Basis risk can be partially offset by the sale of puts on the futures contract. The puts sold are expected to expire worthless while avoiding the possibility of extreme interest rate movements. Subject to market conditions, it is possible to continually collect a small premium to offset this basis risk on a routine basis, as long as the strike price of the sold put option is far enough away from the underlying futures contract price to retain some downside protection. Adding this tool to the hedging strategy requires ongoing maintenance and adjustment.
Using futures contract to hedge a bond portfolio to protect the value and to allow the original planned uses at maturity is a viable approach. It is suggested that approximately 5% to 10% of the portfolio value be deposited into a futures trading account specified for hedging purposes. The actual positions may require approximately 1% of the portfolio to open the positions. The additional cash deposited adds prudent money management guidelines to keep the margin used to 20% or less of the account value on deposit. The success of such a program will easily be measured by comparing the values of the two accounts. The first goal of this program is to maintain the net value during the life the bond portfolio is held. This may be further enhanced by the continual selling of put options to offset the costs to operate a hedging program and the basis risk.
Jeffrey L. Stouffer, CFP, CAIA, is the principal of Mercantile Capital Group, a Herndon Va.-based introducing broker registered with the CFTC and a member of the National Futures Association. As a practicing financial advisor serving the needs of individuals and small businesses, he believes in using a wide range of investment strategies, including alternative investments. All strategies are client centric and unique. He can be reached at [email protected].