CFA 2018 r30 risk management applications of swap strategies

Level III Risk Management Applications of Swap Strategies www.ift.world Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Contents Introduction Strategies and Applications for Managing Interest Rate Risk Strategies and Applications for Managing Exchange Rate Risk Strategies and Applications for Managing Equity Market Risk Strategies and Applications Using Swaptions www.ift.world Introduction • Two parties exchange a series of cash flows • At least of set of cash flows must be variable • Interest rate swaps • Currency swaps • Equity swaps www.ift.world Strategies for Managing Interest Rate Risk 2.1 Using Interest Rate Swaps to Convert Floating-Rate Loan to a Fixed Rate Loan 2.2 Using Swaps to Adjust the Duration of a Fixed Income Portfolio 2.3 Using Swaps to Create and Manage the Risk of Structured Notes www.ift.world 2.1 Using Interest Rate Swaps to Convert a Floating-Rate Loan to a Fixed Rate Loan IBP’s cash flow is hedged but there is an opportunity cost if interest rates fall www.ift.world www.ift.world www.ift.world Duration of floating rate bond is approximately half the time remaining till next payment Duration of floating rate bond with quarterly payments = 0.125 Duration of fixed rate bond with quarterly payment = 0.75 Pay fixed swap = Issue fixed rate bond and use proceeds to buy a floating rate bond Duration of pay fixed swap = - 0.75 + 0.125 = - 0.625 Negative duration means that pay fixed party will benefit from rising rates and falling market value www.ift.world 2.2 Using Swaps to Adjust the Duration of a Fixed Income Portfolio 500 million bond portfolio with a duration of 6.75 We want to reduce the duration to 3.5 using interest rate swaps www.ift.world Say we use a fixed pay one year swap with semi-annual payments This is the same as: long a floater and short a fixed rate bond Duration = 0.25 – 0.75 = -0.50 Steep! With a five year swap Duration = 0.25 – 3.75 = -3.50 www.ift.world 10 Strategies and Applications Using Swaptions A swaption is an option to enter into a swap It is like an interest rate option because it has an exercise rate Example: You have an option to enter into a three-year swap with semi-annual payments with an exercise rate of 7% Payer swaption allows holder to enter swap as a fixed rate payer Receiver swaption allows holder to enter a swap fixed rate receiver www.ift.world 35 5.1 Using an Interest Rate Swaption in Anticipation of a Future Borrowing BCHEM will need to borrow 10 million euro after year and will have to pay the bank a floating rate Loan will require semi-annual payments for two years How can we use a swaption to convert the floating rate loan to a fixed rate loan? FS (1,3) = 7% is the fixed rate on a swap established at year and ending at year www.ift.world 36 www.ift.world 37 www.ift.world 38 A B www.ift.world 39 www.ift.world 40 5.2 Using an Interest Rate Swaption to Terminate a Swap Two possible strategies for early termination of a swap: 1) Enter an offsetting swap 2) Buy a swaption A Japanese company enters into a five-year 800 million yen swap as fixed rate payer (3%) After two years floating rate is down (2%) and company wants to terminate swap It can enter another swap as fixed rate receiver Or, company could have purchased a swaption when it entered the swap at T = Payer or receiver swaption? What is the cost and benefit? www.ift.world 41 www.ift.world 42 IMS is no longer concerned about rising interest rates and would like to return to status of floating-rate borrower www.ift.world 43 www.ift.world 44 www.ift.world 45 www.ift.world 46 5.3 Synthetically Removing (Adding) a Call Feature in Callable (Noncallable) Debt and 5.4 A Note of Forward Swaps Not mentioned in learning objectives Review Example 14 if you want to be diligent A very brief section 5.4 tells us that forward contracts on swaps exist These are called forward swaps www.ift.world 47 Summary • Use interest rate swaps to:  Covert floating rate loan to fixed rate loan  Adjust duration on a fixed income portfolio • Use currency swaps to:  Convert loan from one currency to another  Convert foreign currency receipts to domestic currency • Use equity swaps to:  Diversify concentrated portfolio  Achieve international diversification  Change an asset allocation between stocks and bonds • Use swaptions to:  Change payment pattern of anticipated future loan  Terminate a swap www.ift.world 48 Conclusion • Swaps are particularly important for two reasons  Heavily used in developed financial markets  Many examples and practice questions in the curriculum • Usual advice     Examples Summary Practice Problems Learning Objectives www.ift.world 49 ... Introduction Strategies and Applications for Managing Interest Rate Risk Strategies and Applications for Managing Exchange Rate Risk Strategies and Applications for Managing Equity Market Risk Strategies. .. and Applications Using Swaptions www.ift.world Introduction • Two parties exchange a series of cash flows • At least of set of cash flows must be variable • Interest rate swaps • Currency swaps... Equity swaps www.ift.world Strategies for Managing Interest Rate Risk 2.1 Using Interest Rate Swaps to Convert Floating-Rate Loan to a Fixed Rate Loan 2.2 Using Swaps to Adjust the Duration of a