Learning Outcomes
After reading this article, you will be able to explain how futures and options overlays are used in portfolio risk management for the CFA Level 3 exam. You will distinguish between futures and options overlays, describe their risk management applications, implement calculation methods for hedging and tactical adjustments, and recognize the key risks involved. This knowledge is essential for effective exam preparation.
CFA Level 3 Syllabus
For CFA Level 3, you are required to understand the application of derivatives, specifically futures and options overlays, in the context of portfolio risk management. Your revision should focus on the ability to:
- Describe how futures contracts are used to manage or alter portfolio exposures
- Explain how options overlays are constructed to control portfolio risk
- Calculate and interpret the number of contracts needed for hedging and tactical overlays
- Evaluate the risks and limitations associated with derivative overlays, including basis risk and transaction costs
- Compare derivatives overlays with alternative risk management techniques
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What is a futures overlay and how can it be used to adjust portfolio risk?
- Explain how an options collar can function as an overlay to limit both downside risk and upside potential.
- How is the number of futures contracts determined for hedging a $20 million equity portfolio using an index future?
- What is “basis risk” and why does it matter in managing a futures overlay?
Introduction
Derivative overlays using futures and options are essential portfolio management tools for risk and tactical exposure control at CFA Level 3. You are expected to identify situations where overlays are appropriate, perform calculations, and analyse key risks. Overlays enable managers to adjust or hedge systematic exposures efficiently—often to implement temporary tactical views, rebalance, or manage risk without disturbing existing portfolio holdings.
Key Term: derivatives overlay
The use of exchange-traded or OTC derivative contracts, such as futures or options, layered on top of a physical asset portfolio to modify or hedge the portfolio’s risk or exposures.
FUTURES OVERLAYS
A futures overlay allows quick, efficient changes to a portfolio’s asset allocation or risk profile. This is accomplished by adding or reducing notional exposure using liquid exchange-traded futures contracts tied to market indexes or interest rates.
Key Term: futures overlay
The process of buying or selling futures contracts to increase or decrease portfolio exposure to a specific market or risk factor without trading the actual securities.
Typical Uses
- Equity exposure adjustment: Increase or decrease equity beta swiftly without trading the cash equities.
- Tactical asset allocation: Temporarily tilt exposure to asset classes or regions.
- Implementing rebalancing: Return to policy targets efficiently.
- Temporary cash equitization: Maintain market exposure while holding cash.
Worked Example 1.1
A manager wants to add $10 million equity exposure for 10 days using S&P 500 futures while a cash inflow settles. Each S&P 500 future contract is valued at $200,000. How many contracts should the manager buy?
Answer:
$10,000,000 / $200,000 = 50 contracts. The manager should go long 50 S&P 500 futures contracts to replicate the required exposure until receiving the cash.
Calculating Hedge Ratios
The standard formula for the number of contracts required to overlay (or remove) risk exposure is:
For risk factor overlays (e.g., reducing portfolio beta), adjust for beta and the basis of the futures contract index relative to the actual holdings.
OPTIONS OVERLAYS
Options overlays use listed or OTC options—often calls, puts, or combinations such as collars—to cap losses or adjust payoff profiles without selling portfolio positions.
Key Term: options overlay
The use of exchange-traded or OTC options, such as calls, puts, or collars, applied to a portfolio to manage or limit portfolio risk at predetermined price levels.
Typical Uses (Options)
- Downside risk protection: Purchase puts or implement collars to limit losses below a threshold.
- Return capping: Sell calls to partially fund puts, thus creating a cost-effective risk-reward corridor.
- Enhancing income: Sell covered call options to generate options premium from existing holdings.
Worked Example 1.2
An equity fund trades at $50 per share. The manager buys a 6-month $48 put for $1.50 and sells a 6-month $54 call for $1.50. What is the effect of this collar overlay?
Answer:
The zero-cost collar limits downside loss to $48/share and caps upside gain at $54/share for the cost of $0. The investor is protected below $48 and participates in gains up to $54.
Overlay Construction Steps
- Determine exposure to protect or modify.
- Select option types and strikes: Based on risk tolerance and strategy.
- Evaluate cost: Balance premium paid for protection with any call premium received.
Worked Example 1.3
A portfolio worth $2 million is to be fully protected from losses below 95% of current value for the next quarter. The fund manager buys at-the-money put options on an index with a delta of 1. How many puts (contract size $100,000) are needed?
Answer:
$2,000,000 / $100,000 = 20 contracts, enough to cover full portfolio value.
KEY PRACTICAL CONSIDERATIONS
Maintaining precise exposure with derivatives overlays is subject to:
- Basis risk: Potential differences between futures and cash asset performance cause imperfect hedges.
- Contract expiry and roll: Overlays may require rolling contracts to maintain continuous coverage.
- Liquidity and transactions costs: Particularly relevant for large overlay positions or less liquid contracts.
Key Term: basis risk
The risk that changes in the price of a derivative (e.g., futures contract) will not perfectly offset changes in the value of the hedged portfolio, leading to residual gain or loss.
RISK AND LIMITATIONS
- Imperfect hedges: Matching index, beta, and contract features is essential but not always possible for custom portfolios.
- Gearing effects: Derivatives introduce gearing, which can magnify both returns and losses if not closely monitored.
- Counterparty/credit risk: Particularly relevant for OTC options and swaps; less urgent for exchange-traded contracts.
Exam Warning
Many candidates incorrectly assume that a futures or options overlay completely eliminates risk. In practice, overlays are subject to basis risk, gap risk, early exercise (for some options), and expiration mismatch. Always address these elements in exam responses.
Summary
Derivative overlays using futures and options are key tools in risk management. By overlaying positions, managers can adjust risk exposures rapidly, control drawdowns, or implement tactical views without physically buying or selling all holdings. However, overlays carry limitations such as basis risk, imperfect hedges, and additional operational complexity. For the CFA exam, ensure you can explain the purpose, mechanics, and risks of both futures and options overlays in concise, calculation-focused answers.
Key Point Checklist
This article has covered the following key knowledge points:
- Understand objectives and methods of futures and options overlays in portfolio risk management
- Calculate required futures or options contracts to adjust exposure or achieve hedges
- Identify and explain typical uses of overlays—tactical asset allocation, cash equitization, risk reduction
- Evaluate main risks—basis risk, transaction cost, contract expiry, gearing effects—and how these impact overlay effectiveness
- Compare overlays with outright buying, selling, or physical rebalancing approaches
Key Terms and Concepts
- derivatives overlay
- futures overlay
- options overlay
- basis risk