Trustner AcademyTrustner AcademyCourses
Reading 1CFA L3 DerivFull chapter

Derivatives in portfolio management

In this chapter: Beta hedge using equity index futures · Duration hedge using bond futures · Currency overlay (forwards, options) · Options collars and protective puts

~3 min readLayer 4 · Professional CertificationsFree

Portfolio managers use derivatives to fine-tune exposures without trading underlying. CFA L3 tests choosing the right derivative + sizing the hedge.

Foundation

**Beta hedge**: Number of equity futures = (β_target – β_p) × V_p / (β_f × multiplier × F) Usually β_f ≈ 1 for major index futures. **Duration hedge**: Number of bond futures = (D_target – D_p) × V_p / (D_f × F × CF) Where CF = conversion factor for cheapest-to-deliver. **Currency hedge**: Notional = foreign-asset value × hedge ratio. Hedge ratio = β_FX × σ_FX × asset-FX correlation. Often 50-100%. Forward vs options: forwards lock rate (no upside on FX gain); options premium-cost but preserve upside.

Deep Dive

**Protective put**: - Long stock + long put. - Limits downside; preserves upside. - Cost: option premium. - Net P&L: max(S – K, 0) – Premium for ITM strikes; for OTM: max(0, S – S0) – Premium. **Covered call**: - Long stock + short call. - Earns premium; gives up upside above K. - Net P&L: min(S, K) – S0 + Premium. **Collar (put + call)**: - Long stock + long put + short call. - Caps both downside (put) and upside (call). - Premium can be funded by short call. **Straddle**: - Long call + long put at same strike. - Profits from large move either direction. - Volatility play; expensive in high IV environment.

Advanced

L3 essay: "Manager has 100m USD India equity portfolio. Concerned about INR depreciation 6 months ahead. Recommend hedge." Framework: 1. Determine exposure: full or partial hedge? 2. Instrument: forward (cheap, locks), option (premium-cost, preserves upside), futures (mark-to-market), swap. 3. Tenor: match to investment horizon. 4. Counterparty + credit considerations. 5. Cost-benefit: hedge cost vs expected protection benefit. For 6-month INR exposure: NDF forwards or options. Listed currency futures on NSE/MCX. Choice depends on size + counterparty.

Regulatory references
  • SEBI Derivatives Framework
  • RBI Hedging Guidelines
  • CFA Institute Derivatives curriculum
Common mistakes & pitfalls
  • Forgetting basis risk — hedge instrument may not perfectly track underlying.
  • Over-hedging (cost > benefit).
  • Ignoring rolling cost in long-term hedges using short-dated futures.

Frequently asked

When to use options vs forwards for FX hedge?
Forwards: lock rate cheaply; no upside if FX moves favorably. Options: preserve upside but pay premium. Use options when expecting potential favourable move.
How precise can beta hedge be?
Within margin of error. Beta estimates change; futures basis fluctuates. Re-balance periodically. Overall reduction of 60-80% of beta exposure typical.

Practice questions

Click each question to reveal the answer and explanation.

Q 1
To reduce portfolio beta from 1.2 to 0.8, manager should:
  1. (a)Buy index futures
  2. (b)Short index futures
  3. (c)Buy puts only
  4. (d)Increase cash
Correct: (b) Short index futures
Short futures to reduce beta. Long futures increase beta.
Q 2
Protective put position:
  1. (a)Long stock + short put
  2. (b)Long stock + long put
  3. (c)Short stock + long put
  4. (d)Long call + short put
Correct: (b) Long stock + long put
Protective put = long stock + long put (insurance).
Q 3
Covered call gives up:
  1. (a)Downside protection
  2. (b)Premium
  3. (c)Upside above strike
  4. (d)Nothing
Correct: (c) Upside above strike
Covered call: keep premium, but call away if stock rises above K.
Q 4
Collar consists of:
  1. (a)Two calls
  2. (b)Long put + short call (with stock)
  3. (c)Two puts
  4. (d)Long stock only
Correct: (b) Long put + short call (with stock)
Collar: long stock + long put (downside protection) + short call (financing).
Q 5
Currency forward at premium suggests:
  1. (a)Foreign rate higher
  2. (b)Domestic rate higher
  3. (c)No difference
  4. (d)Inflation lower
Correct: (b) Domestic rate higher
High-yield (DC) currency at forward discount (FC at premium). CIP.
Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.