Use of Derivatives in Overlays: Downside Protection and Upside Capture

The use of derivatives in constructing tactical asset allocation TAA overlays for multi-asset portfolios is demonstrated in this chapter. It illustrates how derivatives enable portfolio managers to achieve additional returns while managing risks. Using instruments like equity index futures, government bond futures, and options, portfolio managers can implement TAA overlays to diversify and generate uncorrelated returns, known as “portable alpha,” without disrupting the core portfolio. The case also explains the mechanics of using derivatives, emphasizing basis risk, initial margin requirements, and duration mismatches to achieve efficient exposure to various asset classes. The study highlights the strategic role of options for downside protection and upside capture, showcasing their effectiveness during market volatility, such as the COVID-19 pandemic. By integrating call options into a TAA overlay, portfolio managers benefited from the convex payoff profile, allowing dynamic risk-level adjustments. Options mitigate losses during sharp drawdowns and facilitate participation in market recoveries. The use of options is presented as a more flexible tool than linear instruments like futures, providing portfolio managers with a robust means to navigate uncertain market conditions. The case underscores the advantages of derivatives in multi-asset portfolio construction through detailed calculations and illustrations.