Question

How can futures be used to manage interest rate risk in a fixed income portfolio? How can futures be used to manage beta in an equity portfolio? Explain the mechanics of a fixed-floating swap, describing the rationale for each participant.

Answer 1

1]

If interest rates rise, bond prices fall. Therfore, if interest rates rise, the value of a fixed income portfolio would fall.

Bond futures have bonds as the underlying. Thus, if interest rates rise, bond futures would fall in value.

Therefore, to hedge a fixed income portfolio against interest rate risk, bond futures can be sold. The fall in value of the fixed income portfolio would be offset by the gains on the bond futures, thus hedging interest rate risk

2]

Futures can be bought or sold to modify the beta of an equity portfolio.

Usually, the portfolio beta is different from the futures beta.

To increase portfolio beta, futures contracts should be bought, and to decrease portfolio beta, futures contracts should be sold.

The number of futures contracts to buy or sell = ((target beta - portfolio beta) / futures beta) * (portfolio value / (futures price * contract multiplier))

3]

In a fixed-floating swap, the fixed rate payer pays a fixed interest rate on the notional amount, and the floating rate payer pays a floating rate, based on some reference rate.

A fixed rate payer may enter into a fixed-floating swap to convert their floating rate obligation into a fixed rate obligation. This could be the case if they believe that interest rates may rise in the future.

A floating rate payer may enter into a fixed-floating swap to convert their fixed rate obligation into a floating rate obligation. This could be the case if they believe that interest rates may fall in the future.