Title LM2 Swaps, Forwards, and Futures Strategies IFT Notes.pdf ✅

LM2 Swaps, Forwards, and Futures Strategies 2024 Level III Notes © IFT. All rights reserved 1 LM2 Swaps, Forwards, and Futures Strategies 1. Managing Interest Rate Risk with Swaps ................................................................................................3 Changing Risk Exposures with Swaps, Futures, and Forwards.....................................................3 2. Managing Interest Rate Risk with Forwards and Futures................................................................8 Fixed-Income Futures....................................................................................................................................9 3. Managing Currency Exposure...................................................................................................................14 Currency Swaps.............................................................................................................................................14 Currency Forwards and Futures.............................................................................................................17 4. Managing Equity Risk ..................................................................................................................................18 Equity Swaps ..................................................................................................................................................18 Equity Forwards and Futures ..................................................................................................................20 Cash Equitization..........................................................................................................................................22 5. Volatility Derivatives: Futures and Options ........................................................................................22 Volatility Futures and Options.................................................................................................................22 6. Volatility Derivatives: Variance Swaps .................................................................................................24 7. Using Derivatives in Asset Allocation....................................................................................................26 Cash Equitization..........................................................................................................................................26 8. Using Derivatives in Asset Allocation ....................................................................................................27 Changing Allocations between Asset Classes Using Futures .......................................................27 Rebalancing an Asset Allocation Using Futures................................................................................30 Changing Allocations between Asset Classes Using Swaps..........................................................31 9. Using Derivatives to Infer Market Expectations................................................................................33 Summary................................................................................................................................................................35 This document should be read in conjunction with the corresponding reading in the 2024 Level III CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute.
LM2 Swaps, Forwards, and Futures Strategies 2024 Level III Notes © IFT. All rights reserved 2 Version 1.0
LM2 Swaps, Forwards, and Futures Strategies 2024 Level III Notes © IFT. All rights reserved 3 1. Managing Interest Rate Risk with Swaps This reading covers how swaps, forwards, futures, and volatility derivatives can be used to modify risk exposures, hedge investment positions, take directional bets and infer current market expectations. Sections 2-4 of this reading show how swaps, futures, and forwards can be used to increase or decrease the risk exposure of an existing position. Sections 5 and 6 cover derivatives on volatility. Sections 7-9 demonstrate the applications of derivatives in portfolio management. The following table from the curriculum shows common uses of derivatives in portfolio management and the types of derivatives typically used. Common Uses of Swaps, Forwards, and Futures Typical Derivatives Used Modifying Portfolio Returns and Risk Exposures (Hedging and Directional Bets) Interest Rate, Currency, and Equity Swaps and Futures; Fixed-Income Futures; Variance Swaps Creating Desired Payoffs Forwards, Futures, Total Return Swaps Performing Asset Allocation and Portfolio Rebalancing Equity Index Futures, Government Bond Futures, Index Swaps Inferring Market Expectations for Interest Rates, Inflation, and Volatility Fed Funds Futures, Inflation Swaps, VIX Futures Changing Risk Exposures with Swaps, Futures, and Forwards To manage the risk exposures of portfolios, financial managers use various derivative instruments. Managing Interest Rate Risk Interest Rate Swaps Interest rate swaps are OTC contracts between two parties that can be customized as required. An interest rate swap is an agreement between two parties to exchange cash flows on specified dates. • Party A agrees to pay a fixed payment and receive a floating payment, from counter- party B. • Party A pays a fixed rate (the swap rate), and Party B pays a floating rate based on a reference rate (say Libor), both determined at initiation. • The payments are calculated on an agreed notional principal amount. • The parties agree on a swap tenor that specifies time to expire. • The payments are typically netted – the party owing the greater amount pays the difference to the other party.