Derivatives create new investment opportunities. This chapter examines techniques which are used in portfolio management with particular reference to derivatives.

Readers are likely to have heard of Lehman Brothers, the once-famous and now-notorious American investment bank which became bankrupt in 2008. Figure 20.1 below shows the price of the shares of Lehman Brothers from 2004 to 2008. It was difficult to predict that Lehman Brothers would go bankrupt when it was hitting all-time highs in early 2007. Even in early 2008 its share price was higher than in 2004. Within a few months, it collapsed. Clearly the market valuation did not reflect the company's inherent position and the stock market did not have the right information as would have been expected under textbook finance theory.

Consider the hypothetical case of a person whose entire portfolio of investments consisted of only the shares of Lehman Brothers. He would have lost all his money. And if he was leveraged through futures, margin loans etc., then there would have been large margin calls as well in which extra payments over and above the initial equity had to be paid to the broker.

The conventional answer would be that the investor should have diversified into other shares. And indeed, compared to a portfolio invested entirely in Lehman Brothers, a diversified portfolio of equities would have done better. But almost all broad-based equity indices lost half, if not more, of their net worth during the period from late 2007 to early 2009 which marked the global financial crisis. Thus, diversification into other equities would have provided only limited protection. This illustrates that true diversification does not mean just different equities; it entails diversification across asset classes as well, with equities constituting just one asset class. Government bonds, corporate bonds, convertible debentures, preferred shares, precious metals, other commodities and cash or short-term bank deposits/money market investments, real estate etc. are other asset classes. Having some exposure to them in one's portfolio in 2008 would have cushioned the fall more than a pure equity portfolio.