Derivatives, hedging and risk transfer
Derivatives, hedging and risk transfer
This domain tests the use of forwards, futures, options, swaps and credit derivatives to transfer risk, and the risks that hedging itself creates. Expect payoff diagrams, hedge-ratio calculations, put-call parity, basis risk and counterparty risk questions.
Core rules and concepts
- Forwards are customised and settled at maturity; futures are exchange-traded, standardised and marked to market daily with margin. Both lock in a price but create counterparty or basis risk.
- Options give the buyer a right, not an obligation. A protective put sets a floor; a covered call caps upside. European put-call parity is C - P = S - PV(K).
- Swaps exchange cash flows: an interest rate swap converts fixed to floating or vice versa; a cross-currency swap exchanges principal and interest in different currencies; a credit default swap transfers credit risk.
- Hedge ratios adjust for exposure size and sensitivity. For an equity portfolio hedged with index futures, the number of contracts is (target beta minus portfolio beta) x portfolio value divided by futures contract value.
- Central clearing reduces counterparty risk but concentrates it in clearing houses and creates margin liquidity demands. Hedge accounting is not automatic; it requires documentation and effectiveness testing.
Worked example
A portfolio is worth $10 million with beta 1.2. The manager wants beta 0.5 and uses index futures priced at $200,000 per contract. Contracts = (0.5 - 1.2) x $10m / $200,000 = -35. The manager short 35 contracts. The reasoning: each short futures position offsets market exposure; the negative sign indicates selling. If the index and portfolio do not move perfectly together, residual basis risk remains, and daily margin calls can create liquidity strain even if the hedge is economically sound.
Traps that cost marks
- Treating a hedge as risk elimination; basis, counterparty, liquidity and operational risks remain.
- Mixing option payoffs with forward payoffs, or ignoring the premium paid for options.
- Using futures without accounting for daily settlement and margin calls.
- Assuming hedge accounting follows automatically from an economic hedge.
- Forgetting that derivatives can create leverage and that over-hedging can turn a hedge into a speculative position.