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

Bond prices and interest rates are inversely related. If interest rates rise, the value of the fixed income portfolio would fall. This can be hedged by short selling interest rate futures. Interest rate futures have bonds as the underlying asset. Hence, if interest rates rise, the value of the futures would fall. As the futures are short sold, the gains on the futures would offset the losses on the fixed income portfolio.

Target beta of a portfolio can be achieved by buying/selling futures instead of actually buying/selling the securities in the portfolio. To increase portfolio beta, futures must be bought and to decrease portfolio beta, futures must be sold. Number of futures to buy/sell = ((target beta - current beta) / futures beta) * (portfolio value / (futures price * futures multiplier))

In a fixed-floating swap, the one party agrees to pay a fixed rate on the notional principal to the other party in exchange for receiving a floating rate on the notional principal from the other party. The rationale is that the fixed-rate payer may have a floating rate obligation which they wish to convert into a fixed rate obligation (which means they expect interest rates to rise in the future) whereas the floating-rate payer may have a fixed rate obligation which they wish to convert into a floating rate obligation (which means they expect interest rates to fall in the future).