Risk management, derivatives and hedging
This domain tests whether you can identify, measure and transfer risk, and whether you can size a hedge correctly and explain what the hedge does not cover.
The risk map
Market risk (interest rate, inflation, credit spread, equity, currency), credit and counterparty risk, liquidity risk (funding and market), operational and model risk, concentration risk. Measure with sensitivities (duration, beta, DV01), VaR and expected shortfall, and stress tests. VaR is a quantile, not a maximum loss, and says nothing about the tail beyond it - expected shortfall does.
Derivative toolkit
Futures: exchange-traded, standardised, daily margined - basis and roll risk but little counterparty risk. Forwards: OTC, bespoke, counterparty-exposed. Swaps: interest rate swaps exchange fixed for floating; inflation swaps exchange fixed for realised RPI; total return swaps and CDS transfer market and credit exposure. Options, caps, floors and swaptions give asymmetric protection for a premium, preserving upside at a cost.
Hedging mechanics
Equity futures hedge: contracts = beta × portfolio value / (futures price × contract multiplier). Fixed income hedging uses DV01 matching: notional × duration must offset the exposure being hedged.
Worked example: hedging equity beta
A £50m portfolio with beta 1.2 against FTSE 100 futures at 7,600 and a £10 multiplier, so each contract is worth £76,000. Contracts = 1.2 × 50,000,000 / 76,000 = 789.5, so sell 790 futures. To reduce beta to 0.8 rather than zero, hedge only the excess: (1.2 − 0.8) × 50,000,000 / 76,000 = 263 contracts. The residual is basis risk: the portfolio's beta to the index is estimated, not guaranteed.
Traps
Forgetting the contract multiplier or hedging with the wrong index. Ignoring margining and collateral liquidity, as leveraged LDI structures discovered. Confusing basis risk with counterparty risk. Treating a hedge as free - premia, spreads and roll costs are real.