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CFA® Level III · Derivatives and Risk Management · free lesson
Swaps, Forwards, and Futures Strategies
Swaps, forwards and futures let a manager change interest rate, currency, equity and volatility exposures in minutes, without trading the underlying securities or disturbing the managers who hold them. This module sizes each overlay with basis point values, betas and notionals, shows how variance swaps and VIX futures express volatility views, and reads market expectations from derivative prices, so you can recommend and calculate the right overlay for a Level III case.
What you will learn
1. Calculate the swap notional or number of bond futures needed to move a portfolio's duration to a target, and explain the risks of these overlays.
- BPV = modified duration x value x 0.0001; size every overlay on the BPV gap (target minus current).
- Receive-fixed swaps and long bond futures add duration; pay-fixed swaps and short futures remove it.
- Swap BPV per 100 notional is (fixed-leg duration minus floating-leg duration) x 0.01; a floating leg's duration is about half its reset period.
- Bond futures contracts = BPV gap / BPV of the CTD x conversion factor.
- BPV hedges cover parallel moves only; curve, spread and CTD basis risk remain, and leverage brings collateral calls.
2. Use currency forwards, futures and swaps to hedge foreign exchange exposure and to convert borrowing or investments from one currency into another.
- Covered interest parity: the forward premium or discount reflects the interest differential; the higher-rate currency trades at a forward discount.
- Hedge a foreign asset by selling its currency forward; hedge a foreign payable by buying it forward.
- Currency futures contracts = exposure in the contract's currency / contract size; they are margined daily.
- A currency swap exchanges principal at the start and maturity plus interest in between; the party receiving a currency at the start pays interest in it.
- FX swaps (spot plus offsetting forward) roll hedges and fund in other currencies; the cross-currency basis can widen in stress.
3. Calculate the number of equity futures needed to change a portfolio's beta or to equitize cash, and use equity swaps and forwards to gain or shed equity exposure.
- Contracts to change beta = (target beta - current beta) / futures beta x portfolio value / (futures price x multiplier).
- Target beta of zero creates synthetic cash; buying futures against cash equitizes it.
- To equitize cash, gross the cash up by (1 + r)^T before dividing by the contract value.
- Receiving the total return on an equity swap adds exposure; paying it sheds exposure while keeping the shares.
- Beta instability, tracking error, margin, rolls and counterparty risk mean the achieved exposure only approximates the target.
4. Use VIX futures, VIX options and variance swaps to express or hedge a view on volatility, and calculate variance swap payoffs and values.
- VIX futures price the expected VIX at expiry and converge to spot VIX; they do not track spot one-for-one.
- Contango is normal in calm markets, so long VIX futures lose roll yield; backwardation appears in sell-offs.
- Variance notional = vega notional / (2K); payoff = variance notional x (realized vol squared - strike squared).
- Variance swaps are convex: gains from a volatility rise exceed losses from an equal fall.
- Mark-to-market blends realized variance to date and implied variance for the remaining time, then discounts.
5. Use futures and swaps to rebalance or tactically shift an asset allocation, and infer market expectations for policy rates, inflation and volatility from derivative prices.
- A futures overlay shifts allocation in two legs: sell equity futures (synthetic cash) and buy bond futures sized on BPV, or the reverse.
- Overlays are fast, cheap and leave managers undisturbed, but bring basis risk, margin needs, roll costs and must be unwound.
- Fed funds futures: implied rate = 100 - price; probability of a move = (implied - current) / (size of move), using the midpoint of the range.
- Inflation swaps and breakevens reveal inflation expectations plus a risk premium; the VIX and skew reveal expected volatility and crash fear.
- Market-implied expectations are risk-neutral benchmarks, not forecasts; act only where your view differs from what is priced.
Module at a glance
- Size duration overlays on the BPV gap: swap notional = gap / swap BPV x 100; futures = gap / BPV of the CTD x CF.
- Receive-fixed swaps and long bond futures add duration; pay-fixed swaps and short futures remove it.
- Currency forwards follow covered interest parity; currency swaps exchange principal and interest, converting whole funding or investment streams.
- Equity futures change beta: N = (target beta - current beta) / futures beta x S / F; gross cash up by (1 + r)^T to equitize it.
- VIX futures converge to spot VIX and usually roll down in contango; variance swaps pay N_var x (realized^2 - K^2) with N_var = vega / 2K.
- Futures overlays shift allocations quickly and cheaply but bring basis, margin and roll risks.
- Fed funds futures imply policy probabilities: (implied rate - current midpoint) / size of the move.
This free module has 5 lessons, 18 practice questions with full explanations and 1 essay case with a model answer.