CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r30 risk management applications of swap strategies IFT notes

Using Interest Rate Swaps to Convert a Floating-Rate Loan to a Fixed-Rate Loan and Vice Versa LO.a: Demonstrate how an interest rate swap can be used to convert a floating-rate fixed-r

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Risk Management Applications of Swap Strategies

1 Introduction 3

2 Strategies and Applications for Managing Interest Rate Risk 3

2.1 Using Interest Rate Swaps to Convert a Floating-Rate Loan to a Fixed-Rate Loan (and Vice Versa) 3 2.2 Using Swaps to Adjust the Duration of a Fixed-Income Portfolio 5

2.3 Using Swaps to Create and Manage the Risk of Structured Notes 6

3 Strategies and Applications for Managing Exchange Rate Risk 6

3.1 Converting a Loan in One Currency into a Loan in another Currency 6

3.2 Converting Foreign Cash Receipts into Domestic Currency 9

3.3 Using Currency Swaps to Create and Manage the Risk of a Dual-Currency Bond 10

4 Strategies and Applications for Managing Equity Market Risk 10

4.1 Diversifying a Concentrated Portfolio 10

4.2 Achieving International Diversification 11

4.3 Changing an Asset Allocation between Stocks and Bonds 12

4.4 Reducing Insider Exposure 14

5 Strategies and Applications Using Swaptions 14

5.1 Using an Interest Rate Swaption in Anticipation of a Future Borrowing 14

5.2 Using an Interest Rate Swaption to Terminate a Swap 15

5.3 Synthetically Removing (Adding) a Call Feature in Callable (Noncallable) Debt 17

5.4 A Note on Forward Swaps 17

6 Conclusions 17

Summary 18

Examples from the Curriculum 20

Example 1 20

Example 2 21

Example 3 22

Example 4 22

Example 5 23

Example 6 24

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Risk Management Applications of Swap Strategies IFT Notes

Example 10 26

Example 11 27

Example12 27

Example 13 28

Example 14 29

This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA®

Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the

products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are

trademarks owned by CFA Institute

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1 Introduction

A swap is a transaction in which two parties agree to exchange a series of cash flows over a specific

period of time At least one set of cash flows must be variable (not known at the beginning of the

transaction) The other set of cash flows can be either fixed or variable

The main types of swaps that we will cover in this reading are:

 Interest rate swaps

 Currency swaps

 Equity swaps

2 Strategies and Applications for Managing Interest Rate Risk

2.1 Using Interest Rate Swaps to Convert a Floating-Rate Loan to a Fixed-Rate Loan (and Vice

Versa)

LO.a: Demonstrate how an interest rate swap can be used to convert a floating-rate (fixed-rate)

loan to a fixed-rate (floating-rate) loan

Most banks prefer to make floating rate loans, because they want to pass on interest rate risk to the

borrowers Typically a borrower agrees to borrow at a floating rate, though the borrower prefers a fixed

rate The borrower will then use a swap to convert its floating rate loan to a fixed rate loan

Exhibit 1 demonstrates this scenario

IBP borrows $25 million from a bank PLB at a floating rate of LIBOR + 3%

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Thus using a swap IBP was able to remove its interest rate exposure It is important to note that by

doing this IBP is speculating on rising interest rates If rates do go up, IBP will benefit from the swap

However, if interest rates fall, IBP will not be able to take advantage of the falling rates

Swaps can also be used to convert fixed rate loans to floating rate loans This is illustrated in Example 1

Refer to Example 1 from the curriculum

Some important points to note are:

 A bank has issued a fixed rate loan and but wants to convert this to a floating rate loan

 It can do so by entering a pay-fixed, receive-floating swap

 If market rates go up that hurts the fixed rate lender as it will continues to receive the fixed rate

agreed at initiation of the loan

 If the credit risk of the borrow goes up that will also hurt the fixed rate lender

LO.b: Calculate and interpret the duration of an interest rate swap

A pay-fixed, receive-floating swap is equivalent to issuing (going short) a fixed rate bond and using the

proceeds to buy (going long) a floating rate bond Hence, the duration of a pay-fixed, receive-floating

swap is equal to the duration of a short position in a fixed-rate bond the duration of a long position in a

floating-rate bond and

Consider a one-year pay-fixed, receive-floating swap with quarterly settlements This swap can be

thought of as the combination of:

1 A long position in a one-year floating rate bond with quarterly payments AND

2 A short position in a one-year fixed rate bond with quarterly payments

If we can determine the duration of these two instruments the swap duration can easily be calculated

Duration of a floating rate bond: The price of a floating rate bond (floater) typically does not drift much

from par value On reset dates the price of a floater reverts to par value assuming there is no change in

credit risk For this reason the interest risk or duration of a floater is low Specifically it can be shown

that the duration of a floater is equal to half the time between reset dates If a floater has reset dates

every quarter (i.e every 0.25 years), the duration is approximately 0.25/2 = 0.125 years

Duration of a fixed rate bond: The duration of a one-year zero coupon bond is 1 year Now consider a

1-year bond which makes a fixed coupon payment every quarter Intuitively the duration of this bond will

be less than 1 but more than 0.5 because a large percentage of payments are being made at the end of

the year It can be shown that the duration of such as bond is approximately 0.75 years From the

perspective of an issuer (short position) the duration will be -0.75

Given the above discussion, the duration of a one-year pay-fixed, receive-floating swap with quarterly

settlements = 0.125 – 0.75 = - 0.625

Note that in general pay-fixed, receive-floating swaps will have a negative duration and pay-floating,

receive-fixed swaps will have a positive duration

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2.2 Using Swaps to Adjust the Duration of a Fixed-Income Portfolio

Consider a scenario where a company controls a $500 million fixed-income portfolio that has a duration

of 6.75 It wants to reduce the portfolio duration to 3.5 by using swaps The main questions that it faces

are:

1 Should the company use pay-fixed, receive floating swaps or pay-floating, receive fixed swaps?

2 What should be the terms of the swap?

3 What should be the notional principal?

Should the company use pay-fixed, receive floating swaps or pay-floating, receive fixed swaps?

To reduce the duration, we must add a negative-duration position Hence, the swap should be pay-fixed

swap, receive-floating

What should be the terms of the swap (maturity, payment frequency)?

The swap should have a maturity at least as long as the period during which the duration adjustment

applies Otherwise the company would have to initiate another swap after the expiry of the first swap

We know that the duration of a fixed rate bond is approximately 75% of its maturity Hence:

 A one-year swap with semi-annual payments would have a duration of 0.25 – 0.75 = –0.50

 A one-year swap with quarterly payments would have a duration of 0.125 – 0.75 = –0.625

 A two-year swap with semiannual payments would have a duration of 0.25 – 1.50 = –1.25

 A two-year swap with quarterly payments would have a duration of 0.125 – 1.50 = –1.375

The different durations affects the notional principal required Hence an appropriate payment frequency

can be chosen after the third question is answered

LO.d: Determine the notional principal value needed on an interest rate swap to achieve a desired level

of duration in a fixed-income portfolio

What should be the notional principal?

Suppose the company adds a position in a swap with a notional principal of NP and a modified duration

of MDURS The NP can be calculated as:

𝑁𝑃 = $500,000,000(3.50 − 6.75

𝑀𝐷𝑈𝑅𝑆 )

If the company uses a one-year swap with semiannual payments, then as calculated above its duration

would be -0.50 The required notional principal will be:

𝑁𝑃 = $500,000,000(3.50 − 6.75

−0.50 ) = $3,250,000,000

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𝑁𝑃 = $500,000,000(3.50 − 6.75

−3.50 ) = $464,290,000 Hence using a longer duration, gives us a much reasonable amount of notional principal

In general, the notional principal of a swap necessary to change the duration of a bond portfolio worth B

from MDURB to a target duration, MDURT, is:

𝑁𝑃 = 𝐵(𝑀𝐷𝑈𝑅𝑇− 𝑀𝐷𝑈𝑅𝐵

LO.c: Explain the effect of an interest rate swap on an entity’s cash flow risk

By using swaps, cash flow risk is reduced because the uncertain future floating rate payments on loans

are essentially converted into fixed rate payments These fixed payments can be more easily planned

for, resulting in the reduction of cash flow risk

2.3 Using Swaps to Create and Manage the Risk of Structured Notes

(Note: This section is not explicitly mentioned in the learning objectives.)

Structured notes are short- or intermediate-term floating-rate securities that have some type of unusual

feature that distinguishes them from ordinary floating-rate notes The unusual feature can be:

 Leverage, which results in the interest rate on the note moving at a multiple of market rates

 Inverse floater, which means that the interest rate on the note moves opposite to the market

rates

Important points to note are:

From the perspective of a party which issues the structured note:

 An interest rate swap can be used to manage the risk related to a structured note with a coupon

at a multiple of a floating rate by adjusting the notional principal on the swap to reflect the

coupon multiple for the structured note The swap should be receive-floating, pay fixed swap

 An interest rate can be used to manage the risk of the issuance of an inverse floating-rate note

by paying the floating rate to the swap dealer When interest rates rise (fall), the inverse floater

payment decrease (increase) and this effect is passed on to the dealer, which in turn pays a fixed

rate

3 Strategies and Applications for Managing Exchange Rate Risk

3.1 Converting a Loan in One Currency into a Loan in another Currency

LO.e: Explain how a company can generate savings by issuing a loan or bond in its own currency and

using a currency swap to convert the obligation into another currency

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Consider the following example from the curriculum ROTEC is a British company which plans to expand

in Europe and needs euros The options available to ROTEC are:

 It could issue a euro-denominated bond, but it is not as well known in the euro market, hence its

cost of borrowing will be higher

 It could issue a pound-denominated bond and convert it to a euro-denominated bond using a

currency swap This will lower its cost of borrowing

Exhibit 4 illustrates this scenario:

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Panel A shows the flow of funds at the start of the transaction

Panel B shows the interest payments and swap payments made each year

Panel C shows the flow of funds at the end of the life of the swap and the maturity date of the bond

A currency swap can be of the following types:

 Fixed-Fixed

 Fixed-Floating

 Floating-Fixed

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 Floating-Floating

The example discussed above was a fixed-fixed swap ROTECH could enter into a different swap to pay

fixed and receive floating or pay floating and receive fixed depending on its view of interest rates If it

believes that interest rates are likely to fall it will choose floating rates If it believes that interest rates

are likely to rise it will choose fixed rates

Consider the swap discussed in Exhibit 4 Suppose that mid-way through the life of the swap, ROTECH

has a view that euro interest rates are going down To act on this view, it could enter into a plain vanilla

interest rate swap in euros with SB or some other dealer It would promise to pay the counterparty

interest in euros at a floating rate and receive interest in euros at a fixed rate This transaction would

shift the euro interest obligation to floating Exhibit 5 illustrates this scenario

3.2 Converting Foreign Cash Receipts into Domestic Currency

LO.f: Demonstrate how a firm can use a currency swap to convert a series of foreign cash receipts

into domestic cash receipts

If a company has foreign subsidiaries then it will regularly generate cash in foreign currencies This cash

will be repatriated back in domestic currency on a regular basis If these cash flows are predictable in

quantity, then by using a currency swap we can lock the rate at which they are converted

Consider the example from the curriculum where a US based company COLS has a foreign subsidiary in

Japan It converts income generated in Japan into US dollars four times a year To lock in its conversion

rate for the entire year, it enters into a currency swap with a dealer USMULT Through this swap COLS

will make fixed payments in Japanese yen and receive fixed payments in US dollars at a fixed exchange

rate Exhibit 6 illustrates this scenario

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Risks faced by COLS in the above swap are:

 Credit risk of the counterparty defaulting

 Risk that its operations will not generate ¥300 million

3.3 Using Currency Swaps to Create and Manage the Risk of a Dual-Currency Bond

(Note: This section is not explicitly mentioned in the learning objectives.)

In a dual currency bond, the interest is paid in one currency and the principal is paid in another Dual

currency bonds are equivalent to issuing an ordinary bond in one currency and combining it with a

currency swap with no principal payments

4 Strategies and Applications for Managing Equity Market Risk

LO.g: Explain how equity swaps can be used to diversify a concentrated equity portfolio, provide

international diversification to a domestic portfolio, and alter portfolio allocations to stocks and

bonds

This LO is covered in sections 4.1, 4.2 and 4.3

4.1 Diversifying a Concentrated Portfolio

Consider a scenario where a charitable organisation receives a large donation of a single stock This

donation can result in a high degree of concentration However, the charitable organization may be

constrained from selling the stock or may not wish to sell the stock In such cases, to achieve

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diversification without selling the stock, equity swaps can be used

Exhibit 8 illustrates this scenario

A charitable organization CWF has received a large donation of ZYKT stock To achieve diversification,

without selling the stock, it enters into an equity swap with a dealer CAPS It would pay the returns on

the stock to the dealer and in return receive returns on the S&P index from the dealer

A risk faced by CWF is that if ZYKT performs very well and S&P has negative returns, then it will incur a

huge cash outflow

4.2 Achieving International Diversification

Consider the example from the curriculum, where an organization USRM has $500 million invested in US

stocks The appropriate benchmark for this portfolio is the Russell 3000 index The organization wants to

invest 10% of its portfolio internationally It can achieve this objective in the following ways:

 Option 1: Sell $50 million and invest internationally But transaction costs will be high

 Option 2: Enter into an equity swap Transaction costs will be lower

Exhibit 9 illustrates the second option

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USRM enters into a swap with dealer AGB It will pay the returns on Russell 3000 to the dealer and in

exchange receive returns on equity markets in Europe, Australia and the Far East (EAFE)

By using this swap risks faced by USRM are:

 If Russell 3000 outperforms EAFE then it will result in a negative cash flow

 Tracking error: USRM’s domestic stock holding generates a return that will not match perfectly

the return on the Russell 3000

4.3 Changing an Asset Allocation between Stocks and Bonds

A combination of equity swaps and fixed income swaps can be used to change asset allocation

Consider the example from the curriculum, where an investment management firm TMM wants to

change its asset allocation The table below shows the current position and the desired position and the

transactions required to go from current position to the desired position

Stock

Current ($150 Million, 75%)

New ($180 Million, 90%) Transaction

Large cap $90 million (60%) $117 million (65%) Buy $27 million

Mid cap $45 million (30%) $45 million (25%) None

Small cap $15 million (10%) $18 million (10%) Buy $3 million

Bonds

Current ($50 Million, 25%)

New ($20 Million, 10%) Transaction

Government $40 million (80%) $15 million (75%) Sell $25 million

Corporate $10 million (20%) $5 million (25%) Sell $5 million

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To avoid transaction costs, instead of executing these transactions, TMM can execute a series of swaps

that would provide the same results

The swaps required are:

Equity swaps

Receive return on S&P500 on $27 million

Pay Libor on $27 million

Receive return on SPSC on $3 million

Pay Libor on $3 million

Fixed-income swaps

Receive Libor on $25 million

Pay return on LLTB on $25 million

Receive Libor on $5 million

Pay return on MLCB on $5 million

By eliminating LIBOR and by combining the equity and fixed income swaps, we get a single swap with

the following payments

Receive return on SP500 on $27 million

Receive return on SPSC on $3 million

Pay return on LLTB on $25 million

Pay return on MLCB on $5 million

Exhibit 10 illustrates this swap

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 Tracking error risk

4.4 Reducing Insider Exposure

(Note: This section is not explicitly covered in the learning objectives.)

The founders of a company usually have a highly concentrated position in the stock of the company To

achieve diversification without selling the company stock they can use equity swaps

5 Strategies and Applications Using Swaptions

LO.g: Explain how equity swaps can be used to diversify a concentrated equity portfolio, provide

international diversification to a domestic portfolio, and alter portfolio allocations to stocks and

bonds

This LO is covered in sections 5.1 and 5.2

A swaption is an option to enter into a swap It is like an interest rate option because it has an exercise

rate For example: You have an option to enter into a three-year swap with semi-annual payments with

an exercise rate of 7%

There are two types of swaptions:

1 A payer swaption allows the holder to enter a swap as a fixed rate payer

2 A receiver swaption allows the holder to enter a swap as a fixed rate receiver

5.1 Using an Interest Rate Swaption in Anticipation of a Future Borrowing

Consider a scenario where a company anticipates that it will take out a loan at a future date The

company expects that the bank will require it to be a floating rate loan To eliminate interest rate risk it

will use a swap to convert this loan into a fixed rate loan If the company wants to enter into the swap at

an attractive rate, it can use a swaption

Exhibit 12 illustrates this scenario Company BCHEM wants to borrow in the future at a floating rate

from bank ANB It wants to enter into a swap to pay fixed rate if the rates are attractive To do so it buys

a swaption from dealer DTD

In Panel A the company pays the dealer, the swaption premium In Panel B, we examine what happens

starting when the swaption expires one year later In part (i) of Panel B we assume that at expiration of

the swaption, the rate in the market on the underlying swap, is greater than the swaption exercise rate

The swaption will therefore be exercised The company will make fixed payments to the dealer and in

return will receive floating payments form the dealer These floating payments will be used to offset its

floating payment to the bank

In Part (ii) of Panel B, at expiration of the swaption, the rate in the market on the underlying swap is less

than or equal to the swaption exercise rate The swaption will therefore not be exercised The company

will still enter into a swap with the dealer, but it will do so at the lower market rate

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Exhibit 12

Thus by using a swaption the company has obtained the right to pay a fixed rate of 7% or less However,

this comes at a cost in the form of the premium Whether it was worth paying this premium will depend

on how far the market ended above 7% at the time the loan was taken out

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