only are you getting the dividends that have been reflected in the pricing of the derivative, you're also able to borrow at pretty close to the risk-free rate as opposed to the margin rate that's sure to be significantly higher charged by a broker. Do I have that kind of halfway right anyway?

Kamesh: That is exactly correct, yes.

Stewart: Okay, good deal. So I mean that's a really important aspect there is you're getting the same notional exposure much more efficiently.

Kamesh: That's correct, and I'll add to that point that in an ETF the future dividends you will receive is uncertain over the next three months, they depend on what dividends will be declared and paid by the companies of the S&P 500 in the next three months. However, in the futures contract, embedded in the price is already the market's best expectation of what the dividends are, so the financing cost and the dividends are known upfront, and you're removing that uncertainty by using the future's contract.

Stewart: That's super helpful. What's an example of a non-linear instrument?

Kamesh: Right, so the second flavor of derivatives are non-linear derivatives and they're called non-linear because their payoff is asymmetric in the performance of the underlying. I think this is something closer to home for fixed income investors because if you have ever invested in a callable bond, congratulations, because you have traded a nonlinear derivative, which is embedded inside the callable bond because the issuer of the callable bond is long the option to call the bond at par if the bond price rises above par but doesn't call the bond if it priced below par. So, it is nonlinear in that sense.

Stewart: That's really interesting. So, you've mentioned that derivatives can help modify a portfolio's risk return profile. How do you see this play out specifically in an insurance context like fixed annuities or indexed annuities?

Kamesh: Yeah, so I'll give you two examples. One will be more in the fixed annuity and the indexed annuity context, and then I'll move on to applications. In the general account investing, Stewart, it's all about transforming cash flows. So, let's take the example of a fixed annuity. Essentially a fixed annuity is like a certificate of deposit. The policy holder pays the premium upfront and then it is a five-year contract. So, what the insurance company does, it takes the premium, the $100, and it invests it into its general account investment portfolio. And let's say it earns a yield, a coupon of 6% annualized for the next five years. So, what the insurance company is doing is it is taking the coupon and essentially just passing it through to the policy holder by crediting that 6% coupon to the policy holder's account. But what if the policy holder has a higher risk appetite and they want to perhaps participate in the equity markets and other income derivatives, which can help transform the fixed income type cashflow into more equity-like cashflow with principal protection and herein comes the fixed indexed annuity in contrast to the fixed annuity.

So, in a fixed indexed annuity, the same $100 are invested in the general account, but the 6% coupon, rather than being credited to the policy holders account is used to purchase derivatives called call options, let's say on the S&P 500 index. So, by taking that 6% fixed stream of coupons and investing it into a derivative contract like the S&P 500, there is principal protection on the downside, but also upside participation in the equity markets which may be more in tune with the risk appetite of the policy holder. Shifting gears a little bit, Stewart, I'll say in the context of general account investments, derivatives also have a very interesting application because they actually enable you to do relative value analysis on an apples-to-apples basis. For instance, I have three examples which I think you'll find very interesting. So the first example is callable bond versus straight bond.

So if you want to do relative value analysis between a callable bond and a straight bond, you make an adjustment to the credit spread of the callable bond to get what is called the option adjusted spread. And that option adjusted spread is then compared with the Z spread of a straight bond to determine relative value. And like I alluded to before, a callable bond essentially has a call option derivative embedded inside it, so you have to value that call option to determine what is the option-adjusted spread. Another example is if you want to compare the relative value between a fixed rate bond and say a floating rate bond, and similar to the option-adjusted spread, what you have to do is take the spread of the floating rate bond and adjust it by what is called a swap spread, which is the difference in the swap rate and the benchmark treasury yield. And that adjusted credit spread of the floating rate bond can now be compared directly with the credit spread on the fixed rate bond. And that way you can do an apples-to-apples relative value comparison, and once you decide there is relative value in the floating rate bond, you can then buy the floater and simultaneously enter into the interest rate swap, which is a derivative to lock in that relative value.

Stewart: That's interesting. So you're effectively turning a floating rate instrument into a fixed rate instrument, synthetically. 

Kamesh: That is correct.

Stewart: And that's a very efficient way to do that, right? You can actually capture that effectively alpha in there, right?

Kamesh: That is exactly correct, yes. So you get the duration that you want while being able to capture the alpha that you can get in the floating rate bond. And on the topic of capturing alpha, I'll say the third example is if you want to do relative value analysis between a USD denominated bond and a foreign currency, let's say Japanese yen denominated bond, so similar to the option adjusted spread or adjusting the credit spread of a floating rate bond with a swap spread, what you can do in this case is you can actually do what is called a cross currency basis adjustment. So, you take the credit spread of the JPY denominated bond and adjust it with the cross-currency basis, which you can obtain from the currency swap market, which is again a derivative market. And by making that adjustment, the credit spread of the JPY denominated bond now is normalized to US dollars, and you can do apples-to-apples comparison for relative value decisions with the USD denominated bond.

Stewart: That's super interesting. So, derivatives, at least based on my limited understanding, can sometimes be used as a substitute for direct exposure. Are you familiar with this and have you found it useful particularly in less liquid and harder to access markets?

Kamesh: Yes, definitely Stewart. I mean, liquidity can be better in some derivatives versus the underlying cash bonds. For example, treasury bond futures are very liquid, and one application I can think of is let's say you have an asset sale program where you basically want to sell your corporate bond holdings to raise liquidity. So what you can do is while you are waiting to source the liquidity for your corporate bonds, you can actually short treasury bond futures. So it acts as a hedge against interest rate moves as you're waiting to source that liquidity. So definitely, derivatives can be very liquid and more efficient than underlying cash bonds in some instances. 

Stewart: That's super interesting. So there are people who look at derivatives markets as a window into sentiment. Do you use derivatives like interest rate futures or implied volatility measures to help shape macro views?

Kamesh: In general I'll say there are many applications for derivatives, and one of the application, as you rightly said, is using the derivatives market to infer market expectations. So for example, currently the fed fund futures are implying a 17% market implied probability of a 25 basis point rate cut in the next FOMC meeting in June, and using the Fed fund futures market to imply that probability can help determine how your views as a portfolio manager on interest rates differ from those implied from the derivatives market. I'll also say that it has been found that excess returns for corporate bonds over the next quarter or the next year can be positively correlated with the current levels of the VIX, which is the volatility index. The value of the VIX is based on the S&P 500 index options and higher implied volatility in the equity markets is reflected in the VIX and is bullish for corporates most likely reflecting risk-averse pricing. So, a higher VIX signifies a higher risk premium across all markets, including the credit markets. So, it can be a valuable tool to forecast or predict what the future total returns of a corporate bond can be.

Stewart: One of the things I think that some people, there's a perception that derivatives also come with some operational complexity. What are the biggest considerations that if someone is currently not using derivatives, what should they be thinking about? Whether it's legal or accounting or collateral or just what are some other considerations? Because as you pointed out, derivatives offer a very efficient and scalable access to markets. What's your take there? 

Kamesh: That's a great question. So there are several considerations, very important considerations in order to run a derivatives program. The first would be legal. So in order to trade over the counter derivatives like cross currency swaps, you typically require an ISDA agreement, which is the International Swaps and Derivatives Association agreement, which has to be negotiated. While if you want to trade exchange traded derivatives like futures, those can be accessed through a futures commission merchant setup. So there is definitely a legal perspective to setting up a derivatives framework. On the accounting front, like we discussed, you can use derivatives and pair them with floating rate bonds, and in those kinds of applications you may want the accounting on the derivatives to match the accounting on the bond. So there could be some hedge accounting rules that may apply and can influence the financial statement presentation of derivatives positions that also need to be kept in mind. Then with derivatives, there also comes counterparty exposure. So that means you need to have a robust collateral management framework in place because what you have to do is regular valuation of your derivatives and any changes in the value of the derivative will then dictate what is the collateral that needs to be exchanged, and that can also add complexity. And last but not the least operationally, you have to have an effective lifecycle management to manage derivatives including trade capture, confirmations and settlement, all of which are essential to support these transactions.

Stewart: Yeah, super helpful and very well thought out. Looking ahead, what are the most important capabilities you believe that insurers should be building to use derivatives more effectively as the market environment shifts and evolves?

Kamesh: Yeah, you have to be attuned with all the regulation of derivatives and ensure that you have all the framework and legal documentation set up and you need to have knowledgeable personnel, who can effectively understand not just the risks embedded in derivatives, but also do the derivatives trading error-free and in an effective fashion.

Stewart: Yeah, it's interesting derivatives, as far as some takeaways, and these are just my notes, but I'm keen to get your take on them, which is the derivatives aren't just for hedging. They're an essential tool to manage risk and access markets that would otherwise be out of reach. Keen to get your take on that one. And then the successful usage requires infrastructure expertise and a clear investment purpose beyond just the trade itself. Can you talk about those two as takeaways and what you might add to them?

Kamesh: Yeah, I mean, derivatives are definitely a great hedging tool, but as we discussed, they also expand your investment universe, whether you're looking at fixed or floating rate bond or foreign currency denominated bonds as we discussed. But I'll also give you another application because I alluded to Monte Carlo simulation at the beginning of this talk. I think Monte Carlo simulation is a very valuable toolkit in the valuation of derivatives, but that same skillset can be used to simulate the joint probability of default when you're investing in CLOs. So one of the key inputs that go into the CLO pricing is the joint probability of defaults between the loans in the collateral pool and Monte Carlo simulation provides a very systematic process to generate the full distribution of say, the equity tranche internal rate of return. And the equity tranche is the riskiest tranche of the CLO.

So you're not just looking at the expected return or looking at the risk through historical scenarios, but you can get a better sense of the tail risk and therefore the economic capital while judging relative value between different CLO equity tranches you're looking to invest in to build out a portfolio by using the Monte Carlo framework, which is core to derivatives pricing. And the ratings agencies also use similar approaches in their analysis as well. And like I said, the infrastructure set up is key, but once you have all the infrastructure set up, it's being on top of all the regulatory changes in the derivatives markets, being knowledgeable of new derivatives that come into the markets, and just expanding your knowledge about cross asset derivatives. What other derivatives are there in the volatility markets like the VIX from which you can infer expectations that you can use to invest in your specific asset class that you specialize in.

Stewart: That's awesome. We've gotten a great education on derivatives in action from you today. I've got a couple of fun ones for you that are kind of a little bit away from that topic, but maybe related, and really it gets into what characteristics are you looking for when you're adding people to your team? Not necessarily what skills they have or what school they went to, but are there particular characteristics that you're looking for while you're interviewing?

Kamesh: I think there are several, Stewart, honestly, but the top two on my list would be having an exceptional work ethic and being coachable.

Stewart: I think those are two really important aspects. The last one I'll ask is kind of a fun one, which is you can have dinner with up to four people, including yourself, and your guests can be alive or dead, fictional or real, and you don't have to have all three. You can choose one, two, or three guests, but who would you most like to have dinner with alive or dead?

Kamesh: Well, Stewart, I'm a student of leadership and for that reason would love to have dinner with Abraham Lincoln for his leadership in unifying the country during the Civil War and issuing the Emancipation Proclamation. So I would love to get some leadership tips from him. And I'm also Stewart, a student of the business, so Charlie Munger is another luminary I would love to have dinner with. Warren Buffet has credited Munger with being the architect of Berkshire Hathaway's business philosophy, which emphasizes value investing, long-term thinking and ethical business practices, all three of which I think are key to business success.

Stewart: That is very cool. What a great choice. I appreciate so much you being on and giving us a deep dive on the derivatives front. And just wanted to say thank you so much for being on. I know that you listen to our podcast and it's great to have you on as a guest as well. 

Kamesh: Yes, thank you so much, Stewart. I'm a big fan of your podcast and it was an honor to be on this. 

Stewart: Thank you. Thank you very much. We've been joined today by Kamesh Chilukuri, managing Director, head of Derivatives at Symetra Investment Management. If you have ideas for podcasts, please shoot me a note at Stewart@insuranceaum.com. Please rate us like us and review us on Apple Podcast, Spotify, Amazon, or our brand new YouTube channel. Thanks for listening. We'll see you again next time at the Home of the World’s Smartest Money, InsuranceAUM.com.