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CFA Level II Exam · Measuring and Managing Market Risk

Managing Market Risk and Hedging Strategies

Updated 7 October 2026 · Fact-checked

Managing market risk means changing a portfolio's exposure to price moves. You can diversify, set risk limits, or use derivatives such as futures, forwards, swaps and options to offset exposure. To solve a question, measure the exposure, pick the tool that fits it, size the hedge, and check the residual risk.

Understand Managing Market Risk and Hedging

Market risk is the risk that prices, rates, exchange rates or commodity prices move against you. You cannot remove it for free. You can only reduce it, transfer it, or reshape it into a form you can accept.

There are three broad levers. Diversification spreads money across assets that do not move together, which cuts risk that is specific to one asset. It does not remove broad market risk. Constraints are limits you set: position limits, VaR limits, stop-loss rules, and capital allocated to each desk. They stop risk from growing beyond what the firm can bear. Derivatives let you change exposure quickly and cheaply, without selling the underlying assets.

Within derivatives, the tool depends on the exposure. Use futures or forwards to lock in a price or neutralise equity, rate or currency exposure. Use swaps to convert exposure, for example floating-rate to fixed-rate, or one currency to another. Use options when you want protection against a bad outcome but still want to keep the good one. An option costs a premium. A forward or future costs nothing upfront but gives up the gain.

A hedge is rarely perfect. Basis risk arises when the hedging instrument does not move one-for-one with the exposure. A hedge ratio fixes the size of the position, and you must resize it as exposure changes. Hedging also has costs: premiums, margin and collateral, transaction costs, and counterparty risk on over-the-counter contracts.

To reduce VaR, you cut position size, add negatively correlated or hedging positions, or hedge the dominant risk factor. Check the effect on the whole portfolio, not on one position. Marginal VaR and component VaR tell you which positions drive the total and where a trade helps most.

Key formulas to remember

Futures hedge ratio (minimum variance)
h = ρ × (σ_S ÷ σ_F)
Equal to the slope of spot changes regressed on futures changes. Number of contracts = h × (exposure value ÷ value of one futures contract).
Equity beta adjustment with futures
N = [(β_T − β_S) ÷ β_F] × (S ÷ f)
S is portfolio value, f is the futures contract value, β_T target beta, β_S current beta. Positive N means buy; negative means sell.
Bond duration adjustment with futures
N = (BPV_T − BPV_P) ÷ BPV_F
BPV_T is the target portfolio basis point value. BPV_P is the current portfolio basis point value. BPV_F is the basis point value of the futures contract (for a bond future, based on the cheapest-to-deliver bond, adjusted by the conversion factor). Positive N means buy futures to raise duration; negative means sell to lower it.
Delta hedge
Options needed = − (Position delta ÷ Option delta)
Hedge is only valid for small price moves. Gamma changes delta, so rebalance.
Portfolio risk of two assets
σ_p = √(w₁²σ₁² + w₂²σ₂² + 2w₁w₂ρσ₁σ₂)
Lower correlation ρ lowers σ_p, which is why diversification reduces VaR.
Parametric VaR (normal)
VaR = (z × σ_p − μ_p) × portfolio value
Use z = 1.65 for 95% and 2.33 for 99% one-tailed. With μ_p near zero, cutting σ_p cuts VaR roughly in proportion.

How to solve Managing Market Risk and Hedging questions

Read the vignette for the exposure first, then match tool to exposure. Most questions test whether you pick the right instrument and the right direction.

  1. 1Identify the risk factor: equity index, interest rate, currency, credit or commodity.
  2. 2Identify the direction of exposure: are you long or short, and will loss come from a rise or a fall?
  3. 3Decide the goal: remove risk fully, reduce it, change it to a target level, or keep upside.
  4. 4Choose the tool: futures or forwards for a lock-in, swaps to convert, options for protection with upside, diversification or limits for non-specific risk.
  5. 5Size the hedge using the right ratio: hedge ratio, beta, BPV or delta.
  6. 6Check the sign: sell futures to cut exposure, buy to add exposure.
  7. 7Name the leftover risks: basis risk, premium cost, counterparty risk, rebalancing needs.
  8. 8Re-read the question to confirm what is asked: contracts, VaR change, or the best strategy.

Quickest way: Match exposure to tool, then size

When to use it: Use when an item set gives a short exposure description and asks which hedge is best or how many contracts to trade.

  1. Underline the exposure and the client's goal in the vignette.
  2. If the client wants upside kept, lean to options. If the client wants a fixed outcome at no premium, lean to forwards or futures.
  3. If the goal is a changed target (beta, duration), use the target-minus-current formula and read the sign.
  4. Eliminate any answer with the wrong direction first.
  5. Compute once, round only at the end, and match to the nearest option.

Common mistakes in Managing Market Risk and Hedging

  • Buying futures when the goal is to reduce a long exposure.

    You confuse hedging with adding exposure.

    Fix: A long exposure is hedged by selling futures. Check the sign of the result of (target − current).

  • Claiming diversification removes all market risk.

    You mix up specific risk with systematic risk.

    Fix: Diversification cuts asset-specific risk. Broad market risk remains and needs derivatives or lower exposure.

  • Treating a hedge as perfect.

    The textbook ratio looks exact.

    Fix: Always mention basis risk, rebalancing and counterparty risk when asked about limits of a hedge.

  • Using a delta hedge for large moves and calling it complete.

    You ignore gamma.

    Fix: Delta works for small moves only. Large moves change delta, so you must rebalance.

  • Assuming adding any position lowers VaR.

    You look at the new position alone.

    Fix: VaR depends on correlation with the existing portfolio. Use marginal VaR to see the effect.

  • Ignoring the cost of the option strategy.

    Protection feels free once the payoff is clear.

    Fix: Subtract the premium from the protected outcome and compare with a futures hedge.

Worked examples

Example 1

A fund holds ₹50,00,00,000 of equities with a beta of 1.2 against an index. The manager wants a beta of 0.8 using index futures with a beta of 1.0. One futures contract has a value of ₹25,00,000. How many contracts should the manager trade?

Show the solution
  1. Target beta β_T = 0.8, current beta β_S = 1.2, futures beta β_F = 1.0.
  2. N = [(0.8 − 1.2) ÷ 1.0] × (₹50,00,00,000 ÷ ₹25,00,000).
  3. Portfolio value ÷ contract value = 200.
  4. N = −0.4 × 200 = −80.
  5. The sign is negative, so the manager sells.

Answer: Sell 80 futures contracts.

Example 2

An asset manager holds a long position of 10,000 shares. A call option on the stock has a delta of 0.50. The manager wants to hedge a small price fall by writing calls. (a) How many call options on one share each should be written to be delta neutral? (b) Why must the hedge be adjusted over time?

Show the solution
  1. Position delta = 10,000 × 1 = 10,000.
  2. Options needed = −(10,000 ÷ 0.50) = −20,000.
  3. A negative number means write (sell) 20,000 calls.
  4. Check: 20,000 short calls × 0.50 = −10,000 delta, which offsets +10,000.
  5. The option's delta changes as the share price moves, and gamma measures that change. Delta also drifts with the passage of time and with changes in volatility. So the hedge stops being neutral and must be rebalanced.

Answer: (a) Write 20,000 calls. (b) Delta changes as the share price moves (gamma) and also drifts with time and volatility, so the hedge must be rebalanced.

Exam tips

  • Read the client's goal first. Protection with upside points to options; a locked price points to forwards or futures.
  • Check the sign of your contract result before choosing an answer. Sign errors are the usual trap.
  • When asked about limits of a hedge, list basis risk, cost, counterparty risk and rebalancing.
  • For VaR reduction questions, think about correlation and the biggest risk driver, not just position count.
  • No marks are lost for wrong answers, so never leave a question blank.

Managing Market Risk and Hedging: frequently asked questions

How do I reduce the VaR of a portfolio?

Reduce position sizes, add hedges against the main risk factor, or add assets with low or negative correlation to the portfolio. Marginal VaR shows which positions add the most risk. Always check the effect on the whole portfolio.

When should I use options instead of futures to hedge?

Use options when you want protection against a bad outcome but also want to keep gains, and you accept paying a premium. Use futures or forwards when you want to fix the outcome and avoid upfront cost, giving up the gain.

What is basis risk in hedging?

Basis risk is the risk that the hedge instrument and the hedged exposure do not move together exactly. It leaves some residual gain or loss even after the hedge is placed. It arises from mismatched assets, dates or contract sizes.

Does diversification protect against market risk?

Only partly. It reduces risk that is specific to individual assets, but systematic market risk stays. To reduce that, you need lower exposure or derivatives.