Swaps and risk management - Hedging with futures and options

Learning Outcomes

This article explains swaps and risk management with futures and options, including:

• the roles of swaps, futures, and options in managing interest rate, currency, and market risks;
• the contractual features, cash flow structures, and valuation basics of plain-vanilla interest rate and currency swaps;
• how standardized futures contracts are margined, marked to market, and used to construct hedges for bond and commodity portfolios;
• how options create asymmetric payoff profiles, allowing downside protection with upside potential, and the trade-off between protection and premium cost;
• step-by-step worked examples illustrating hedging corporate debt, asset portfolios, and foreign-currency cash flows using swaps, futures, and options;
• comparison of key advantages, limitations, basis risk, and residual exposures across swaps, futures, and options strategies;
• practical exam-style guidance on interpreting payoff diagrams, identifying appropriate hedging instruments, and avoiding common CFA Level 1 pitfalls;
• the specific learning focus relevant to CFA Level 1 candidates, emphasizing concise problem-solving approaches for derivatives and hedging questions.

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are required to understand the basic principles and practical application of derivative instruments for risk management, with a focus on the following syllabus points:

• Understanding how swaps, futures, and options are structured and valued
• Explaining how futures and options are used to hedge risks in portfolios
• Identifying the differences between hedging with swaps, futures, and options
• Recognizing the limitations and risks associated with various derivative hedges
• Describing the relationship between spot prices, forward/futures prices, and the risk‑free rate (cost of carry)
• Interpreting payoff diagrams for basic long and short futures, calls, and puts

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the primary objective of using futures contracts for hedging purposes?
   1. To maximize speculative profits with amplified exposure
   2. To lock in a future transaction price and reduce price uncertainty
   3. To diversify across many asset classes
   4. To time the market more effectively
2. A currency swap is most accurately described as an instrument that allows a firm to:
   1. Convert fixed-rate debt in one currency into fixed- or floating-rate debt in another currency
   2. Eliminate all foreign exchange risk with no credit risk
   3. Speculate on interest rate movements in a single currency
   4. Guarantee the lowest possible borrowing cost in any currency
3. Compared with a futures hedge, an options hedge:
   1. Provides symmetric gains and losses as prices move
   2. Requires no upfront cash and no margin
   3. Provides downside protection while preserving upside potential
   4. Always costs less because it can expire worthless
4. In derivatives hedging, basis risk refers to:
   1. The risk of default by the exchange’s clearinghouse
   2. The risk that the hedging instrument’s price does not move in perfect lockstep with the hedged exposure
   3. The risk of incorrectly forecasting future interest rates
   4. The risk that an option finishes out of the money at expiration

Introduction

In risk management, swaps, futures, and options are key derivative instruments that help investors and companies reduce uncertainty in financial outcomes. The CFA Level 1 exam expects candidates to recognize when each derivative type is appropriate, how they are constructed, and how they work in practice to hedge market, interest rate, and currency exposures.

Key Term: derivative
A financial contract whose value depends on the value of a reference asset, such as a stock, bond, commodity, or currency.

Most derivatives used for hedging are based on a simple no‑arbitrage idea: the derivative price is linked to today’s spot price and the risk‑free rate, sometimes adjusted for costs and benefits of holding the reference asset. At initiation, many derivatives (forwards, futures, swaps) are set up so that their value is approximately zero; their value then changes as market prices and interest rates move.

Key Term: forward contract
A customized over‑the‑counter agreement today to buy or sell an asset at a specified price on a specified future date, with no cash exchanged at initiation.

Futures and swaps are standardized or packaged versions of multiple forward contracts, while options provide a right but not an obligation. For exam purposes, you must be able to:

• identify the direction of the hedging position (long vs short) that offsets a given exposure;
• sketch or interpret simple payoff profiles at expiration;
• understand qualitatively how changes in the reference asset price affect the value of the hedge.

Key Term: hedging
The process of reducing risk by taking a position in a financial instrument that offsets potential losses in another investment or exposure.

The following sections focus on how swaps, futures, and options are structured and how they are used in simple hedging strategies.

Swaps: Structure and Hedging Applications

Swaps are contracts under which two parties agree to exchange future cash flows based on specified terms. The most common swap types at CFA Level 1 are interest rate swaps and currency swaps.

Key Term: swap
An agreement where two parties exchange cash flows of different types over a period, usually to change the type of exposures or interest payments.

Key Term: notional principal
The reference amount on which swap interest payments are calculated; it is generally not exchanged for interest rate swaps.

Interest rate swaps

An interest rate swap exchanges fixed-rate and floating-rate interest payments, typically to manage exposure to interest rate changes. One party agrees to pay a fixed rate and receive a floating rate (often referenced to LIBOR or another benchmark), while the other party does the opposite.

Key Term: interest rate swap
A swap in which one party pays fixed interest and receives floating interest, and the other party pays floating and receives fixed, calculated on a notional principal.

Key points for Level 1:

• On plain‑vanilla interest rate swaps, the notional is not exchanged; only net interest differences are paid each period.
• At initiation, the fixed rate is chosen so that the present value of fixed‑leg payments equals the expected value of floating‑leg payments; the swap has zero value to both parties.
• After initiation, if interest rates fall, the fixed‑rate payer is worse off (paying “too much” relative to market), and the fixed‑rate receiver’s position gains value, and vice versa when rates rise.

Swaps can be used to convert an existing liability or asset:

• A company with fixed‑rate debt can swap into floating payments (pay floating, receive fixed).
• A company with floating‑rate debt can swap into fixed (pay fixed, receive floating) to lock in funding cost.

Worked Example 1.1

A manufacturing firm has issued $10 million in fixed-rate debt but expects interest rates to drop, making floating-rate debt cheaper. How can a swap be used to reduce expected financing costs?

Answer:
The firm can enter into an interest rate swap to pay floating and receive fixed rates. This changes its net cash flows to resemble floating-rate debt, allowing it to benefit if interest rates drop. Economically, the firm is still legally obliged on the original fixed-rate bond, but the received fixed payments from the swap offset most of those fixed interest payments, leaving a net floating-rate obligation.

Currency swaps

A currency swap allows two parties to exchange principal and interest payments in different currencies, thereby managing currency risk on loans or investments.

Key Term: currency swap
A swap in which counterparties exchange principal amounts in different currencies at initiation, make periodic interest payments in those currencies, and usually re‑exchange principals at maturity.

Typical structure:

• At initiation, principals in two currencies are exchanged at the prevailing spot exchange rate.
• Throughout the life of the swap, each party pays interest in one currency and receives interest in the other currency (either fixed or floating).
• At maturity, the principals are usually re‑exchanged, undoing the initial exchange.

Applications:

• A firm that borrows in its home currency but needs funding in a foreign currency can use a currency swap to synthetically “convert” the loan.
• An investor holding a foreign-currency bond can use a currency swap to convert the principal and coupon flows into domestic currency, reducing foreign exchange risk.

Worked Example 1.2

A US company needs €20 million for five years to finance a European project but can borrow more cheaply in US dollars than in euros. How could a currency swap help?

Answer:
The company can issue USD debt at its lower domestic borrowing rate and simultaneously enter a currency swap. Under the swap, it exchanges the USD principal for €20 million at initiation, pays euro interest to the swap counterparty, and receives USD interest. At maturity, the principals are swapped back. Overall, the firm effectively has a euro liability (matching project cash flows) while still taking advantage of its lower USD borrowing cost.

Swaps are customized, over-the-counter (OTC) contracts. They do not eliminate all market risk; rather, they transform it into a different form (for example, from fixed interest payments to floating) or shift it to another currency. They also introduce counterparty credit risk: the risk that the other party may default on swap payments.

Futures: Standardized Hedging Tools

Futures are standardized contracts traded on exchanges obligating the buyer to purchase, or the seller to deliver, a specified asset at a predetermined price on a future date. Futures are most often used to lock in prices for commodities, bonds, currencies, and stock indices.

Key Term: futures contract
A standardized, exchange-traded contract that obligates the buyer to purchase and the seller to deliver a specific asset at a set price on a set date.

Because they trade on organized exchanges and are cleared through a clearinghouse, futures have several important features for risk management.

Key Term: futures price
The agreed price in a futures contract for future purchase or sale of the reference asset; it is set so that the contract’s value is approximately zero at initiation.

Key Term: margin
A performance bond (good-faith deposit) that both long and short futures traders must post with the clearinghouse to cover potential losses.

Key Term: initial margin
The amount that must be deposited when a futures position is opened.

Key Term: maintenance margin
The minimum margin account balance that must be maintained; if the account falls below this level, the trader faces a margin call.

Key Term: marking-to-market
The daily process of adjusting a futures margin account for gains or losses based on that day’s price change in the futures contract.

Key exchange‑traded features:

• Standardized contract size, maturity dates, and tick size.
• Daily marking-to-market: gains are credited and losses debited daily.
• If the margin balance falls below the maintenance margin, the investor must deposit additional funds (variation margin).
• Central clearing greatly reduces counterparty risk relative to OTC forwards and swaps.

Pricing link: futures, spot, and the risk‑free rate

For a reference asset with no additional costs or benefits of holding, the theoretical no‑arbitrage futures price is linked to the current spot price and the risk‑free rate:

where:

• $S_0$ = current spot price
• $r$ = risk‑free rate for maturity $T$
• $T$ = time to maturity in years
• $f_0(T)$ = theoretical futures price for delivery at time $T$

If the risk‑free rate is positive, this implies a futures price above the spot price. If interest rates are very low or even negative, the futures price can be close to or even below the spot price.

In practice, many reference assets pay income (dividends, coupons) or involve storage and other costs. These are captured through the cost of carry.

Key Term: cost of carry
The net effect of financing costs, storage and other costs, and income or benefits from holding the reference asset over the life of a futures or forward contract.

For the exam, you should understand qualitatively:

• Higher financing or storage costs tend to increase futures prices relative to spot.
• Higher income or benefits from holding the reference asset tend to reduce futures prices relative to spot.

Using futures to hedge

Futures provide an efficient way to hedge against adverse price movements. For example:

• A commodity producer can lock in a minimum selling price by shorting futures.
• A bondholder can hedge against rising interest rates (falling bond prices) by shorting bond futures.
• An index fund can temporarily reduce equity market exposure by shorting stock index futures.

Key Term: short hedge
A hedge that involves selling (shorting) futures to protect against a price decrease in an asset you currently own or will own.

Key Term: long hedge
A hedge that involves buying (going long) futures to protect against a price increase in an asset you plan to buy in the future.

Key Term: basis risk
The risk that arises when the change in the value of a hedge is not perfectly offset by the change in the value of the hedged asset, often because the reference asset for the hedge does not perfectly match the exposure.

Basis risk arises because:

• The futures contract may be on a related but not identical asset (cross‑hedge).
• Hedge and exposure may mature at different times.
• The relationship between spot and futures (the basis) can change unexpectedly.

Worked Example 1.3

A pension fund holds $5 million of government bonds but fears that bond prices will fall due to rising rates. How can the fund hedge this exposure with futures?

Answer:
The fund can sell government bond futures. If bond prices fall, the futures price will also fall. As a short futures holder, the fund will record a gain (it can buy back the futures at a lower price), which offsets the loss on its bond holdings. If interest rates instead fall and bond prices rise, the hedge will lose money on the futures, offsetting the gain on the bonds. The hedge therefore trades away some upside to reduce downside risk.

Worked Example 1.4

An equity portfolio is worth £20 million and tracks a stock index currently at 5,000. Each futures contract on the index has a contract size of £10 times the index level. The manager wants to fully hedge market risk for the next three months. Approximately how many index futures should be sold?

Answer:
Each futures contract has a notional value of
$£10 \times 5{,}000 = £50{,}000.$

The number of contracts needed is approximately:
$£20{,}000{,}000 / £50{,}000 = 400$ contracts (short).

By shorting around 400 index futures, the manager offsets broad market movements over the hedge horizon, leaving primarily stock‑specific (idiosyncratic) risk.

Exam warning

On the exam, do not assume futures hedging gives a perfect offset. Remember that basis risk, contract maturity differences, and mismatched contract sizes can leave part of the exposure unhedged.

Options: Flexibility in Hedging

Options provide the right, but not the obligation, to buy (call) or sell (put) an asset at a pre-agreed price before or at expiration. Options can hedge downside risk while allowing participation in upside potential, but require an up-front premium.

Key Term: option
A contract giving the holder the right, but not the obligation, to buy (call) or sell (put) an asset at a specified price within a specified period.

Key Term: call option
An option that gives the holder the right to buy the reference asset at the strike price.

Key Term: put option
An option that gives the holder the right to sell the reference asset at the strike price.

Key Term: strike price
The price at which the holder of an option can buy (call) or sell (put) the reference asset if the option is exercised.

Options hedges are asymmetric: they protect against losses beyond a certain price (the strike) but leave gains unlimited after paying the premium.

Key Term: option premium
The price paid by the buyer of an option for the protection the option provides, regardless of whether the option is eventually exercised.

At expiration:

• A long call is valuable if the asset price is above the strike; payoff = max(0, $S_T - K$).
• A long put is valuable if the asset price is below the strike; payoff = max(0, $K - S_T$).

Options are especially useful when the hedger wants insurance against adverse moves but also wants the ability to benefit from favorable moves in the reference asset.

Common hedging structures

Key Term: protective put
A strategy in which an investor holds the asset and buys a put option on that asset to limit downside risk.

Key Term: covered call
A strategy in which an investor holds the asset and sells a call option on that asset, generating premium income in exchange for giving up some upside.

Key Term: collar
A strategy that combines a protective put with a written call (on the same asset and horizon), creating a band within which the investor’s effective price will lie.

Protective put:

• Used when you own an asset but want a floor on its value.
• You pay a premium for the put; if the asset price falls below the strike, losses are limited.

Covered call:

• Used when you own an asset and are willing to sell it if the price rises above a certain level.
• You receive premium income, which offers limited downside buffer, but you cap upside above the strike.

Collar:

• Buy a put with a lower strike and sell a call with a higher strike.
• Option premiums may partially offset; the resulting hedge can be lower cost than a pure protective put, but both downside and upside are limited.

Worked Example 1.5

An investor holds 1,000 shares of a stock currently trading at $50 and wants to limit potential losses over the next six months but still participate in upside. The investor buys 1,000 six‑month put options with a strike of $45. How does this hedge work at expiration?

Answer:
The investor has created a protective put:

• If the stock is at or above $45 at expiration, the put expires worthless. The investor keeps the shares and any price appreciation above $50 (less the put premium paid).
• If the stock falls below $45, the investor exercises the put and can sell the shares for $45 each, limiting the loss (excluding the premium) to $5 per share.

The hedge therefore sets an approximate floor of $45 per share while leaving unlimited upside, at the cost of the option premium.

Worked Example 1.6

A US exporter anticipates receiving €2 million in three months. The manager wants to protect against euro depreciation but retain upside if the euro strengthens. What hedging instrument should be recommended, and why?

Answer:
The manager should buy a euro put option (or equivalently, a USD call option on the EUR/USD rate), paying a premium to insure against the euro falling below the strike price.

• If the euro depreciates, the put finishes in the money, and exercising the put ensures that the dollar value of the euro receipts does not fall below the protected level.
• If the euro appreciates, the exporter lets the put expire and converts at the favorable spot rate.

Compared with a forward or futures hedge, this options hedge preserves upside while providing a floor on the USD value of the future euro inflow.

Hedging Strategy Comparison

Some additional exam‑relevant contrasts:

• Swaps and forwards are OTC; futures and most options are exchange‑traded.
• Futures and options involve daily margining; most swaps do not (although collateral is common in practice).
• Futures hedges remove most upside and downside linked to the asset price; options hedges keep upside at the cost of a premium.
• All derivatives are subject to basis risk if the reference asset for the contract does not perfectly match the exposure being hedged.

Common CFA Level 1 pitfalls

• Confusing the direction of the hedge:
  • Long asset exposure → usually short futures or buy puts.
  • Short asset exposure (future purchase obligation) → usually long futures or buy calls.
• Forgetting that at initiation, the value of a forward, futures, or swap is approximately zero.
• Ignoring basis risk: a “perfect hedge” is rare; hedges often leave residual risk.
• Mixing up payoff signs for long vs short option positions.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the purpose and structuring of swaps, futures, and options
• Describe swaps for managing interest rate and currency risk
• Recognize that swaps, forwards, and futures have approximately zero value at initiation and are priced using spot, risk‑free rates, and cost‑of‑carry logic
• Summarize use of futures for hedging price or market exposures and interpret the role of margin and marking‑to‑market
• Discuss options as insurance-type hedges, factoring in premium cost and asymmetric payoffs
• Compare advantages, limits, and residual risks of swaps, futures, and options in hedging applications
• Identify and explain basis risk, long and short hedges, and common exam pitfalls in derivatives risk management questions

Key Terms and Concepts

• derivative
• forward contract
• hedging
• swap
• notional principal
• interest rate swap
• currency swap
• futures contract
• futures price
• margin
• initial margin
• maintenance margin
• marking-to-market
• cost of carry
• short hedge
• long hedge
• basis risk
• option
• call option
• put option
• strike price
• option premium
• protective put
• covered call
• collar