The recent Dodd-Frank Act introduced sweeping changes to the derivatives market. Daniel Farrell, Putnam’s Head of Equity Trading, discusses how Putnam uses derivative contracts and the impact of the bill on Putnam equity funds.

Broadly speaking, what are derivatives and how are they used?
Derivatives are investments whose value is based on — or “derived” from — the performance of an underlying entity — typically a security or an index, but derivatives can also be linked to interest rates or changes in currency exchange rates.

How does Putnam use derivatives in its funds?
Putnam generally uses derivatives in one of two ways: either as a means for reducing our risk exposure as it relates to an existing investment, or as a means for gaining exposure to an investment opportunity while limiting our downside risk. Let me give examples of each. First, if a fund manager has a negative short-term outlook for equities and is concerned about volatility detracting from fund performance, he might buy a put option on a broad stock market index to help offset potential market declines. For the second example, let’s say an analyst identifies the stock of a company that has the potential to appreciate significantly if, for instance, it gets a new drug approved, but it also has the potential to decline substantially if that approval fails to materialize. In that case, simply taking a long position in the stock may not make sense. Using put options or other derivatives contracts can help a fund manager gain exposure to the upside potential of a stock while limiting the impact to shareholders should the stock decline. In Putnam’s fixed-income funds, the implementation of derivatives is a little more complex, but the philosophy guiding why we use them is the same.

Can you explain the role of collateral in derivatives trading?
Certain derivatives, such as swaps, typically will involve payments made over time from one institution to another. For that reason, some form of collateral usually is earmarked for the payments due to the counterparty. Different firms have different policies regarding how much and what forms of collateral are set aside. That said, we at Putnam are stringent in our counterparty risk analysis, both as it relates to payments made and payments received. For futures trades, we calculate and post all necessary collateral on a daily basis and as a rule will enter into contracts only with firms that do the same; OTC transactions are collateralized on a weekly basis. In either case, mitigating counterparty risk is a significant part of Putnam’s risk management process, and we ensure that all transactions that have the potential to affect shareholders are fully collateralized on both ends.

What changes are we likely to see to the derivatives market as a result of the recent financial reform legislation?
Many derivatives that were traded over the counter — meaning via private transactions between buyer and seller — will be traded on a public exchange using a central clearing platform going forward. That change will likely introduce greater transparency to the derivatives market in general, and in particular to the more exotic varieties of derivatives, whose risks are often unclear. At Putnam, we use derivatives primarily as a tool to seek to reduce risk, and the derivatives contracts we enter have clear, well-defined risks associated with them. As a result, I don’t think Putnam’s day-to-day business will see a significant change stemming from the financial reform bill.

From a logistical standpoint, the Act sets broad guidelines for changes to the derivates market, and it will be up to the Securities and Exchange Commission and the Commodity Futures Trading Commission to decide how those guidelines are actually implemented — and that process could very well take several months.