How Institutional Investors Use Derivatives

People who manage assets think about the currency risk of foreign-currency assets and the allocation of equity holdings, and people who manage risk think about interest rate risk on assets and liabilities. Both use derivatives for these jobs.

Who institutional investors are and the risks they face

Institutional investors include life insurers, pension funds and investment trust management companies. Japan's Stewardship Code has a list of the institutional investors that have signed up to it. The list groups them into trust banks, investment trust and investment advisory companies, life and non-life insurers, pension funds, and others¹. Institutional investors are broadly divided into asset managers, which are entrusted with funds and invest them, and asset owners, which include the providers of those funds².

The value of the assets that institutional investors manage changes with exchange rates, stock prices and interest rates³. Life insurers are making greater use of derivatives to hedge interest rate risk and currency risk⁴.

The difference between hedging, which limits losses, and speculation, which seeks profit, is covered in Hedging, Speculation and Arbitrage.

Hedging the currency risk of foreign-currency assets

An institutional investor that holds foreign-currency assets can reduce its currency risk by fixing in advance the rate at which it will convert them into yen, using an FX forward or a similar contract. This kind of transaction, which limits changes in the yen value caused by exchange rate moves, is called currency hedging⁵. Consider a hypothetical example in which Life Insurer R (a fictional life insurer) holds USD 100 million of US Treasuries and the current rate is 150 yen per dollar. The yen value is 15.0 billion yen. Life Insurer R enters into an FX forward to sell USD 100 million in one year at 147 yen per dollar. For simplicity, assume the dollar price of the bonds does not change, and ignore interest. Figure 1 shows the gain or loss on this FX forward in one year.

Figure description

This is the gain or loss per dollar on an FX forward to sell dollars at 147 yen in one year. If the yen is stronger than 147 in one year (the dollar is cheaper), it is a gain; if the yen is weaker (the dollar is dearer), it is a loss, and it changes by the amount the rate moves. The vertical axis times USD 100 million gives the gain or loss on the FX forward in the table below.

If the yen strengthens to 130 yen per dollar in one year, the unhedged yen value falls by 2.0 billion yen. Under the FX forward, Life Insurer R can sell dollars worth 130 yen for 147 yen, so the difference of 1.7 billion yen is a gain and the total is 14.7 billion yen. If the yen instead weakens to 170 yen, the unhedged value rises by 2.0 billion yen. But Life Insurer R must sell dollars worth 170 yen for 147 yen under the forward, a loss of 2.3 billion yen, so the total is again 14.7 billion yen. Currency hedging prevents losses from a stronger yen, but in exchange it also gives up gains from a weaker yen.

The FX forward rate is set by the current rate (the spot rate) and the difference between the two currencies' interest rates. When dollar interest rates are higher than yen rates, the yen is stronger at the forward rate than at the spot rate (fewer yen per dollar). The 147 yen in this example assumes that dollar rates are higher than yen rates. Because Life Insurer R sells USD 100 million at 147 yen instead of today's 150 yen, a difference of 0.3 billion yen arises. This cost, which comes from the interest rate gap, is called the hedging cost. In an example given by the Investment Trusts Association, Japan, if you invest in higher-yielding foreign government bonds and hedge the currency risk, the yield after deducting the hedging cost is about the same as the yen interest rate⁶.

Different institutional investors use currency hedging as follows.

• Part of the investment funds of the Government Pension Investment Fund (GPIF) is allocated to foreign bond funds with currency hedging, and GPIF treats that part as domestic bonds. The transactions used for currency hedging include FX forwards and similar contracts (GPIF's glossary calls them foreign exchange forward transactions)⁵.
• Japanese life insurers use FX swaps and similar transactions to hedge the currency risk of their foreign-currency bonds. Hedging through FX swaps and similar transactions has declined in recent years as higher US interest rates raised hedging costs⁷.
• For an investment trust, currency hedging means reducing the chance that exchange rate moves change its net asset value, and FX forwards are generally used⁸.

Adjusting asset allocation with equity index futures

Equity index futures are used in rebalancing, which brings an asset allocation back to its target, to limit the effect of price moves until the stock trades are completed. Consider a hypothetical example in which Pension Fund S (a fictional pension fund) has 1 trillion yen of assets. Its target is 25% of total assets (250 billion yen) in domestic equities. A rise in stock prices and a fall in other assets together leave total assets at 1 trillion yen, while domestic equities have grown to 270 billion yen. Because this is 20 billion yen above the target, Pension Fund S sells 20 billion yen of stocks to return to the target. In this example, assume it takes several days to finish selling the stocks. The fund first sells 20 billion yen of equity index futures and buys the futures back once it has finished selling the stocks. For simplicity, assume the stocks held and the futures move by the same percentage, and ignore fees.

If stock prices fall 3%, the proceeds from selling the stocks fall by 0.6 billion yen, but the futures sold in advance gain 0.6 billion yen, and the total is 20.0 billion yen. If stock prices rise 3%, the stocks sell for 0.6 billion yen more, but the futures lose 0.6 billion yen. Using futures lets the fund restore its allocation at an amount close to the stock prices at the time it decided to sell, but it gives up any gain from prices rising afterward.

GPIF sets out its long-term target asset allocation as its policy portfolio. The policy portfolio applied from April 1, 2025, sets domestic bonds, foreign bonds, domestic equities and foreign equities at 25% each. It also sets deviation limits (the range of permitted deviation from the policy portfolio) of ±5–6 percentage points for each asset⁹. GPIF cannot invest in stocks directly, and except for part of its domestic bonds, it leaves the choice of individual securities to external asset managers. GPIF itself, on the other hand, makes the rebalancing decisions¹⁰.

In accordance with laws and regulations, GPIF uses equity index futures as a temporary substitute for selling assets it holds. It does not trade equity index futures for speculative purposes¹¹. Futures involve posting margin and daily mark-to-market settlement.

Adjusting interest rate risk with interest rate swaps

An interest rate swap is one way for a life insurer with long-dated liabilities to manage its interest rate risk: it narrows the gap between how its assets and its liabilities move when rates change. The change in value when interest rates move by 0.01 percentage points is called DV01. Consider a hypothetical example in which Life Insurer R holds government bonds with a market value of 1 trillion yen. Its liabilities (future insurance payouts) also have a market value of 1 trillion yen. The DV01 of the assets is 1.0 billion yen and the DV01 of the liabilities is 1.5 billion yen, and both rise in value when interest rates fall¹². Life Insurer R enters into an interest rate swap with a DV01 of 0.5 billion yen in which it receives a fixed rate and pays a floating rate.

When interest rates fall by 0.1 percentage points (10 times 0.01 percentage points), the assets rise by 10.0 billion yen and the liabilities by 15.0 billion yen, so assets minus liabilities falls by 5.0 billion yen. The side that receives the fixed rate and pays the floating rate benefits when rates fall, because the floating rate it pays goes down¹³. In this example the swap gains 5.0 billion yen in value, which offsets the fall. When rates rise by 0.1 percentage points, assets minus liabilities rises by 5.0 billion yen, but the swap loses 5.0 billion yen, giving up that increase¹⁴.

At Japanese life insurers, which have many long-term contracts such as whole life and endowment insurance, the duration of liabilities (the period until insurance payouts) exceeds 10 years (median of the four large insurers with available disclosures, end of fiscal 2024)¹⁵. In Japan, economic value-based solvency regulation, which also values liabilities at market value, has applied since the end of March 2026¹⁶.

Selling JGB futures is another way to limit a fall in the value of government bonds you hold¹⁷.

As of January 2023, life insurers were narrowing the duration gap between their assets and liabilities in anticipation of the economic value-based solvency regulation. The main means was adding super-long-term bonds. Transactions that use derivatives or repos (lending and borrowing of bonds such as government bonds) are called leveraged transactions, and interest rate swaps and repos were also increasing, though on a limited scale. On a net notional amount basis, the four large insurers' receive-fixed swaps exceeded their pay-fixed swaps¹⁸.

Additional margin and the UK corporate pension case

The Bank of Japan lists additional margin calls in times of market stress as a potential risk of the derivatives that life insurers use to hedge interest rate and currency risk¹⁹. Margin on OTC derivatives that are not cleared through a central counterparty is covered in Margin Requirements for Uncleared Derivatives.

In late September 2022, UK long-term interest rates rose sharply after the government announced a fiscal package that included large tax cuts. Some UK corporate pension funds had adopted liability-driven investment (LDI). LDI is an approach that manages assets so that their market value moves with the market value of liabilities. These pension funds used interest rate swaps in which they received a fixed rate and paid a floating rate, among other tools, to balance their liabilities and assets against interest rate moves. Funds that managed money for the pension funds and used leveraged transactions with derivatives and repos faced very large margin calls as rates jumped, and sold some of their assets. Those sales pushed rates up further, and the Bank of England announced temporary purchases of government bonds²⁰.

As of January 2023, most Japanese corporate pension funds invested in line with a predetermined asset mix (policy asset composition ratios) and made little use of leverage at the time²¹.

Limits on investment trusts' derivative transactions

Investment trusts' derivative transactions are subject to a limit set by rules. The management company (the settlor) calculates, by a method it sets in advance, an amount corresponding to the risk that may arise from changes in interest rates, currency values and other factors. An investment trust may not enter into derivative transactions that would make this amount exceed its total net assets²².

An investment trust that uses derivative transactions for purposes other than hedging states its investment approach clearly in its basic terms and conditions. Long-term bond investment trusts, medium-term government bond funds and certain other trusts may use derivative transactions only for hedging²³. The basic terms and conditions set out the details of the investment trust agreement, and the management company must notify the Prime Minister of them before concluding the agreement²⁴. For an investment trust whose basic terms and conditions limit FX forwards to hedging, the forward sales cover the foreign-currency assets it holds and similar items. The amount of the forwards must stay within the limits set by the detailed rules under the association's rules²⁵.

Notes

1. Financial Services Agency, "スチュワードシップ・コードの受入れを表明した機関投資家のリストの公表について" (Publication of the list of institutional investors that have signed up to the Stewardship Code) (in Japanese), categories of the list as of June 30, 2026. "Others" means service providers to institutional investors and the like. ↩

2. Financial Services Agency, "「責任ある機関投資家」の諸原則 ≪日本版スチュワードシップ・コード≫" (Principles for Responsible Institutional Investors, Japan's Stewardship Code) (in Japanese), June 26, 2025, preamble item 4, page 2 (page 3 of the PDF). English version: "Principles for Responsible Institutional Investors ≪Japan's Stewardship Code≫". ↩

3. For exchange rates and stock prices, Government Pension Investment Fund, "カ行用語集" (Glossary, ka row) (in Japanese), the entries "為替ヘッジ付き外国債券" (Foreign bonds with currency hedging) and "株価指数先物" (Equity index futures). For interest rates, Japan Exchange Group, "国債先物入門" (Introduction to JGB futures) (in Japanese), by Takahiro Hattori, 2021, section "2．2 先物の役割：リスク管理の提供" (The role of futures: providing risk management), page 3 (page 4 of the PDF). ↩

4. Bank of Japan Financial System and Bank Examination Department, "生命保険会社の国際比較：ビジネスモデルの変化に伴う金融安定上の論点" (Bank of Japan Review 2026-J-7) (in Japanese), May 2026, main text on page 5. English version: "International Comparison of Life Insurers: Evolving Business Models and Financial Stability Issues" (Bank of Japan Review 2026-E-7). ↩

5. Government Pension Investment Fund, "カ行用語集" (in Japanese), the entry "為替ヘッジ付き外国債券" (Foreign bonds with currency hedging). ↩ ↩²

6. Investment Trusts Association, Japan, "為替ヘッジってなに？‐2" (What is currency hedging? Part 2) (in Japanese), email newsletter No. 183, June 3, 2009, the sections "フォワードレートの決まり方" (How forward rates are set) and "ヘッジコスト" (Hedging cost). ↩

7. Bank of Japan Financial System and Bank Examination Department, "生命保険会社の国際比較：ビジネスモデルの変化に伴う金融安定上の論点" (Bank of Japan Review 2026-J-7) (in Japanese), May 2026, footnote 18 (page 8). ↩

8. Investment Trusts Association, Japan, "為替ヘッジってなに？‐2" (in Japanese), email newsletter No. 183, June 3, 2009, the opening paragraph and the section "先物為替予約でヘッジ" (Hedging with FX forwards). ↩

9. Government Pension Investment Fund, "基本ポートフォリオの考え方" (Approach to the policy portfolio) (in Japanese), the table "第５期中期目標期間（2025年度からの５カ年）における基本ポートフォリオ" (Policy portfolio for the fifth medium-term objectives period, the five years from fiscal 2025). ↩

10. Government Pension Investment Fund, "GPIFは自ら運用を行っているのですか。" (Does GPIF manage its investments itself?) (in Japanese), the second and fourth paragraphs of the answer. ↩

11. Government Pension Investment Fund, "カ行用語集" (in Japanese), the entry "株価指数先物" (Equity index futures). ↩

12. For how government bond values move with interest rates, "国債先物入門" (in Japanese), section 2.2, page 3. For how liabilities move, Bank of Japan Review 2026-J-7, main text on page 3 and footnote 10 (page 8). ↩

13. Central Council for Financial Services Information, "4-2 金利スワップの仕組み" (How interest rate swaps work), in "やさしいデリバティブ" (Derivatives made easy) (in Japanese), the example of the side that receives the fixed rate and pays the floating rate, and the opposite side. ↩

14. Bank of Japan Financial System and Bank Examination Department, "企業年金の運用戦略からみた金融安定への含意 ―英国債市場の混乱からの教訓―" (Bank of Japan Review 2023-J-2) (in Japanese), January 2023, main text on page 3 (receive-fixed interest rate swaps used to balance liabilities and assets against market rate moves). English version: "Corporate Pension Funds' Investment Strategies and Financial Stability: Lessons from the Turmoil in the UK Gilt Market" (Bank of Japan Review 2023-E-3, March 2023). ↩

15. Bank of Japan Financial System and Bank Examination Department, "生命保険会社の国際比較：ビジネスモデルの変化に伴う金融安定上の論点" (Bank of Japan Review 2026-J-7) (in Japanese), May 2026, main text on page 1 and Chart 1. ↩

16. Bank of Japan Review 2026-J-7, footnote 2 (page 7). That liabilities are also valued at market value is from Bank of Japan Review 2023-J-2, main text on page 6 and footnote 23 (page 8). ↩

17. Japan Exchange Group, "国債先物入門" (in Japanese), by Takahiro Hattori, 2021, section "2．2 先物の役割：リスク管理の提供", page 3 (page 4 of the PDF). ↩

18. Bank of Japan Review 2023-J-2, main text on page 6 and the note to Chart 12, and main text on page 3. For repos, "国債先物入門", section 2.2, page 3. ↩

19. Bank of Japan Financial System and Bank Examination Department, "生命保険会社の国際比較：ビジネスモデルの変化に伴う金融安定上の論点" (Bank of Japan Review 2026-J-7) (in Japanese), May 2026, main text on page 5 and Chart 13. ↩

20. Bank of Japan Financial System and Bank Examination Department, "企業年金の運用戦略からみた金融安定への含意 ―英国債市場の混乱からの教訓―" (Bank of Japan Review 2023-J-2) (in Japanese), January 2023, main text on pages 1 and 3, and footnote 2 on page 7. ↩

21. The same document, main text on page 6. ↩

22. Investment Trusts Association, Japan, "投資信託等の運用に関する規則" (Rules on the management of investment trusts, etc.) (in Japanese), as amended on September 19, 2024, Article 17 (pages 14–15). ↩

23. The same document, Article 18 (page 18). ↩

24. "投資信託及び投資法人に関する法律" (Act on Investment Trusts and Investment Corporations) (in Japanese), Article 4, paragraph (1). English translation: "Act on Investment Trusts and Investment Corporations" (Japanese Law Translation; the translation reflects amendments up to Act No. 28 of 2019). ↩

25. Investment Trusts Association, Japan, "投資信託等の運用に関する規則" (in Japanese), as amended on September 19, 2024, Article 16 (page 14). ↩