The Chinese Pension System
February 12, 2025
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Pension funds across the world are meant to be low-risk financial instruments. They are allowed to take slightly more risks in some parts of the world as compared to others. However, for the most part, pension fund across the world is advised to stay away from risky instruments such as derivatives.
Derivatives have been known for playing a pivotal role in many market crashes. Hence, pension funds have been traditionally asked to stay away from derivatives. However, that has changed in the recent past. Pension funds are now allowed to have limited exposure to derivatives in most parts of the world.
In this article, we will have a closer look at how pension funds use derivatives to manage their portfolios in a better manner.
In most parts of the world, pension funds use derivatives in a restricted manner. The common restrictions which are levied on the use of derivatives have been explained below.
For example, if the pension funds have some investments in foreign currency, they would end up being exposed to foreign exchange fluctuations. In such cases, they can use derivatives to hedge their foreign exchange risk.
Pension funds have adopted the use of derivatives on a large scale. This is because the use of derivatives provides a lot of advantages. Some of these advantages have been listed below:
For example, sometimes pension funds are able to find investments denominated in foreign currency which provide higher returns. In such cases, they get exposed to forex risks. Hence, they are unable to buy these assets.
However, the pension funds can purchase the investment and nullify the forex risk with the help of a derivative. This will help them to lock in a better return. This is the case with many other investment opportunities. For instance, sometimes the fund may hold floating-rate bonds. In such cases, they can use derivatives to swap their cash flow for a fixed rate of interest.
The bottom line is that derivatives have some utility for pension funds. Even though pension funds cannot use them in an uninhibited manner like hedge funds, they can and must find a way to include derivatives as a risk management tool in their overall strategy.
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