Derivatives for portfolio risk management - Swaps collars an...

Learning Outcomes

After reading this article, you will be able to identify and explain how derivatives—especially swaps, collars, and protective option strategies—are used to manage portfolio risk. You will understand the structure, mechanics, and key applications of interest rate swaps and equity swaps, describe how to construct basic collar and protective strategies, and evaluate when and why to apply these tools for different portfolio objectives for the CFA Level 3 exam.

CFA Level 3 Syllabus

For CFA Level 3, you are required to understand and apply derivatives-based portfolio risk management with focus on swaps, collars, and related protective strategies. For revision, carefully review the following concepts:

• Explain the rationale and mechanics of using interest rate and equity swaps to manage risk exposure or alter asset class exposure.
• Describe how exchange-traded and OTC derivatives can be structured to protect against adverse price movements or to synthetically rebalance a portfolio.
• Construct and interpret collar strategies combining protective puts and written calls.
• Assess the suitability of swaps and collars for various risk management objectives and portfolio constraints.
• Evaluate payoff profiles, risks, and limitations of derivatives-based risk management solutions.

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.

1. Which derivative instrument is typically used to convert fixed-rate portfolio exposure to floating-rate, or vice versa, without actually selling constituent assets?
2. How does a collar strategy constructed with listed options protect an equity position, and what risk does it leave?
3. Why might a portfolio manager prefer to implement a synthetic protective put using derivatives rather than a direct put purchase?
4. In what circumstances can using swaps or collars introduce new risks to a portfolio rather than reducing them?

Introduction

Derivatives allow portfolio managers to precisely manage risk and return exposures. By incorporating swaps, collars, and protective strategies, managers can either hedge unwanted exposures, create synthetic positions, or construct cost-effective downside protection. This article explains how these techniques work, the key terms involved, and practical CFA exam scenarios you may be tested on.

Key Term: swap
A contractual agreement in which two parties exchange sequences of cash flows, typically to alter risk exposures or synthetically adjust portfolio positions.

Key Term: collar
An options-based strategy that combines buying a protective put and selling a covered call to cap both downside loss and upside gain on a position.

Key Term: protective put
A strategy involving a long position in the asset and a long put option, providing downside insurance while retaining most upside.

Using Swaps in Portfolio Risk Management

Mechanics and Purpose of Swaps

Swaps are OTC contracts where two parties agree to exchange sets of cash flows on specified dates and notional amounts. In most portfolio risk management contexts, the two most common types are interest rate swaps and equity swaps.

Key Term: interest rate swap
An agreement to exchange fixed interest payments for floating rate payments, or vice versa, based on a set notional and schedule.

Key Term: equity swap
A swap in which one party pays the return on an equity index or basket, and the other typically pays a fixed or floating interest payment.

Portfolio managers use swaps to:

• Convert fixed-rate to floating-rate (or vice versa) exposure.
• Alter the asset class exposure synthetically (for example, shifting from equity to fixed income).
• Manage risk without buying or selling the constituent securities.

Worked Example 1.1

A pension fund holds $50 million in 5-year fixed-rate bonds, but expects rates to rise. How can the fund use swaps to reduce interest rate risk?

Answer:
The fund can enter into a pay-fixed, receive-floating interest rate swap with a notional of $50 million and matching maturity. This converts the fixed rate exposure to floating, reducing sensitivity to rising rates, but leaves basis risk if swap and portfolio coupons do not move identically.

Key Risks of Swaps

• Basis risk arises if the swap cash flows do not perfectly offset the risk in the actual portfolio.
• Counterparty risk: OTC swaps depend on the creditworthiness of the counterparty.
• Liquidity risk can arise if it is costly or impossible to unwind the swap before maturity.

Revision Tip

Remember: CFA exam questions often focus on how swaps change the duration of a portfolio or create exposures not otherwise achievable with cash assets.

Collars and Their Role in Risk Management

Collars use listed (or OTC) options to define a band of possible returns, providing targeted risk reduction at low or zero cost.

Construction of a Basic Collar

A collar involves holding the reference asset:

1. Buy a put option at a chosen strike to insure against a drop below that price (protective put).
2. Sell a call option at a higher strike to fund the put by giving up upside above that level.

Result: Downside is limited (by the put), and upside is capped (by the call).

Worked Example 1.2

An investor holds 1,000 shares of XYZ at $60. She buys a $50-strike put for $2 and sells a $70-strike call for $2. What's her payoff profile?

Answer:
For each share:

• Maximum loss = $10 per share if XYZ falls below $50 (protected by long put).
• Maximum gain = $10 per share if XYZ rises above $70 (called away).
• If XYZ between $50 and $70, she participates in price movement minus net premium (zero here).

Key Term: zero-cost collar
A collar constructed so that the premium paid for the protective put equals the premium received for the written call, resulting in no net outlay.

Guidelines for Using Collars

• Collars are especially useful when protection against losses is wanted but upside can be sacrificed.
• Zero-cost collars are popular for hedging company stock or concentrated positions subject to sale restrictions.

Protective Put Strategies

Protective puts are simpler than collars—they provide downside asset protection with most of the upside retained. The downside is the cost of the option premium.

Worked Example 1.3

A manager wishes to hedge a $5m equity portfolio against significant market falls for the next 6 months. The index at 4,000 has 6-month ATM puts priced at 100. How could this be used?

Answer:
The manager could buy enough put options to cover the portfolio value. If the market falls significantly, the put's exercise value will offset portfolio losses below 4,000, less the option premium paid.

Synthesizing Swaps and Options: Creating Synthetic Positions

Portfolio managers can combine swaps and option-based strategies to structure tailored solutions.

• Synthetic equity exposures: Use equity swaps to replace direct asset purchases or avoid market access issues.
• Synthetic downside protection: Construct a protective put using a long asset plus a sold forward (synthetic put), or replicate option payoffs using combinations of swaps and options.

Exam Warning

A common CFA exam error is failing to account for the cash flows and risks of both legs of a derivative strategy—always specify both the gains and foregone benefits (for example, capped upside with collars).

Summary

Swaps, collars, and protective strategies are versatile tools in the portfolio risk management toolkit. Swaps adjust exposures across rates or asset classes without trading constituent assets. Collars and protective puts offer cost-effective methods to manage downside risk. For CFA Level 3, precise understanding and clear calculation of payoffs, risks, and implementation details is essential for exam success.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the structure and risk management purpose of interest rate swaps and equity swaps.
• Construct basic collar strategies and describe their risk/reward profiles.
• Identify advantages, risks, and trade-offs of using swaps and collars versus direct asset or simple option positions.
• Calculate and interpret payoffs for swaps, collars, and protective puts.
• Recognize synthetic risk management applications of combining swaps and options.

Key Terms and Concepts

• swap
• collar
• protective put
• interest rate swap
• equity swap
• zero-cost collar