Hedging Duration with Treasury Futures

The point is efficiency: Treasury futures let you adjust portfolio duration without selling bonds. Need to reduce rate exposure before an FOMC meeting? Buy or sell futures contracts worth the desired duration change. The physical portfolio stays intact (avoiding transaction costs and tax consequences), while the overlay shifts your effective duration up or down within hours.

Why Futures for Duration Management

Physical bond trading has friction. Selling $50 million of 10-year Treasuries to reduce duration means:

• Crossing the bid-ask spread (currently 1-3/32nds for on-the-run 10-years)
• Settling in T+1, not immediately
• Potential market impact on larger trades
• Wash sale considerations if repurchasing similar maturities

Treasury futures eliminate most of these frictions. CME Group's Treasury complex offers contracts spanning the yield curve from 2-year through Ultra bonds (25+ years). Each contract represents $100,000 face value of deliverable Treasuries, with margin requirements typically 3-5% of notional - meaning significant leverage is available (CME Group, 2024).

The durable lesson: futures are a precision tool for duration, not a bet on rates. Use them to fine-tune exposure, not to speculate.

Contract Specifications (What You're Trading)

The Treasury futures suite covers six primary tenors:

DV01 (dollar value of a basis point) tells you how much the contract gains or loses for each 1 bp move in yields. A 10-year future with $70 DV01 gains $70 when 10-year yields fall 1 bp, and loses $70 when yields rise 1 bp.

In March 2024, CME launched Micro Treasury Futures at 1/10 the size ($10,000 face value), enabling finer-grained hedging for smaller portfolios. Micro 10-year futures have approximately $7 DV01 - useful for retail accounts or precise institutional adjustments.

The BPV Hedge Ratio

The core calculation for duration hedging uses basis point value (BPV, equivalent to DV01):

Hedge Ratio = Portfolio BPV / Futures Contract BPV

Setup: A portfolio manager holds $100 million in 10-year Treasuries with duration of 7.2 years. She wants to reduce effective duration to 5.0 years before an expected hawkish Fed statement.

Calculation:

• Portfolio DV01: $100M x 0.00072 = $72,000 per basis point
• Target DV01: $100M x 0.00050 = $50,000 per basis point
• DV01 reduction needed: $72,000 - $50,000 = $22,000
• 10-year future DV01: approximately $70 per contract
• Contracts to sell: $22,000 / $70 = 314 contracts (round to 315)

Interpretation: Selling 315 10-year Treasury futures reduces portfolio duration from 7.2 to approximately 5.0 years. If rates rise 50 bps, the futures gain approximately $1.1 million (315 x $70 x 50), offsetting losses on the physical bonds that would have occurred without the hedge.

The catch: this calculation assumes parallel curve shifts. If 10-year rates rise 50 bps but 2-year rates rise 100 bps (curve flattening), the hedge may over- or under-perform depending on portfolio composition.

Adjusting for Curve Risk (Key Rate Duration)

Single-duration hedges work for parallel shifts but miss curve reshaping. Key rate duration measures sensitivity to specific points on the curve - typically 2-year, 5-year, 10-year, and 30-year.

A -> B -> C: A barbell portfolio with 50% 2-year bonds and 50% 20-year bonds has overall duration of 10 years. But hedging with only 10-year futures misses the curve risk. If the curve steepens (long rates rise more than short), the 20-year bonds lose more than the 10-year futures gain. Portfolio still suffers.

The solution: hedge each key rate exposure separately.

This multi-contract approach neutralizes both parallel and non-parallel rate moves - essential for portfolios with significant barbell or bullet characteristics.

The 1994 Lesson: When Hedges Matter

The 1994 bond massacre remains the canonical example of duration risk realized. The Fed raised rates from 3% to 5.5% in 12 months, triggering approximately $1.5 trillion in global bond losses. Bonds with 20+ year maturities dropped over 20% (Fortune, 1994).

Managers with futures hedges in place experienced dramatically different outcomes:

• Unhedged 20-year portfolio: -20% to -22%
• 50% duration-hedged 20-year portfolio: -10% to -12%
• Fully duration-hedged: approximately flat (minus hedge costs)

The test: run your portfolio through a 1994-style shock (250 bps in 12 months) before deciding how much duration exposure to carry unhedged.

The 2013 Taper Tantrum: Speed of Adjustment

The 2013 Taper Tantrum demonstrated how quickly rates can move. After Fed Chair Bernanke's May 22, 2013 testimony, 10-year yields rose 100+ bps in 10 weeks (from approximately 1.63% to 2.74% by early July).

Why this matters for futures hedging: the market moved faster than many institutional committees could meet and approve hedge adjustments. Pre-authorized hedge triggers (if duration exceeds X, reduce by Y contracts) proved more effective than deliberative decision-making after the move started.

The durable lesson: establish hedge protocols before volatility arrives. Decide now what duration level triggers action.

Practical Hedge Construction

Step 1: Calculate Current Portfolio DV01

Sum the DV01 of each holding: (position size) x (modified duration / 10,000)

For a $200 million portfolio with 6.5-year duration: DV01 = $200M x 0.00065 = $130,000

Step 2: Determine Target Duration

If reducing from 6.5 to 4.5 years: target DV01 = $200M x 0.00045 = $90,000

DV01 reduction: $130,000 - $90,000 = $40,000

Step 3: Select Appropriate Contract

Match the futures contract to where your duration lives on the curve. A portfolio heavy in 7-10 year securities should hedge with 10-year futures, not 2-year futures (unless intentionally introducing curve bets).

Step 4: Calculate Contract Count

$40,000 / $70 per contract = 571 contracts to sell

Step 5: Execute and Monitor

Place the order through your futures broker. Monitor daily as rates move and contract DV01 shifts with price. Rebalance the hedge monthly or when deviation exceeds tolerance (typically 5-10%).

Costs and Considerations

Margin Requirements: Initial margin for 10-year futures runs approximately $2,000-$3,000 per contract (varies with volatility). For 571 contracts, that's $1.1-$1.7 million tied up in margin, though earning overnight rates.

Roll Costs: Treasury futures expire quarterly. Rolling from the expiring contract to the next costs 2-5 bps per quarter, depending on curve shape and liquidity. Annual cost: approximately 8-20 bps of notional duration exposure.

Basis Risk: Futures track cheapest-to-deliver (CTD) bonds, which may differ from your portfolio's composition. During delivery months, CTD switches can cause unexpected P&L.

23-Hour Trading: CME Treasury futures trade nearly around the clock, enabling hedges against overnight rate moves (useful for global managers or ahead of foreign central bank announcements).

When Futures Hedging Makes Sense

Strong Use Cases:

• Temporary duration reduction before known events (FOMC, employment reports)
• Tax-efficient adjustment (no realized gains from selling bonds)
• Quick implementation when physical trading is impractical
• Overlay management for liability-driven investors

Weaker Use Cases:

• Permanent duration change (just buy different bonds)
• Very small portfolios (micro futures help but commission drag matters)
• Credit-heavy portfolios where rate duration is secondary to spread risk

Essential Pre-Hedge Checklist

1. Portfolio DV01 calculated at key rate durations (2Y, 5Y, 10Y, 30Y)
2. Target duration defined with acceptable range
3. Hedge trigger levels pre-authorized by investment committee
4. Margin and collateral requirements confirmed with broker

High-Impact Implementation Steps

1. Run hedge through 1994 and 2013 scenarios to validate effectiveness
2. Document roll schedule and cost assumptions
3. Establish daily P&L monitoring for futures positions

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Citation: Burghardt and Belton (2005) demonstrated that BPV hedge ratios reduce duration exposure by 85-95% for parallel curve shifts, with effectiveness declining to 60-75% for non-parallel shifts unless key rate duration hedging is employed.

Source: CME Group Treasury Futures specifications and educational materials (2024). Historical rate data from Federal Reserve. Hedge ratio methodology from industry standard fixed income risk management practices.