Why use Derivatives
Can be used to gain useful tax efficiencies
For example by entering into a contract for difference instead of an outright purchase, they can avoid paying stamp duty attached to the physical asset
(Stamp duty is currently not applicable to contracts for difference)
For example by entering into a total return swap they can reduce (or even eliminate) withholding the tax on periodic payments of interest and dividends
For example the asset could be transferred to a bank that can reclaim the withholding tax while using a TRS to shift the risk of the asset back to the hedge fund.
Derivatives allow investors to manoeuvre anonymously in the markets.
Hedge funds may want to remain large holders of a convertible bond or loan but at the same time reduce their net exposure to the credit using CDS.
Accessing Restricted Markets
If a country has currency controls that will restrict the hedge funds ability to "repatriate" either profits or capital then it may be advantageous for the hedge fund to gain exposure to a targeted asset using a derivatives contract.
Similarly if there are restrictions on foreign ownership, so shares eligible for foreign share ownership trade at a significant premium to domestic shares the hedge fund could secure exposure to the domestic shares using derivatives with a local counterparty and then sell short the more expensive foreign shares hoping the two will converge.
Trading Non Deliverable Assets
Shifting Operational Burdens
Hedge funds can use derivatives to shift the operational burden to thir parties to save time, effort and costs.
Off Balance Sheet Items
Because a lot of derivatives do not require a movement of principal funds at maturity they were often excluded from companies balance sheets.
However there have recently been new accounting regulations (notably FASB 133 and IAS 39) which mean that a lot of derivaties have to now appear on a balance sheet.
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