Liability-Relative Approach

[BMiller12]

In the discussion of Liability-Relative Pension Portfolios, it mentions that the use of derivatives to hedge variousmarket exposures frees up capital to earn higher returns.
How does this free up capital?
I understand a derivative, a call option for instance, doesn’t require the upfront investment that buying the security outright would, but if you ultimately call the option…you have to shell out the strike or agreed upon price. So it’s not like you’re saving money, perhaps delaying it.
Any clarification?

 

[cpk123]

futures contracts are more the kind of derivatives they are talking about.

 

[BMiller12]

But how does that free up capital? As the long or short, they either have to buy or give something away in the future, which costs money. Are they suggesting that prior to that time, money is freed up to invest? Not sure I get how derivatives free up capital for further invest ment

 

[cpk123]

you use futures contracts to hedge your bets.
with a futures contract you are also going to perform a mark-to-market operation … so you would pay a difference (gain or loss) on the transaction. since most often you would be entering into the contract with the same counterparty with whom you have a good relationship - and there is NO initial cost - you are better of than enteriing into any other type of contractm, and this does free up your capital to engage in higher return producing transactions.

 

[njcfa11]

I think it also mean options - in your original it is if they are in the money but I think they use cheaper ones that aren’t likely to expire ITM.