Risk management, derivatives and hedging applications
This domain tests identification, measurement and control of investment risk, and the practical use of derivatives. You should be able to design a hedge, quantify it and explain why it may fail.
Risk taxonomy and controls
Market risk includes interest rate, inflation, credit, equity, currency and property risk. Liquidity risk has two forms: asset liquidity and funding liquidity. Counterparty risk is managed by collateral, netting and central clearing. VaR is a quantile over a horizon; stress testing explores severe but plausible scenarios that VaR misses.
Hedging
A hedge ratio compares the sensitivity of the exposure with the sensitivity of the hedging instrument. For interest rates, use PV01 or dollar duration. For equities, use beta and futures notional. Basis risk arises when the hedge and exposure are not identical.
Worked example
A 100m equity portfolio has beta 1.2. Index futures have a beta of 1.0 and a contract value of 40,000. To reduce beta to 0.6, the number of contracts is (1.2 - 0.6) x 100m / 40,000 = 1,500 contracts sold. This hedges market beta, not stock-specific risk. If the portfolio's actual beta is unstable, or the futures basis moves, the hedge will be imperfect.
Traps
- Hedging notional rather than sensitivity.
- Forgetting margin calls and roll costs.
- Treating VaR as a maximum loss.
- Ignoring counterparty and collateral risk in over-the-counter hedges.