FINM7405 Chap.6 Forwards, Futures and Swaps
Forwards, Futures and Swaps
Derivative hedging begins with replication and direction. A forward delivery price follows from spot and carry rather than a forecast of the terminal asset price. Futures standardise the exposure and settle gains and losses daily through margin, which changes liquidity needs even when the terminal economics resemble a forward. Treasury futures adjust portfolio duration through contract dollar duration.
Interest rate swaps exchange fixed and floating cash flows, can be valued as two bonds, and provide positive or negative duration without trading the underlying portfolio.
Cash-and-carry reasoning links spot, financing, income, storage cost and convenience yield. If a quoted forward violates that relationship, a buy-sell-repay sequence can lock in the difference without predicting terminal spot.
Futures preserve a similar economic exposure but mark the contract to market every day. Variation margin can therefore create a funding demand before the physical exposure produces its offsetting cash flow.
Duration hedging applies the same replication logic to rates. Treasury futures add or remove contract dollar duration, subject to deliverable-basket and basis effects.
A pay-fixed swap is economically a floating-rate bond position minus a fixed-rate bond, giving negative duration that can offset a long bond portfolio. Swaps offer custom horizon and notional but add collateral, counterparty and curve risks. Instrument choice follows the driver and operational constraints.
What this chapter covers
- 01
Forward contracts and carry pricing
- 02
Futures margin and daily settlement
- 03
Commodity and basis hedging
- 04
Treasury futures and duration targeting
- 05
Swap valuation and swap duration
Worked example · free
Reducing duration with Treasury futures
This five-point weighting structures the hedge calculation and is not an official university mark allocation.
- +1Compute the duration gap: 5.0 minus 8.2 equals -3.2.
- +1Multiply by portfolio value to obtain -$160 million years-dollars.
- +1One contract supplies $1,428,250 years-dollars.
- +1Divide to obtain approximately -112 contracts.
- +1Sell 112 contracts and record basis and rounding risk.
Key terms
- Forward Price
- The delivery price that gives a forward contract zero value when it begins.
- Variation Margin
- The daily cash settlement of gains and losses on a futures position.
- Basis Risk
- The residual exposure when the futures contract and hedged item do not move identically.
- Pay-Fixed Swap
- A swap position that pays fixed and receives floating, normally contributing negative duration.
Forwards, Futures and Swaps FAQ
Why is forward price not a forecast?
The no-arbitrage forward price comes from spot, financing and any income, storage cost or convenience yield. It is the price that prevents cash-and-carry arbitrage, not a claim about the most likely terminal spot.
How can a successful futures hedge create liquidity risk?
Futures gains and losses settle daily. A hedge can be economically sound at the final date but require adverse variation margin before the offsetting physical cash flow arrives. The firm therefore needs a funding buffer.
Why does pay-fixed reduce duration?
The pay-fixed position is equivalent to owning a short-duration floating-rate bond and shorting a longer-duration fixed-rate bond. The resulting swap duration is negative, so it offsets positive duration in a long bond portfolio.
Exam move
Derive every hedge direction from the underlying cash exposure. A future buyer hurt by a price rise needs a long hedge; a future seller hurt by a fall needs a short hedge. Recompute forward price from spot and carry, then write the complete cash-and-carry trade when a quote is wrong. For futures, calculate the contract count and add basis, timing and variation-margin analysis so the hedge includes its liquidity path.
For duration futures, rebuild the portfolio dollar duration after rounding the contract count. For swaps, value the floating and fixed bond legs separately, connect a rate rise to pay-fixed value, and verify target duration after the notional calculation. Compare futures and swaps by horizon, standardisation, daily cash flow, collateral and counterparty structure.
Finish by naming the residual mismatch between derivative and underlying rather than assuming matched notional means matched risk. Draw the physical cash exposure on a timeline before adding the derivative. Mark the date, amount and state that causes loss; the required long or short direction then follows without a memorised slogan.
For forward pricing, list every carry component with its sign—financing cost, income, storage and convenience yield—and verify the quoted price by writing both sides of the cash-and-carry transaction. For futures hedges, distinguish quantity matching from value or duration matching and show how contract rounding changes the residual.
Add a basis scenario at hedge close, because convergence at contract delivery does not guarantee a perfect offset at an earlier date or for a different grade. Track variation margin through at least one adverse interim move to separate final hedge performance from liquidity pressure. For swaps, identify the fixed and floating legs, valuation date and next reset before using bond equivalence.
Recalculate the combined portfolio dollar duration after the proposed notional and test a non-parallel curve move. Compare bilateral and centrally cleared arrangements in terms of collateral and counterparty exposure. Finish with a brief hedge-performance test that attributes any shortfall to basis, timing, quantity, curve or credit mismatch.
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