Swaps, Forwards, and Futures Strategies (2024)

Refresher Reading

This reading on swap, forward, and futures strategies shows a number of ways in which market participants might use these derivatives to enhance returns or to reduce risk to better meet portfolio objectives. Following are the key points.

• Interest rate, currency, and equity swaps, forwards, and futures can be used to modify risk and return by altering the characteristics of the cash flows of an investment portfolio.

• An interest rate swap is an OTC contract in which two parties agree to exchange cash flows on specified dates, one based on a floating interest rate and the other based on a fixed rate (swap rate), determined at swap initiation. Both rates are applied to the swap’s notional value to determine the size of the payments, which are typically netted. Interest rate swaps enable a party with a fixed (floating) risk or obligation to effectively convert it into a floating (fixed) one.

• Investors can use short-dated interest rate futures and forward rate agreements or longer-dated fixed-income (bond) futures contracts to modify their portfolios’ interest rate risk exposure.

• When hedging interest rate risk with bond futures, one must determine the basis point value of the portfolio to be hedged, the target basis point value, and the basis point value of the futures, which itself is determined by the basis point value of the cheapest-to-deliver bond and its conversion factor. The number of bond futures to buy or sell to reach the target basis point value is then determined by the basis point value hedge ratio: $BPVHR=\left(\frac{BP{V}_T-BP{V}_P}{BP{V}_{CTD}}\right)\times CF$.

• Cross-currency basis swaps help parties in the swap to hedge against the risk of exchange rate fluctuations and to achieve better rate outcomes. Firms that need foreign-denominated cash can obtain funding in their local currency (likely at a more favorable rate) and then swap the local currency for the required foreign currency using a cross-currency basis swap.

• Equity risk in a portfolio can be managed using equity swaps and total return swaps. There are three main types of equity swap: (1) receive-equity return, pay-fixed; (2) receive-equity return, pay-floating; and (3) receive-equity return, pay-another equity return. A total return swap is a modified equity swap; it also includes in the performance any dividends paid by the underlying stocks or index during the period until the swap maturity.

• Equity risk in a portfolio can also be managed using equity futures and forwards. Equity futures are standardized, exchange-listed contracts, and when the underlying is a stock index, only cash settlement is available at contract expiration. The number of equity futures contracts to buy or sell is determined by $N_f=\left(\frac{{\beta }_T-{\beta }_S}{{\beta }_f}\right)\left(\frac{S}{F}\right)$.

• Cash equitization is a strategy designed to boost returns by finding ways to “equitize” unintended cash holdings. It is typically done using stock index futures and interest rate futures.

• Derivatives on volatility include VIX futures and options and variance swaps. Importantly, VIX option prices are determined from VIX futures, and both instruments allow an investor to implement a view depending on her expectations about the timing and magnitude of a change in implied volatility.

• In a variance swap, the buyer of the contract will pay the difference between the fixed variance strike specified in the contract and the realized variance (annualized) on the underlying over the period specified and applied to a variance notional. Thus, variance swaps allow directional bets on implied versus realized volatility.

• Derivatives can be used to infer market participants’ current expectations for changes over the short term in inflation (e.g., CPI swaps) and market volatility (e.g., VIX futures). Another common application is using fed funds futures prices to derive the probability of a central bank move in the federal funds rate target at the FOMC’s next meeting.