Financial futures contracts may be used either to enhance or reduce the risk of a bond portfolio. For instance, a manager who wishes to reduce the interest rate risk of his portfolio may choose to sell futures contracts, rather than selling out his position. Hedging with the futures offers major advantages in terms of reduced transactions costs and enhanced liquidity. But the manager should also consider the potential return from his “synthetic security”—his short futures-long bond position—in comparison with the return available from the alternative—i.e., reinvesting in money market instruments—when making his decision.
In essence, given the proper ratio between the futures contracts sold and the par value of the underlying bonds, changes in the market value of the bonds will be offset by margin calls on or credits to the futures contract. Thus interest rate risk for the period between the sale of the contract and the delivery is eliminated; the return to the synthetic security will roughly approximate the interest income from the bond. This return may be augmented or reduced, however, by changes in the relative pricing of the futures and cash markets. In general, the hedger will end up paying something in exchange for the reduction of his portfolio’s risk.
The purchase of financial futures, on the other hand, can increase portfolio risk and expected return. Futures may be especially useful in the management of an immunized portfolio. Immunization requires matching a bond portfolio’s duration (a measure of its interest rate sensitivity) to the time remaining to the end of a chosen investment horizon. This may present problems if the investment horizon is a fairly long one, since the maximum duration available from standard coupon bonds is limited and, furthermore, declines sharply as the level of interest rates rises; at a 14 per cent interest rate, for example, the duration of a 40-year bond at par is only 7.1 years. Because the purchase of a futures contract is equivalent to buying bonds on leverage, however, adding a long futures position to a long-term bond portfolio will increase the portfolio’s interest rate sensitivity and, by definition, its duration.