Futures Forwards Risk

Section: Futures and Forwards in Risk Management Estimated study time: 45 minutes Content: Futures and forward contracts are linear derivatives used extensively in portfolio risk management for their capital efficiency, liquidity, and precision in adjusting exposures. Unlike options, futures and forwards have symmetric payoffs — gains on one side equal losses on the other. They are used to modify duration, equity beta, currency exposure, and commodity exposure without buying or selling the underlying assets. Equity futures are used to adjust portfolio beta. The number of futures contracts needed to change portfolio beta from β_P to β_T (target) is: N = (β_T − β_P) × (V_P / V_F), where V_P is portfolio value and V_F is the value of one futures contract (futures price × multiplier). To increase beta, buy futures (long); to decrease beta (including hedging to zero), sell futures (short). Portable alpha strategies use futures to separate alpha from beta: invest the portfolio in an alpha-generating strategy (e.g., long-short equity) and use equity index futures to overlay the desired market beta separately. Fixed income futures are used to adjust portfolio duration. The number of contracts needed: N = [(D_T − D_P) × V_P] / (D_F × V_F), where D_T is target duration, D_P is portfolio duration, D_F is the futures contract duration (typically the cheapest-to-deliver bond's duration), and V_F is futures contract value. Sell futures to shorten duration (rates rising view); buy futures to extend duration (rates falling view). Forward contracts are OTC (over-the-counter) instruments with no standardized specifications and no daily mark-to-market settlement (unlike futures, which are settled daily through variation margin). Forwards are used when customization is required — specific settlement date, custom notional amount, or…