This strategy involves using perpetual swaps to neutralize the basis risk or funding rate exposure associated with holding or writing traditional options or futures contracts. Effective application requires precise calculation of the required notional amount to offset the target risk exposure. The goal is to isolate the desired risk factor from the perpetual contract’s inherent characteristics.
Funding
The cost of maintaining this hedge is intrinsically linked to the perpetual swap’s funding rate, which must be continuously monitored against the cost of carry for the hedged instrument. A sustained negative funding rate can significantly erode the profitability of the hedging position. Traders must model the expected funding rate volatility.
Risk
Successful perpetual swap hedging mitigates basis risk but introduces new risks, primarily the risk of funding rate divergence or contract failure. A sudden, large shift in the funding rate can cause the hedge to become ineffective or even result in negative carry costs. Continuous evaluation of the funding mechanism’s stability is therefore non-negotiable.
