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Monday 18 October 2010

Futures, Forwards, Options and Exchange-Traded Funds

Investors are using futures, forwards, options and Exchange-Traded Funds (ETFs) in a wide variety of contexts. For example, borrowers are using futures contracts to lock in borrowing costs for anticipated needs. Lenders are using such instruments to lock in lending spreads in anticipation of receiving cash to invest in the future. Fixed income portfolio managers are using financial futures to hedge portfolio holdings and expected cash flows, and/or to facilitate the orderly sale of securities during asset mix changes. Equity portfolio managers are using index futures and ETFs to shift asset allocations in anticipation of buying and/or selling of the physical securities associated with an asset class, an industrial sector or a geographic region.

In addition, for portfolios of large agricultural real estate investments, agricultural commodity futures contracts for corn, cotton, soybeans and wheat are used to sell short the commodity futures contract to protect against a price decline in an agricultural commodity in which the investor has or expects to have an inventory of those particular crops.

In these particular examples, we are talking about 'hedging', and not speculation, because there are risks associated with the underlying investment securities and/physical products. These instruments, when used for hedging, can be used to offset potential declines in the value of portfolio securities. They can also help facilitate large securities transactions and reduce the risks associated with security-specific and market-specific risks as well as exogenous variables such as political, monetary, weather and currency uncertainties.

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