How to use leverage and how to manage risk

Over the last 10 years, UK pension funds have increased their usage of derivatives, either directly or through fund managers, as they focus on managing the risks associated with their liabilities. The 2012 NAPF Annual Survey results showed that 57% of members’ schemes are using derivatives. 

As derivative strategies have become more commonplace, risk regulation has tightened. A number of EU and OECD directives and guidelines have been issued requiring all counterparties with derivative contracts to report the details of them to a trade repository. The regulatory trend towards greater data transparency and governance is also growing. 

After the financial crisis, the European Commission proposed a Financial Transaction Tax (FTT), which would be set at a minimum of 0.01% for derivatives transactions. NAPF member pension schemes estimate their potential cost at around EUR 35 million.[1] 

However, the responsibility still remains with pension trustees to adopt appropriate derivative risk management processes for their pension schemes. This makes it even more important that pension trustees understand the risks inherent in their scheme’s investments. 

• Exchange-traded and over-the-counter derivative instruments – their uses and relative benefits 

• Market and counterparty credit risks 

• Risk methodologies – how to calculate, interpret and apply them 

The risk methodologies include ESMA’s guidelines for UCITS funds in Europe, which could be used to supplement the high level guidance provided by Article 14(1) of the European Directive on the Activities and Supervision of Institutions for Occupational Retirement Provision 2003/41/EC and The Pensions Act 2004 in the UK.