Thursday, August 25, 2016

Pension Funds using options.

Two states, Hawaii and South Carolina are using Cash Secured Puts to boost the yield of their pension funds.

So what exactly is a cash secured put?  

A put is a bet that the underlying stock will fall in price.

  • Buying a put results in a payoff when the stock price falls below the strike.   

  • Conversely, selling a put results in a loss when the stock price is below the strike.   

The benefit to writing (selling) a put is that you earn a premium when the stock is trading above the strike.   But when the stock price falls, the writer incurs a loss.  The payoff from this strategy is basically the same as a covered call.

A cash secured put involves keeping cash on hand to cover this loss.   In the case of a pension fund, this cash is probably in the form of Treasuries.   Holding this cash doesn't make the loss go away, it just means that you have the money to cover it.   When the option is exercised, the writer sells the Treasuries to buy the stock, and ends up holding the stock.

If as a portfolio manager, you wanted to move money from Treasuries to, say the S&P 500, but wanted to do so when the price of the index fell below a certain level, then a cash secured put would be one way of doing this.  During the periods when the index was high, you'd keep your money in Treasuries and instead earn the option premium.  It's similar to issuing a limit order.

So is this a risky strategy for a pension fund as implied by the Wall Street Journal?   I don't think so.   The payoffs are pretty clear and the risk is quite quantifiable providing that the strategy is managed
carefully.  That said, essentially what these states are doing is providing market insurance to other market participants.   The insurance business is a great business to be in, except when there is a disaster.   Just ask AIG.

A bigger issue is whether or not the optimal asset allocation of the pension fund is being compromised.  For example, if the pension fund is holding larger allocations to Treasuries instead of stocks, the fund will miss out on stronger performance by stocks in an up market.   The fund will instead be an aggressive buyer of stocks in a declining market which may result in an overweighting of stocks in a bear market.