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

Risk Management Applications of Swap Strategies IFT Notes Risk Management Applications of Swap Strategies Introduction 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) 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 Strategies and Applications for Managing Exchange Rate Risk 3.1 Converting a Loan in One Currency into a Loan in another Currency 3.2 Converting Foreign Cash Receipts into Domestic Currency 3.3 Using Currency Swaps to Create and Manage the Risk of a Dual-Currency Bond 10 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 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 Conclusions 17 Summary 18 Examples from the Curriculum 20 Example 20 Example 21 Example 22 Example 22 Example 23 Example 24 Example 25 Example 25 Example 26 IFT Notes for the Level III Exam www.ift.world Page 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 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved 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 IFT Notes for the Level III Exam www.ift.world Page Risk Management Applications of Swap Strategies IFT Notes 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 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 demonstrates this scenario IBP borrows $25 million from a bank PLB at a floating rate of LIBOR + 3% To convert this loan to a fixed rate loan it enters into a swap with a dealer SPI It will pay fixed rate of 6.27% to the dealer and in exchange will receive LIBOR from the dealer The net effect is that IBP will pay a fixed rate of 6.27% plus 3% i.e 9.27% IFT Notes for the Level III Exam www.ift.world Page Risk Management Applications of Swap Strategies IFT Notes 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 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 Refer to Example 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 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: A long position in a one-year floating rate bond with quarterly payments AND 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 year Now consider a 1year bond which makes a fixed coupon payment every quarter Intuitively the duration of this bond will be less than 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 IFT Notes for the Level III Exam www.ift.world Page Risk Management Applications of Swap Strategies IFT Notes 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: Should the company use pay-fixed, receive floating swaps or pay-floating, receive fixed swaps? What should be the terms of the swap? 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: 3.50 − 6.75 𝑁𝑃 = $500,000,000( ) 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: 3.50 − 6.75 𝑁𝑃 = $500,000,000( ) = $3,250,000,000 −0.50 A notional principal of more than $3 billion would be a very large swap and probably too large to execute If the company enters a five-year swap with semi-annual payments Its duration would be 0.25 – 3.75 = –3.50 Then the notional principal would be: IFT Notes for the Level III Exam www.ift.world Page Risk Management Applications of Swap Strategies IFT Notes 3.50 − 6.75 𝑁𝑃 = $500,000,000( ) = $464,290,000 −3.50 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: 𝑀𝐷𝑈𝑅𝑇 − 𝑀𝐷𝑈𝑅𝐵 𝑁𝑃 = 𝐵( ) 𝑀𝐷𝑈𝑅𝑆 Refer to Example from the curriculum 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 Refer to Example from the curriculum Refer to Example from the curriculum 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 IFT Notes for the Level III Exam www.ift.world Page Risk Management Applications of Swap Strategies IFT Notes 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 illustrates this scenario: IFT Notes for the Level III Exam www.ift.world Page Risk Management Applications of Swap Strategies IFT Notes 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 IFT Notes for the Level III Exam www.ift.world Page Risk Management Applications of Swap Strategies  IFT Notes 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 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 illustrates this scenario Refer to Example from the curriculum 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 illustrates this scenario IFT Notes for the Level III Exam www.ift.world Page Risk Management Applications of Swap Strategies IFT Notes Risks faced by COLS in the above swap are:  Credit risk of the counterparty defaulting  Risk that its operations will not generate ¥300 million Refer to Example from the curriculum 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 Refer to Example from the curriculum 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 IFT Notes for the Level III Exam www.ift.world Page 10 Risk Management Applications of Swap Strategies IFT Notes quarterly floating payments at Libor from a lender called Financial Solutions (FINSOLS) Fearing an increase in interest rates, IMS engages in a pay-fixed, receive-floating swap that converts the loan into a fixed-rate loan at percent IMS believes, however, that the interest rate outlook could change, and it would like the flexibility to terminate the swap, thereby returning to the status of a floating-rate payer To give it this flexibility, IMS purchases an American-style receiver swaption for $515,000 The swaption allows it to enter into a receive-fixed, pay-floating swap at a fixed rate of percent at the swaption expiration The swap and swaption counterparty is Wheatstone Dealer (WHD) Exhibit 13 illustrates this scenario IFT Notes for the Level III Exam www.ift.world Page 16 Risk Management Applications of Swap Strategies IFT Notes In Panel A, IMS takes out the loan from FINSOLS It engages in the swap with WHD, thereby committing to pay fixed and receive Libor IMS pays WHD $515,000 for the swaption In Panel B(i), at the expiration of the swaption, the market swap rate is greater than or equal to percent This panel shows the cash flows if the loan plus swap (note that the loan is floating rate) is converted to a fixed rate using the market fixed rate because the swaption is out-of-the-money In Panel B(ii), the market swap rate is less than percent and the loan is converted back to a floatingrate loan by exercising the swaption From the above example we can see that the swaption offers the holder the opportunity to terminate the swap at the exercise rate or better Refer to Example 13 from the curriculum 5.3 Synthetically Removing (Adding) a Call Feature in Callable (Noncallable) Debt (Note: This section is not explicitly mentioned in the learning objectives.) The core points are:  We can sell a receiver swaption to offset the call feature on a bond  We can buy a receiver swaption to add a call feature to a bond Refer to Example 14 from the curriculum 5.4 A Note on Forward Swaps (Note: This section is not explicitly mentioned in the learning objectives.) The core point is: Forward contracts on swaps exist These are called forward swaps Conclusions We can use interest rate swaps to:  Covert floating rate loan to fixed rate loan  Adjust duration on a fixed income portfolio We can use currency swaps to:  Convert loan from one currency to another  Convert foreign currency receipts to domestic currency We can use equity swaps to:  Diversify concentrated portfolio  Achieve international diversification  Change an asset allocation between stocks and bonds We can use swaptions to:  Change payment pattern of anticipated future loan  Terminate a swap IFT Notes for the Level III Exam www.ift.world Page 17 Risk Management Applications of Swap Strategies IFT Notes Summary 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; Swaps can also be used to convert fixed rate loans to floating rate loans For example, b calculate and interpret the duration of an interest rate swap;    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 1-year bond which makes a fixed coupon payment every quarter is approximately 0.75 years The duration of a one-year pay-fixed, receive-floating swap with quarterly settlements = 0.125 – 0.75 = - 0.625  Pay-fixed, receive-floating swaps will have a negative duration  Pay-floating, receive-fixed swaps will have a positive duration 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 d determine the notional principal value needed on an interest rate swap to achieve a desired level of duration in a fixed-income portfolio; Notional principal of swap = Portfolio value * (Target duration – Original duration) / Swap duration Consider a scenario where a company controls a $500 million fixed-income portfolio that has a duration of 6.75 We want to reduce the duration to 3.50 using a five-year swap with semiannual payments Since we want to reduce the duration we should use a pay fixed receive floating swap For a five-year pay fixed receive floating swap the duration is -5*0.75 + 0.25 = -3.50 Notional principal of swap = 500 million * (3.50 – 6.75) / (3.50) = 464,290,000 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; IFT Notes for the Level III Exam www.ift.world Page 18 Risk Management Applications of Swap Strategies IFT Notes Currency Swaps If a company needs to borrow a foreign currency, it 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 Example: 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 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 Example: 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 Risks faced by COLS:  Credit risk of the counterparty defaulting  Risk that its operations will not generate ¥300 million 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;     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 Strategy for diversifying a concentrated Portfolio: By using an equity swap, the concentrated portfolio return can be swapped for diversified portfolio return e.g swapping return on 30 stocks for return on index i.e S&P 500 Strategy for achieving international Diversification: By using an equity swap, domestic return can be swapped for international portfolio return e.g swapping return on S&P for return on EAFE index Strategy for changing asset allocation: By using an equity swap, small-cap equity can be swapped for large-cap equity or equity can be swapped for debt h demonstrate the use of an interest rate swaption 1) to change the payment pattern of an anticipated future loan and 2) to terminate a swap   A swaption is an option to enter into a swap It is like an interest rate option because it has an exercise rate There are two types of swaptions: IFT Notes for the Level III Exam www.ift.world Page 19 Risk Management Applications of Swap Strategies IFT Notes A payer swaption allows the holder to enter a swap as a fixed rate payer A receiver swaption allows the holder to enter a swap as a fixed rate receiver   Using interest rate swaption to change the payment pattern of an anticipated future loan: A swaption gives the flexibility to the buyer of the swaption to enter into the swap at an attractive rate For example, if a firm plans to borrow in the future at floating rate, it can offset its risk of rising interest rates by buying a payer swaption i.e  When fixed rate in the market at swaption expiration > exercise rate of swaption, a firm can exercise the payer swaption  When fixed rate in the market at swaption expiration < exercise rate of swaption, a firm does not exercise the payer swaption; rather, it can enter into a swap at a market rate Using interest rate swaption to terminate a swap: There are two ways to terminate an existing swap: i By entering an offsetting swap: ii By buying a swaption a) When interest rates are expected to fall, a borrower should use receiver swaption to convert its pay-fixed position to a pay-floating position b) When interest rates are expected to rise, a borrower should use payer swaption to convert its pay-floating position to a pay-fixed position Examples from the Curriculum Example Consider a bank that holds a $5 million loan at a fixed rate of percent for three years, with quarterly payments The bank had originally funded this loan at a fixed rate, but because of changing interest rate expectations, it has now decided to fund it at a floating rate Although it cannot change the terms of the loan to the borrower, it can effectively convert the loan to a floating-rate loan by using a swap The fixed rate on three-year swaps with quarterly payments at Libor is percent We assume the number of days in each quarter to be 90 and the number of days in a year to be 360 A Explain how the bank could convert the fixed-rate loan to a floating-rate loan using a swap B Explain why the effective floating rate on the loan will be less than Libor Solution to A: The interest payments it will receive on the loan are $5,000,000(0.06)(90/360) = $75,000 The bank could a swap to pay a fixed rate of percent and receive a floating rate of Libor Its fixed payment would be $5,000,000(0.07)(90/360) = $87,500 The floating payment it would receive is $5,000,000L(90/360), where L is Libor established at the previous reset date The overall cash flow is thus $5,000,000(L – 0.01)(90/360), Libor minus 100 basis points Solution to B: The bank will effectively receive less than Libor because when the loan was initiated, the rate was percent Then when the swap was executed, the rate was percent This increase in interest rates hurts IFT Notes for the Level III Exam www.ift.world Page 20 Risk Management Applications of Swap Strategies IFT Notes the fixed-rate lender The bank cannot implicitly change the loan from fixed rate to floating rate without paying the price of this increase in interest rates It pays this price by accepting a lower rate than Libor when the loan is effectively converted to floating Another factor that could contribute to this rate being lower than Libor is that the borrower’s credit risk at the time the loan was established is different from the bank’s credit risk as reflected in the swap fixed rate, established in the Libor market when the swap is initiated Back to Notes Example A $250 million bond portfolio has a duration of 5.50 The portfolio manager wants to reduce the duration to 4.50 by using a swap Consider the possibility of using a one-year swap with monthly payments or a two-year swap with semiannual payments A Determine the durations of the two swaps under the assumption of paying fixed and receiving floating Assume that the duration of a fixed-rate bond is 75 percent of its maturity B Choose the swap with the longer absolute duration and determine the notional principal of the swap necessary to change the duration as desired Explain your results Solution to A: The duration of a one-year pay-fixed, receive-floating swap with monthly payments is the duration of a one-year floating-rate bond with monthly payments minus the duration of a one-year fixed-rate bond with monthly payments The duration of the former is about one-half of the length of the payment interval That is 1/24 of a year, or 0.042 Because the duration of the one-year fixed-rate bond is 0.75 (75 percent of one year), the duration of the swap is 0.042 – 0.75 = –0.708 The duration of a two-year swap with semiannual payments is the duration of a two-year floating-rate bond with semiannual payments minus the duration of a two-year fixed-rate bond The duration of the former is about one-quarter of a year, or 0.25 The duration of the latter is 1.50 (75 percent of two years) The duration of the swap is thus 0.25 – 1.50 = –1.25 Solution to B: The longer (more negative) duration swap is the two-year swap with semiannual payments The current duration of the $250 million portfolio is 5.50 and the target duration is 4.50 Thus, the required notional principal is 𝑀𝐷𝑈𝑅𝑇 − 𝑀𝐷𝑈𝑅𝐵 𝑁𝑃 = 𝐵 ( ) 𝑀𝐷𝑈𝑅𝑆 4.50 − 5.50 = $250,000,000( ) = $200,000,000 −1.25 So, to lower the duration requires the addition of an instrument with a duration lower than that of the portfolio The duration of a receive-floating, pay-fixed swap is negative and, therefore, lower than that of the existing portfolio IFT Notes for the Level III Exam www.ift.world Page 21 Risk Management Applications of Swap Strategies IFT Notes Back to Notes Example A company issues a floating-rate note that pays a rate of twice Libor on notional principal FP It uses the proceeds to buy a bond paying a rate of ci It also enters into a swap with a fixed rate of FS to manage the risk of the Libor payment on the leveraged floater A Demonstrate how the company can engage in these transactions, leaving it with a net cash flow of 2(FP)(ci – FS) B Explain under what condition the amount (ci – FS) is positive Solution to A: The company has issued a leveraged floater at a rate of 2L on notional principal FP Then it should purchase a bond with face value of 2(FP) and coupon ci It enters into a swap to pay a fixed rate of FS and receive a floating rate of L on notional principal 2(FP) The net cash flows are as follows: From leveraged floater –2L(FP) From bond +(ci)2(FP) Floating side of swap +(L)2(FP) Fixed side of swap –(FS)2(FP) Total 2FP(ci – FS) Solution to B: The difference between the bond coupon rate, ci, and the swap fixed rate, FS, will be positive if the bond has greater credit risk than is implied by the fixed rate in the swap, which is based on the Libor term structure and reflects the borrowing rate of London banks Thus, the gain of 2(ci – FS)(FP) is likely to reflect a credit risk premium Back to Notes Example A company issues an inverse floating-rate note with a face value of $30 million and a coupon rate of 14 percent minus Libor It uses the proceeds to buy a bond with a coupon rate of percent A Explain how the company would manage the risk of this position using a swap with a fixed rate of percent, and calculate the overall cash flow given that Libor is less than 14 percent B Explain what would happen if Libor exceeds 14 percent What could the company to offset this problem? Solution to A: The company would enter into a swap in which it pays Libor and receives a fixed rate of percent on notional principal of $30 million The overall cash flows are as follows: IFT Notes for the Level III Exam www.ift.world Page 22 Risk Management Applications of Swap Strategies From the inverse floater – (0.14 – L)$30,000,000 From the bond it buys + (0.08)$30,000,000 IFT Notes From the swap Fixed payment + (0.07)$30,000,000 Floating payment – (L)$30,000,000 Overall total + (0.01)$30,000,000 Solution to B: If Libor is more than 14 percent, then the inverse floater payment of (0.14 – L) would be negative The lender would then have to pay interest to the borrower For this reason, in most cases, an inverse floater has a floor at zero In such a case, the total cash flow to this company would be (0 + 0.08 + 0.07 – L)$30,000,000 There would be zero total cash flow at L = 15 percent But at an L higher than 15 percent, the otherwise positive cash flow to the lender becomes negative To offset this effect, the lender would typically buy an interest rate cap with an exercise rate of 14 percent The cap would have caplets that expire on the interest rate reset dates of the swap/loan and have a notional principal of $30 million Then when L > 0.14, the caplet would pay off L – 0.14 times the $30 million This payoff would make up the difference The price paid for the cap would be an additional cost Back to Notes Example A Japanese company issues a bond with face value of ¥1.2 billion and a coupon rate of 5.25 percent It decides to use a swap to convert this bond into a euro-denominated bond The current exchange rate is ¥120/€ The fixed rate on euro-denominated swaps is percent, and the fixed rate on yen-denominated swaps is percent All payments will be made annually, so there is no adjustment such as Days/360 A Describe the terms of the swap and identify the cash flows at the start B Identify all interest cash flows at each interest payment date C Identify all principal cash flows at the maturity of the bond Solution to A: The company will enter into a swap with notional principal of ¥1,200,000,000/(¥120/€1) = €10,000,000 The swap will involve an exchange of notional principals at the beginning and end The annual cash flows will involve paying euros and receiving yen The following cash flows occur at the start: From issuance of yen bond + ¥1,200,000,000 From swap – ¥1,200,000,000 + €10,000,000 Net + €10,000,000 IFT Notes for the Level III Exam www.ift.world Page 23 Risk Management Applications of Swap Strategies IFT Notes Solution to B: The following cash flows occur at the annual interest payment dates: Interest payments on bond (¥1,200,000,000)(0.0525) = – ¥63,000,000 Swap payments Yen Euro Net + (¥1,200,000,000)(0.05) = + ¥60,000,000 – (€10,000,000)(0.06) = – €600,000 – ¥3,000,000 – €600,000 Solution to C: The following cash flows occur at the end of the life of the swap: Principal repayment on bond – ¥1,200,000,000 Swap principal payments Yen + ¥1,200,000,000 Euro – €10,000,000 Net – €10,000,000 Back to Notes Example A Canadian corporation with a French subsidiary generates cash flows of €10 million a year It wants to use a currency swap to lock in the rate at which it converts to Canadian dollars The current exchange rate is C$0.825/€ The fixed rate on a currency swap in euros is percent, and the fixed rate on a currency swap in Canadian dollars is percent A Determine the notional principals in euros and Canadian dollars for a swap with annual payments that will achieve the corporation’s objective B Determine the overall periodic cash flow from the subsidiary operations and the swap Solution to A: With the euro fixed rate at percent, the euro notional principal should be €10,000,000/0.04=€250,000,000 The equivalent Canadian dollar notional principal would be €250,000,000 × C$0.825 = C$206,250,000 Solution to B: The cash flows will be as follows: From subsidiary operations IFT Notes for the Level III Exam €10,000,000 www.ift.world Page 24 Risk Management Applications of Swap Strategies Swap euro payment –0.04(€250,000,000) = –€10,000,000 Swap Canadian dollar payment 0.05(C$206,250,000) = C$10,312,500 IFT Notes The net effect is that the €10 million converts to C$10,312,500 Back to Notes Example From the perspective of the issuer, construct a synthetic dual-currency bond in which the principal is paid in US dollars and the interest is paid in Swiss francs The face value will be $20 million, and the interest rate will be percent in Swiss francs The exchange rate is $0.80/SF Assume that the appropriate interest rate for a $20 million bond in dollars is 5.5 percent The appropriate fixed rates on a currency swap are 5.5 percent in dollars and 5.0 percent in Swiss francs Solution: Issue a $20 million bond in dollars, paying interest at 5.5 percent Enter into a currency swap on $20 million, equivalent to SF25 million The currency swap will involve the receipt of dollar interest at 5.5 percent and payment of Swiss franc interest at 5.0 percent You will receive $20 million at the start and pay back $20 million at maturity The annual cash flows will be as follows: On dollar bond issued: – 0.055($20,000,000) = – $1,100,000 Dollars + 0.055($20,000,000) = + $1,100,000 Swiss francs – 0.05(SF25,000,000) = – SF1,250,000 On swap: Net – SF1,250,000 Back to Notes Example The manager of a charitable foundation’s $50 million stock portfolio is concerned about the portfolio’s heavy concentration in one stock, Noble Petroleum (NBP) Specifically, the fund has $20 million of this stock as a result of a recent donation to the fund She is considering using an equity swap to reduce the exposure to NBP and allow the fund to invest indirectly in the Wilshire 5000 Index The stock is currently selling for $20 a share, and the fund owns million shares The manager is not quite ready to reduce all of the fund’s exposure to NBP, so she decides to synthetically sell off one-quarter of the position Explain how she would this and identify some problems she might encounter Solution: To reduce her exposure on one quarter of her NBP holdings, the manager would have the fund enter into a swap to sell the total return on $5 million of NBP stock, which is 250,000 shares The fund will receive from the swap dealer the return on $5 million invested in the Wilshire 5000 The swap may result in cash flow problems, however, because the fund must pay out the return on IFT Notes for the Level III Exam www.ift.world Page 25 Risk Management Applications of Swap Strategies IFT Notes 250,000 shares of NBP stock but does not want to sell that stock If the return received on $5 million invested in the Wilshire 5000 is significantly less than the return the fund pays, or if the return on the Wilshire is negative, the fund could have insufficient cash to make its payment Then it might be forced to sell the stock, something it was trying to avoid in the first place Back to Notes Example A Canadian trust fund holds a portfolio of C$300 million of Canadian domestic stock The manager would like to sell off C$100 million and invest the funds in a pan-European portfolio The manager arranges to so using an equity swap in which the domestic stock is represented by the Toronto 300 Composite and the European portfolio is represented by the Dow Jones Euro STOXX 50, an index of leading stocks in the eurozone Explain how to structure such a swap, and describe how tracking error could potentially interfere with the success of the transaction Solution: The swap would specify the following transactions on a periodic basis for a specific number of years:  receive return on DJ Euro STOXX 50,  pay return on Toronto 300 Tracking error here is the failure of the derivative cash flow to match precisely the cash flow from the underlying portfolio In this case, tracking error means that the return actually earned on the domestic portfolio is not likely to perfectly match the Toronto 300 return These returns are supposed to offset, but they are not likely to so, certainly not with perfection The return received on the DJ Euro STOXX 50 does not give rise to tracking error concerns The index will simply represent the return on the investment in European stocks If an actual investment in European stocks were made, it would likely differ from this return Back to Notes Example 10 A $30 million investment account of a bank trust fund is allocated one-third to stocks and two-thirds to bonds The portfolio manager wants to change the overall allocation to 50 percent stock and 50 percent bonds, and the allocation within the stock fund from 70 percent domestic stock and 30 percent foreign stock to 60 percent domestic and 40 percent foreign The bond allocation will remain entirely invested in domestic corporate issues Explain how an equity swap could be used to implement this adjustment You not need to refer to specific stock indices Solution: Currently the allocation is $10 million stock and $20 million bonds Within the stock category, the current allocation is $7 million domestic and $3 million foreign The desired allocation is $15 million stock and $15 million bonds Thus, the allocation must change by moving $5 million into stock and out of bonds The desired stock allocation is $9 million domestic and $6 million foreign The desired bond IFT Notes for the Level III Exam www.ift.world Page 26 Risk Management Applications of Swap Strategies IFT Notes allocation is $15 million, all domestic corporate To make the change with a swap, the manager must enter into a swap to receive the return on $5 million based on a domestic equity index and pay the return on $5 million based on a domestic corporate bond index The $5 million return based on a domestic equity index should be allocated such that $2 million is based on domestic stock and $3 million is based on foreign stock Back to Notes Example 11 The CEO of a corporation owns 100 million shares of his company’s stock, which is currently priced at €30 a share Given the tremendous exposure of his personal wealth to this one company, he has decided to sell 10 percent of his position and invest the funds in a floating interest rate instrument A derivatives dealer suggests that he so using an equity swap Explain how to structure such a swap Solution: The swap is structured so that the executive pays the return on 10 million shares, which is 10 percent of his holdings, of the company’s stock and receives the return based on a floating interest rate, such as Libor, on a notional principal of €300 million Back to Notes Example12 A company plans to take out a $10 million floating-rate loan in two years The loan will be for five years with annual payments at the rate of Libor The company anticipates using a swap to convert the loan into a fixed-rate loan It would like to purchase a swaption to give it the flexibility to enter into the swap at an attractive rate The company can use a payer or a receiver swaption Assume that the exercise rate would be 6.5 percent A Identify what type of swaption would achieve this goal and whether the company should buy or sell the swaption B Calculate the company’s annual cash flows beginning two years from now for two cases: The fixed rate on a swap two years from now to terminate five years later, FS(2,7), is 1) greater or 2) not greater than the exercise rate Assume the company takes out the $10 million floating-rate loan as planned C Suppose that when the company takes out the loan, it has changed its mind and prefers a floating-rate loan Now assume that the swaption expires in-the-money What would the company do, given that it now no longer wants to convert to a fixed-rate loan? Solution to A: The company wants the option to enter into the swap as a fixed-rate payer, so the company would buy a payer swaption Solution to B: IFT Notes for the Level III Exam www.ift.world Page 27 Risk Management Applications of Swap Strategies IFT Notes The outcomes based on the swap rate at swaption expiration, denoted as FS(2,7), are as follows: FS(2,7) > 6.5 percent Exercise the swaption, entering into a swap The annual cash flows will be as follows: Pay 0.065($10 million) = $650,000 on swap Receive L($10 million) on swap Pay L($10 million) on loan Net, pay $650,000 FS(2,7) ≤ 6.5 percent Do not exercise swaption; enter into swap at market rate The annual cash flows will be as follows: Pay FS(2,7)($10 million) on swap Receive L($10 million) on swap Pay L($10 million) on loan Net, pay FS(2,7)($10 million) (Note: This is less than $650,000) Solution to C: In this situation, the company has changed its mind about converting the floating-rate loan to a fixedrate loan If the swaption expires out-of-the-money, the company will simply take out the floating-rate loan If the swaption expires in-the-money, it has value and the company should not fail to exercise it But exercising the swaption will initiate a swap to pay fixed and receive floating, which would leave the company in the net position of paying a fixed rate of 6.5 percent when it wants a floating-rate loan The company would exercise the swaption and then enter into the opposite swap in the market, receiving a fixed rate of FS(2,7) and paying L The net effect is that the company will pay 6.5 percent, receive FS(2,7), which is more than 6.5 percent, and pay L So in effect it will pay a floating-rate loan of less than Libor Back to Notes Example 13 A company is engaged in a two-year swap with quarterly payments It is paying percent fixed and receiving Libor It would like the flexibility to terminate the swap at any time prior to the end of the twoyear period A Identify the type of swaption that would achieve this objective B Consider a time t during this two-year life of the swaption in which it is being considered for exercise Use a percent exercise rate The fixed rate in the market on a swap that would offset the existing swap is denoted as FS(t,2) Examine the payoffs of the swaption based on whether FS(t,2) is 1) equal to or above percent or 2) below percent Solution to A: IFT Notes for the Level III Exam www.ift.world Page 28 Risk Management Applications of Swap Strategies IFT Notes Because the company is paying a fixed rate and receiving a floating rate, it should enter into a swap to receive a fixed rate and pay a floating rate It thus would want a receiver swaption For maximum flexibility, it should structure the transaction as an American-style swaption Solution to B: FS(t,2) ≥ percent The swaption is out-of-the-money and is not exercised To terminate the existing swap, one would enter into a swap at the market rate This swap would involve receiving the market rate FS(t,2), which is at least percent, and paying Libor The Libor payments offset, and the net effect is a net positive cash flow of FS(t,2) – percent FS(t,2) < percent Exercise the swaption, entering into a swap to receive percent and pay Libor The other swap involves paying percent and receiving Libor The Libors offset, leaving a net positive cash flow of – = percent Note: It is not necessary that the net cash flow be positive The positive net cash flow here is a result of choosing a percent exercise rate, but a lower exercise rate could be chosen The higher the exercise rate, the more expensive the receiver swaption Back to Notes Example 14 A German company issues a five-year noncallable bond with a face value of €40 million The bond pays a coupon annually of 10 percent, of which percent is estimated to be a credit premium A The company would like to make the bond callable in exactly two years Design a strategy using a European swaption that will achieve this goal When the swaption expires, the fixed rate on the underlying swap will be denoted as FS(2,5) Evaluate what happens when this rate is at least the exercise rate and also when it is less than the exercise rate B Reconsider the bond described above and assume it was actually issued as a callable bond with a 10 percent coupon Construct a swaption strategy that will synthetically remove the call feature As in Part A, let the swaption expire in two years and evaluate the outcomes Solution to A: To synthetically add the call feature to this bond, the company should purchase a receiver swaption The exercise rate should be the coupon rate on the bond minus the credit premium: 10 – = percent At the swaption expiration, we have the following outcomes: FS(2,5) ≥ percent The swaption will not be exercised, and the bond will not be called The company continues to pay 10 percent on its bond FS(2,5) < percent IFT Notes for the Level III Exam www.ift.world Page 29 Risk Management Applications of Swap Strategies IFT Notes The swaption is exercised Enter into swap Receive percent Pay Libor Enter into a new swap at the market rate Receive Libor Pay FS(2,5) Company continues to pay 10 percent on its bond Net effect: Pay FS(2,5) + 10% – 7% = Pay FS(2,5) + 3% < 10% The company has thus effectively issued a new bond at a lower rate The option premium, however, effectively raised the coupon rate on the old bond to that of a callable bond Solution to B: To synthetically remove the call feature on this bond, the company should sell a receiver swaption The exercise rate should be the coupon rate on the bond minus the credit premium: 10 – = percent At the swaption expiration, we have the following outcomes: FS(2,5) ≥ percent The swaption will not be exercised The company continues to pay 10 percent on its bond FS(2,5) < percent The swaption is exercised Enter into swap Receive Libor Pay percent Enter into a new swap at the market rate Receive FS(2,5) Pay Libor Bond called Issue new bond at FS(2,5) + 3% Net effect: Pay FS(2,5) + 3% + 7% – FS(2,5) = 10% Therefore, if the company sells the receiver swaption, the bond’s call option is offset and effectively removed The option premium, received up front, effectively reduces the coupon rate on the outstanding bond to make it equivalent to that of a noncallable bond Back to Notes IFT Notes for the Level III Exam www.ift.world Page 30 ... receive-fixed swaps will have a positive duration IFT Notes for the Level III Exam www .ift. world Page Risk Management Applications of Swap Strategies IFT Notes 2.2 Using Swaps to Adjust the Duration of. .. this scenario IFT Notes for the Level III Exam www .ift. world Page Risk Management Applications of Swap Strategies IFT Notes Risks faced by COLS in the above swap are:  Credit risk of the counterparty... a payer swaption Solution to B: IFT Notes for the Level III Exam www .ift. world Page 27 Risk Management Applications of Swap Strategies IFT Notes The outcomes based on the swap rate at swaption