Chartered Institute of Stockbrokers (CISI) Professional Practice Exam

How do portfolio managers mitigate the risk of falling portfolio values using futures contracts?

1. By buying more equities

2. By selling a sufficient number of futures contracts

3. By investing in foreign assets

4. By reducing portfolio exposure

The correct answer is: By selling a sufficient number of futures contracts

Using futures contracts is a strategic way for portfolio managers to hedge against the risk of declining portfolio values. When a portfolio manager anticipates a potential drop in equity prices, they can sell futures contracts, which are agreements to sell an asset at a predetermined price at a future date. By doing this, the manager effectively locks in a selling price for the equities in the portfolio. If the value of the equity market declines following the sale of the futures contracts, the portfolio manager can then offset the losses in the portfolio with the gains made on the futures contracts. This balances the overall risk exposure. The key here is that the sale of futures contracts allows for a protective measure against declines, as the profit from the futures can compensate for the losses in the underlying assets. This strategy is particularly effective because futures contracts are a liquid and efficient way to hedge against market movements, allowing portfolio managers to adjust their exposure without having to sell off actual holdings immediately. Other choices may advocate for different strategies, such as increasing equity positions or diversifying into foreign assets, but those do not specifically address the immediate risk of a downturn in value like the selling of futures contracts does. Reducing portfolio exposure could involve selling off assets, which is not always feasible or desirable, especially if