In a forward contract, commitments are made at the contract outset but settlement is due at expiration. Consider an agreement under which party A agrees to buy the S&P 500 index from party B for 1,500 in one year. If  the S&P 500 is at 1,400, party A owes party B 100, and party B faces potential credit risk (prior to settlement) and actual credit risk (at the time of settlement.) When the S&P 500 is higher than 1,500 it is party A that is subject to credit risk.

Swap contracts are similar to a series of forward contracts, with interim payments occurring along the way. Each payment exposes one party to credit risk. As each payment is made, the total potential credit risk is reduced.

Option contracts have unilateral credit risk – only the seller is obligated to make a payment, so only the buyer is exposed to credit risk once the initial premium has been paid.

• Default risk is the chance the issuer will fail to meet its obligations
• Credit spread risk is the chance the spread between the risky bond and risk-free securities will vary after purchase
• Downgrade risk is the chance a rating agency will lower its rating on the issuer

These risks can be hedged using option contracts.

A binary credit option pays off only if a specified negative event occurs. These can be used to hedge default risk or downgrade risk.

Credit spread options pay off based on the spread over a benchmark rate. They can be used to hedge credit spread risk.

They find that at the short end of the term structure, the skew does give information regarding an impending crash. There is less information conveyed from positive skew. Further along the term structure, information content from volatility skew is weak.

In the January/February 2008 Financial Analysts Journal, Lawrence Morgan addresses this issue and provides an example: in February 2007, the 10-year T-note was yielding 4.625%, but the CTD for the June 2007 10-year note futures was the 4.25% November 2013 note – a 7 year instrument.

Morgan examines whether combination hedges, made by combining two hedging instruments, would provide a better match. Leschhorn (2001) developed and tested an approach for the German bond market in which the weights of the two hedging instruments were determined by their yield differentials. Morgan notes that this approach can frequently result in unstable hedge ratios.

Morgan extends the analysis to combination hedges weighted by option-adjusted and non-option adjusted modified durations, and finds that in general option-adjusted modified duration weighted combination hedges performed best.

In the September/October 2007 Financial Analysts Journal, Brown, Ozik and Scholz demonstrate a derivatives-based strategy that offers significantly lower cost at the expense of being more difficult to design. This is due to the fact that the transaction costs and tracking error of such a synthetic strategy depend both on the cost of trading the derivatives and the length of time the derivatives are held.

Position limits are simply pre-set guidelines on how much exposure can be allocated to a given party. The limits could be in dollar terms, a percentage of the notional value of total contracts, or based on other factors (such as allocating a higher limit to more trusted parties.)

Certain futures contracts are periodically “marked to market,” a process by which the interim differences in value are settled before the contracts expire. The associated mark to market payments are smaller and more frequent, reducing the credit risk compared to a single large payment at the end of the contract. The most one party could lose is the change in value during the time since the last mark to market.

Collateral such as margin are required for many contracts. The margin is a small percentage of the notional value kept in escrow. Usually if the margin falls to a specific percentage of how much is actually owed, either more margin must be put up or the margin is paid out and the contract terminated.

Netting procedures are set up for most contracts so that if both parties owe something only the difference (the net payment) is made by the party owing the larger amount. This reduces the credit risk and causes it to apply only to the party owed the larger amount.

Traditional credit analysis techniques can be used to vet counterparties according to credit standards at the outset of a contract. However, if the contract is long-term in nature the credit quality can change during the contract life.

Finally, there are a number of credit derivatives that can be used to transfer specific aspects of credit risk to other parties willing to accept the risk.

While strategic allocations are revisited only periodically or when there is a change in the investor’s circumstances, TAA is an active, ongoing discipline. In effect, it is active management at the asset class level. It often takes place as an interim step between the strategic asset allocation and the actual asset class management decisions. Alternatively, the asset management can be set and a derivative overlay strategy used to alter the asset class weights tactically.

Tactical asset allocation is based on three principles:

1. Market prices explicitly describe the returns available (either cash yield or a yield + growth formula)
2. Relative expected returns reflect relative perceptions of risk
3. Markets are rational and mean reverting

Tactical asset allocation frequently seeks asset classes where risk premia are well above normal levels in anticipation of mean reversion. This requires judgment, as the mean reversion process can take many years.

One way to capture Beta while maximizing manager skill (alpha) is to equitize the market neutral portfolio by holding index futures contracts.

Furthermore, by using an exchange of futures for physicals, the fund can use the futures as a low-cost way to gain access to a fully replicated portfolio. This can be useful because an all-futures portfolio must be rolled over periodically as futures expire in order to maintain appropriate exposure.

Swaps can be an efficient way for portfolios to gain access to an index, as the cost of the swap may be lower than the transaction costs of replicating the portfolio.

Active managers may also use swaps as an efficient way of increasing/decreasing exposure to various markets over time.