Page 135 - Profile's Unit Trusts & Collective Investments - September 2025

Understanding asset allocation Chapter 7

The rules governing the exposure limits for different classes of securities are complex.
For the full picture, FSB Notice 90 of 2014, which can be found at www.fsca.co.za, is the best
starting point. (This replaced Notice 80 of 2012 in August 2014.)

The three most common types of derivatives are futures, options and warrants.
Futures
A future is a standardised forward contract, and a forward contract is simply an agreement to buy
or sell a specific asset at some future date and pre-defined price. The standardisation of forward
contracts on futures markets gave rise to secondary trade in the contracts themselves, and today
futures markets are amongst the most heavily traded markets in the world.
The forward contract arose because of the need for hedging. A forward contract allows a farmer to
lock in a favourable price for his crop while it is still in the ground (ie, if he thinks prices will be lower by
harvest time). At the same time, it allows a cereal manufacturer to lock in a favourable price for winter
production (ie, if he thinks prices will rise later in the year). Entering into a forward contract or future
to buy because you think prices will rise is called going long the market, and entering into a forward
contract to sell because you think prices will fall is called going short the market.
The problem with a simple forward contract is that it is not readily transferable. If the farmer suffers
catastrophic drought and cannot deliver a crop to the cereal manufacturer, he is in default of contract
and may be out of business. By using a standardised futures contract, the farmer can easily on-sell
the contract to someone else and rid himself of his obligations. He may make a loss on the contract
itself, but he will be able to cut his losses much earlier.
The prices of futures contracts in the secondary market change continually depending on market
conditions. Early indications of a coming drought will see prices of maize futures contracts rising,
while good rains, and the promise of a bumper crop, will see futures prices falling. Being long the
futures market when prices are rising means you will make a profit; being short the futures market
when prices are falling also means you will make a profit.
In the same way, futures on financial instruments allow portfolio managers to hedge positions in
the financial markets. A fund manager who feels that the JSE as a whole is in for a major correction
(ie, a general fall in prices) can use a future on the All Share index to hedge his portfolio. This is
particularly valuable because large portfolios are not easy to convert into cash (ie, it is not easy to
protect a large portfolio by quickly selling off shares).
By going short an All Share index future, the fund manager will make a profit on the futures contract
if prices fall. This hedges the manager’s position because this profit will compensate for the loss in
the share portfolio.
Options
A futures contract, like a forward contract, is binding on both parties. The party on the short side
is obligated to sell the specified asset on or before a certain future date, and the party on the long
side is obligated to buy the specified asset on or before that date. These contractual obligations are
binding and irrevocable.
An option, by contrast, gives the buyer of the option a right (but not an obligation) to take up an
asset at a defined price on or before a certain date. The seller, or grantor, of the option remains
obligated to deliver the asset.
In return for giving the buyer this right, the seller of the option earns an option “premium”.
This has nothing to do with the contracted price (called the strike price) at which the underlying asset
will change hands if the option is exercised – it is a fee, over and above the strike price, payable by
the buyer to the seller. This, of course, makes options more expensive than futures, but in return for
the higher cost, the option buyer has the luxury of simply being able to walk away from the option
contract if it proves to be unprofitable.
An option to buy an asset on or before a future date is called a call option, and an option to sell an
asset is called a put option. A call option is the equivalent of a long position in the futures market, and

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