ESG Considerations for Financial Derivatives

A Fundamental Reshaping of Finance: A Frostbyte Thought Leadership Series

One of the most significant events in sustainable finance came in 2020 when Larry Fink, the CEO of BlackRock, the largest asset manager in the world, called for a fundamental reshaping of finance. The reshaping that Larry had in mind was to put climate change and sustainability issues at the center of risk assessment and capital allocation. The letter is a clear warning to company CEOs: climate and sustainability risk is investment risk. As other investors come to this same realization, the implications for asset values and the reallocation of capital could be profound. Changes to capital markets could come much more quickly than the physical impacts for climate change itself given the propensity of capital markets to discount future risk today.

Considering climate and sustainability risk in your company’s capital allocation process is no longer optional. In fact, BlackRock has even gone as far as to state that they will vote against management and board directors of companies that are not sufficiently incorporating sustainability practices into business plans. BlackRock has stated that they expect that sustainability integration will ultimately result in lower investment risk and better market returns. In short, sustainability is the new standard for investing.

Given that companies will face increasing shareholder pressure to incorporate sustainability into capital allocation, enterprise risk management, and standard operating procedures, it is essential to understand the underlying investment drivers for asset managers and how they might consider environmental, social, and governance (ESG) or sustainability risk factors. Clearly, climate-related risk is the most material ESG risk for many industries and sectors, but health and safety, labor management, anti-corruption, and toxic environmental releases are also key issues that must not be overlooked ^[1].

In this thought-leadership series, we look to put you in the shoes of the asset manager. How are investment decisions made? What are the unique implications for various asset-classes? How do asset managers consider investment risk? How is traditional asset management balanced with ESG considerations? These are some of the questions that we hope to tackle. Our goal is to help companies better understand the asset manager process and prepare for the shifting expectations around sustainability integration and disclosure. Those companies that can navigate this fundamental reshaping in finance will be best positioned for growth as the economy transitions to a more sustainable, lower-carbon future.

Introduction

In this thought-leadership piece, we provide the reader with an overview of derivative strategies and their link to sustainable investment. We begin by detailing option strategies that are used by asset managers including combinations of call and put options. We then shift from a discussion on contingent claims to a discussion on forward commitments (i.e. swaps, forwards, and futures) and how these financial products can be used to manage interest rate risk, currency exposure, equities, and volatility. We then tie these foundational concepts back to sustainable finance. Drawing on research from the European Capital Markets Institute ^[2], we discuss the critical role that derivatives play in economic activity by helping businesses and investors better manage risk, align exposures with risk tolerance, and enhance transparency through the provision of forward information on the underlying asset. In the context of sustainable investment, the derivatives market can enable the capital raising required to transition to a low carbon economy.

Option Strategies

One of the foundational elements of option strategies is the concept of put-call parity. Put-call parity states that a call option (the right but not the obligation to buy at a specified price) combined with a short put option (the right but not the obligation to sell at a specified price) is equivalent to holding the underlying asset financed with a risk-free bond. The put-call parity rule gives us two of the most prolific option strategies in finance: the covered call (in which a call is sold on a stock held long to yield a payoff that is equivalent to a short put option) and the protected put (in which a put is bought on a stock held long to yield a payoff that is equivalent to a call option). The covered call is used for income generation, reducing a position at a favorable price, and for target price realization. The protective put is a form of insurance that acts to limit losses but preserve upside if the stock price increases. The delta (the change in the option price per unit of change in the stock price) for an at-the-money call option is +0.5 and -0.5 for an at-the-money put option, while the delta on holding a long-stock position is +1.0. Deltas for option and stock combinations can be determined through addition. When a stock is sold short and a long call option is purchased, this is analogous to a protective put. When a stock is sold short and combined with a short put option, this is analogous to a covered call.

Call and put options can also be used to produce pay-off strategies that can reduce risk. Common strategies include bull spreads, bear spreads, straddles, and collars. A bull spread can be created with a combination of calls in which the investor is long the call with a low strike price and short the call with a higher strike price. A bull spread can also be constructed in the same way with puts. A bull put spread is called a credit spread while a bull call spread is a debit spread. A bear spread can also be constructed with calls (credit spread) or puts (debit spread), but the investor will be short the option with the high strike price and long the option with the low strike price. The bull spread has a similar payoff profile to a collar; however, a collar is created with the combination of a covered call and a protective put. A straddle is used when the investor expects a large movement up or down in the price of the underlying (high volatility) but is agnostic on the direction of the price movement. A long straddle is made up of the combination of a call and a put option. A short straddle is created by selling a call and put option and the investor then benefits if there is not a large movement in price. Investors can also take directional bets on volatility by going long or short options given a market view. For example, if the investor has a bearish market outlook and expects volatility to increase, the investor can sell call options.

Swaps, Forwards, and Futures

Like contingent claims, forward commitments can be used to modify a portfolio’s risk and return profile. When investors are exposed to interest rate risk, they can modify risk by entering into an interest rate swap and thereby, modify the portfolio duration. Interest rate forwards (like forward rate agreements) and interest rate futures (like short-term interest rate futures) can also be used to modify a portfolio’s risk and return. When a portfolio manager wants to hedge the duration risk of their bond portfolios, they can used fixed-income futures. The hedging ratio is equivalent to the basis point value of the target portfolio less the basis point value of the current portfolio, divided by the bases point value of the futures contract. The basis point value of the futures contract is determined by taking the basis point value of the bond that is cheapest to deliver, divided by a conversion factor.

Currency risk is another type of exposure that an investor may wish to hedge. Currency swaps are a tool that allow investors to carry out synthetic overseas borrowing. This is referred to as a cross currency swap. The mechanics for a cross currency swap involve borrowing in a cheap currency, exchanging this for an overseas currency, and investing to earn interest at a higher rate. This trade is only possible as a result of a breakdown in the covered interest rate parity rule. This breakdown allows one currency to trade at a negative basis and the other at a positive basis. In addition to currency swaps, currency forwards can be used to guarantee an exchange rate. When currency futures are used, the hedging ratio is equivalent to the amount of currency to be exchanged per future contract size.

Equity swaps give an investor synthetic exposure to equity returns while equity futures can be purchased as a standardized, exchange-listed contract. Both derivative products allow an investor to modify the portfolio risk and return profile. The benefits of using equity futures are their low cost, ability to conduct tactical asset allocation without transacting in the underlying, and ability to diversify across different markets. To achieve a target market exposure of beta using equity futures, the investor must size the futures purchase so that the difference in the target and market beta per unit of futures beta, multiplied by the ratio of the market value of the portfolio to futures contract value, is equal to the number of futures contracts. To reduce equity exposure using futures, the target beta should be set to zero. To equitize a cash position, the beta of the portfolio should be set to zero.

Volatility risk can be modified using derivatives. Volatility is commonly measured using the VIX index and while the VIX cannot be traded directly, VIX future contracts can be bought and sold. This allows portfolio managers to offset tail risk events. Portfolio managers can also use variance swaps to make directional bets on implied volatility versus realized volatility. In a variance swap, the seller pays the buyer a settlement amount that is equal to the notional variance multiplied by the difference between the realized variance and the variance strike price. The value of a variance swap can be determined at any time prior to the contract expiration by using the time-weighted realized and implied volatility and adjusting to present value terms. The pricing of VIX futures and options is often used to infer market expectations with respect to volatility.

Derivatives in Sustainable Finance

Congratulations on making it to this point in the newsletter. The background on derivative strategies is detailed and nuanced, but our goal here is to put you in the shoes of the investment manager. Detail and nuance are important. So, given this background on how investment managers use derivatives to manage portfolio risk and return, what are the implications for sustainable finance?

The first important link to draw between derivatives and ESG investing is the notion that derivatives can help capital to be channeled to sustainable investments. Derivatives are effectively a tool use to manage exposure and hedge risk. This can include interest rate risk, currency risk, equity, or volatility risk as discussed above. Puts, calls, and combinations thereof can also be used to modify the risk and return profile of an investment. If an investment manager can hedge risk exposure, this allows them to invest in more risky projects. Often what an investment manager considers to risky can have transformative potential to reduce environmental impacts. For example, before Tesla became the largest auto manufacture in the world (as measured by market capitalization) it was a risky start-up. Early investors in Tesla were able to use derivatives to reduce the risk of this investment thereby allowing the company to fund its trail blazing research and development activities. If an investor wants to take on only some of the risk exposure related to Tesla common equity, they could have converted a portion of their investment into a floating for fixed equity swap. This would allow the investor to keep some upside potential, but hedge against the risk of product failure by continuing to receive a fixed payment regardless of the share price performance. Today, Tesla is a serious threat to the carbon-intensive internal combustion engine because of these early investors and their ability to use derivatives to reduce their investment risk exposure.

Another link between derivatives and ESG investing is emerging with the creation of ESG linked derivatives. While ESG linked derivatives are relatively new, they are a promising tool that could be used to channel capital towards companies focused on sustainability. For example, an ESG foreign exchange derivative could be used to hedge a company's FX exposure. Let’s assume that a US-based renewable energy company wants to build a solar facility in Mexico. The US company wants to hedge its currency risk to avoid volatility in the peso, the unit of currency in which revenues will be earned. The US company could purchase an ESG foreign exchange derivative from a dealer. The dealer would then commit to exchange pesos for dollars at a given exchange rate, but unlike a traditional foreign exchange derivative, the dealer would then be required to reinvest a portion of the premium it receives in a sustainability project (like a forest conservation project that is linked to the UN’s Sustainable Development Goals). In this way, the solar developer uses a derivative product to reduce investment risk, enabling the build out of a new solar facility, while also contributing to the financing of a forest conservation project.

The final link between derivatives and ESG investing that we will highlight here is the ability for derivatives to facilitate transparency, price discovery, and market efficiency. Derivatives can help to contribute to the existing wealth of information on publicly traded securities. This contributes to enhancing the price-discovery process that benefits the capital markets. Efficient price discovery enables traders to make better assessments of risk, budget planning decisions, and portfolio management. Disclosures in relation to information about ESG practices are a fundamental element of sustainability. Complete and accurate disclosure on sustainability issues continues to evolve, but as it does, the investment manager will be better able to price risk and invest in securities that can withstand the increasing regulatory, reputational, and financial pressure that non-sustainable companies might face.

Conclusion

As we look to put you in the shoes of the asset manager, our hope is you will gain a deeper understanding of ESG integration and the investment management process. The companies that understand the asset manager’s decision-making rationale for incorporating sustainability and climate-related risk are likely to be the most responsive to changing investor requirements and trends. As global efforts are made to transition the economy to a more sustainable, lower-carbon future, we expect that investor demands for sustainability performance and disclosure are set for significant growth. Companies should begin to prepare today in order to meet investor expectations in the future. This will require having the right infrastructure for collecting sustainability-related data, understanding performance, reporting on key indicators, and setting targets to improve. Ultimately, companies that can master this core competency will gain more shareholder interest and will be poised for superior performance. Now is the time to seize the opportunity in the shift to sustainable investment.

References

1. https://www.msci.com/www/blog-posts/which-esg-issues-mattered-most/01934601065
2. https://www.isda.org/a/KOmTE/Derivatives-in-Sustainable-Finance.pdf

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