Using Derivatives to Profitably Manage Risk for a Pension Fund (w/ Jim Keohane)
ED HARRISON: We were talking earlier before the interview about your transition and one of the places where you can make a difference is in terms of fees. And it's interesting in terms of how a pension plan can deal with costs. And we were talking in particular about Nortel Networks. They were 37% of the TSX, the Toronto Stock Exchange index, and huge outsized risk for HOOPP at the time. But you were able to manage that risk in a very positive way. You gave me a big number about of $800 million, $850 million. Talk me through that episode when Nortel had tanked during the tech bust. JIM KEOHANE: Sure. So we're a very big user of derivatives-- one of the largest in the world, actually. And most people are scared of derivatives, but if you use them properly, they're very powerful risk management tools. And I think we're a very sophisticated user of derivatives. So what we did at the time-- Nortel became this disproportionate weight in the index and at that time, we had a bunch of outside managers as well. So when you start drilling down in all these portfolios, they all had Nortel in them. So what we did is we did an overlay on top of the thing using derivatives. So I was charged with trying to keep our exposure below 5% of the fund. And so I used what we call a costless collar to do that transaction, which is effectively buying put options-- to sell a stock at a fixed price for a period of time. And to pay for that, we sold call options about 50% above the market, which would cause you to actually force you to sell a stock if it went up by more than 15%. So it effectively capped our exposure within our range. And we did that in very material size, because of the size of the exposure we had. And so I think it was right around 2000, Nortel warned, and stock went down 30% one day. And so in that one day, that offset gained us about $850 million. ED HARRISON: $850 million, right. And the thing is that what you're talking about is reducing the volatility. You still have exposure, but you capping upside and downside. And that's part of the profile that you're talking about in terms of risk. This is something that you can do that individuals can't do. That's something that we're going to be talking about going forward. JIM KEOHANE: Yeah, so individuals just wouldn't have the credit worthiness to do with strategies like that. Because of our size, we're an extremely credit worthy counterparty. So Wall Street banks are very willing to deal with us knowing that when it comes time to pay, we'll pay. Whereas individuals, they would never do that strategy because you know people could go bankrupt and they can't get their money from them.