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

Level III Risk Management Applications of Swap Strategies Summary Graphs, charts, tables, examples, and figures are copyright 2016, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Using an Interest Rate Swap to Convert a Floating Rate Loan to Fixed Rate Loan Swaps can also be used to convert fixed rate loans to floating rate loans 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 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 Using Swaps to Change the Duration of a Bond 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 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 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 Converting Foreign Cash Receipts into Domestic Currency 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 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 Equity Swaps 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 Diversification of a concentrated position International diversification 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 USRM has $500 million invested in US stocks The organization wants to invest 10% of its portfolio internationally A combination of equity swaps and fixed income swaps can be used to change asset allocation Stock Large cap Mid cap Small cap Bonds Government Corporate Current $150 Million, (75%) $90 million (60%) $45 million (30%) $15 million (10%) Current $50 Million, (25%) $40 million (80%) $10 million (20%) New $180 Million, (90%) $117 million (65%) $45 million (25%) $18 million (10%) New $20 Million, (10%) $15 million (75%) $5 million (25%) Transaction Buy $27 million None Buy $3 million Transaction Sell $25 million Sell $5 million 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 Swaptions 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: 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 a swaption to change the payment pattern of a future loan 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 so it buys a swaption from dealer DTD 10 Using a swaption to terminate a swap IMS takes out a $20 million ten-year loan with 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 11 ... 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 Currency Swaps... exercise rate of 7% There are two types of swaptions: 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... receive-floating swaps will have a negative duration Pay-floating, receive-fixed swaps will have a positive duration Using Swaps to Change the Duration of a Bond Portfolio Notional principal of swap =