However, the lack of liquidity also means that for the most part they have low levels of correlation with the broad market.
Derivatives are another possibility, and their potential impact on the portfolio will be discussed in the next question. They can either increase risk or decrease risk, depending on the type of derivative and how it is used.
Overall, the impact of alternative investments is to reduce the degree to which the portfolio is subject to the equity and fixed income markets. Alternative investments are often used as an ancillary component of the portfolio, to reduce the portfolio's overall volatility but with the hopes that returns will not suffer as a result.
3. Derivatives can be used for a couple of different purposes in a portfolio. The first is to increase leverage (risk), thereby delivering greater returns or losses than otherwise would be acquired for the money. The second use of derivatives is to limit the downside risk of a portfolio. They can also be used for asset allocation and diversification purposes.
The latter two purposes are simple -- derivatives are a different asset class and therefore represent a means by which an investor can increase his or her holdings not only of the derivatives class but eventually the underlying asset class as well.
An uncovered derivative increases the risk associated with the portfolio significantly. The investor is able to purchase or sell more of a security than would otherwise be possible, which increases the leverage and volatility of the portfolio. This tactic can be used sparingly in a portfolio to come effect but is largely gambling.
The covered derivative can be used to limit the downside risk to the security owner. Such a derivative strategy requires the portfolio to pay for the privilege of limiting downside risk -- essentially selling that downside risk to another party for a profit. The counterparty may use the same strategy to gain extra income from his or her portfolio.
According to the efficient market hypothesis, enhancing returns through derivatives should not be possible if the derivatives are fairly priced. However, in practice this is not the case (Lhabitant, 2000). One possible explanation is that derivative markets are less liquid than equity markets, which results in arbitrage opportunities. There are also biases built into derivatives markets that...
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