2018 Study Session # 15, Reading # 30 “RISK MANAGEMENT APPLICATIONS OF SWAP STRATEGIES” DCB = Dual Currency Bond CF= Cash Flow INTRODUCTION SWAP ⇒ contractual agreements that are used to exchange a series of CF over a specific period of time Swaps involve credit risk & have zero MV at initiation Swaps can be used to adjust the rate sensitivity of an asset or liability Types of Swaps Interest Rate Swaps Currency Swaps One party pays fixed IR & other pays floating IR or both parties pay floating payments Less credit risk relative to ordinary loans (interest payments are netted) One party makes payments in one currency & other party makes payments in another currency Equity Swaps Agreement in which at least one set of payments is based on the return of a stock price or stock index Commodity Swaps One set of payment is based on the course of a commodity price STRATEGIES AND APPLICATIONS FORMANAGING INTEREST RATE RISK 2.1 Using Interest Rate Swaps to Convert a Floating-Rate Loan to a Fixed-Rate Loan (and Vice Versa) Borrower will not be able to take advantage of falling IR as he/she is locked in to a synthetic fixed rate loan through swap The NP on the swap is set equal to the face value of the loan Duration of floating rate bond ≈ amount of time remaining until the next coupon payment Durations of fixed rate bonds ≈ 75% of its maturity for this reading Receive (pay) fixed swaps ( ) the duration of an existing position MV risk ⇒ uncertainty associated with MV of an asset or liability due to ∆ in IR CF risk ⇒ uncertainty associated with the size of the CFs When floating rate loan is converted to fixed rate loan CF risk & MV risk When fixed rate loan is converted to floating rate loan CF risk & MV risk Copyright © FinQuiz.com All rights reserved 2018 Study Session # 15, Reading # 30 2.2 Using Swaps to Adjust the Duration of a Fixed-Income Portfolio Duration is affected by maturity & frequency of the swap Most preferred approach ⇒ use the swap with a maturity at least equal to the period during which the duration adjustment is applied ܰܲ = ܸ ൬ ெ ೌೝ ିெಳ ெೞೢೌ ൰ Where ܦܯ௧௧ = target market duration ܦܯ = current market duration of portfolio ܦܯௌ௪ = market duration of a swap 2.3 Using Swaps to Create and Manage the Risk of Structured Notes 2.3.1 Using Swaps to Create and Manage the Risk of Leveraged Floating Rate Notes Leverage floater ⇒ type of leveraged structured note Coupon is a multiple of a specific market rate of interest e.g = ݁ݐܽݎ ݊ݑܥ1.5 × ܴܱܤܫܮ No capital is needed ⇒ cost of buying a fixed rate bond will be financed by the proceeds from issuing the structured note 2.3.2 Using Swaps to Create and Manage the Risk of Inverse Floaters Inverse floater is another type of structured note: ܾ = ݁ݐܽݎ ݊ݑܥ− ܴܱܤܫܮ To manage -ve interest payment risk (LIBOR>b), inverse floater issuers should buy an IR cap with followings features: Exercise rate of b NP = FV of loan Caplet expires on the IR reset dates of the swap Caplet payoff = (LIBOR-X) NP Limitation ⇒the lender would have to accept a lower rate (b) to avoid –ve IR problem STRATEGIES AND APPLICATIONS FORMANAGING EXCHANGE RATE RISK 3.1 Converting a Loan in One Currency into a Loan in another Currency Currency swaps ⇒ swaps used to transform a loan denominated in one currency into a loan denominated in another currency Principal amounts are exchanged at the beginning & end of the life of the swap Firms use currency swap to exploit their comparative advantage in foreign borrowings If a firm wants to issue debt in FC at a floating rate: It could issue a fixed rate bond in domestic currency & enter into a swap with the dealer in which the firm pays floating rate in FC against fixed rate domestic currency payment by dealer Firm could issue a domestic currency floating rate bond & enter a floating for floating swap as FC floating rate payer Copyright © FinQuiz.com All rights reserved 2018 Study Session # 15, Reading # 30 3.2 Converting Foreign Cash Receipts into Domestic Currency Currency swaps can be used to convert the FC cash flows into domestic CF (e.g foreign subsidiary’s CF) Credit risk is inherent in such transactions 3.3 Using Currency Swaps to Create and Manage the Risk of a Dual-Currency Bond Dual currency bond ⇒ interest is paid in one currency while the principal is paid in another Synthetic dual-currency bond = ordinary bond in domestic currency +currency swap with no principal payments Profitable if synthetic DCB is cheaper than the actual DCB Take a long position in synthetic bond+ short positions in actual DCB STRATEGIES AND APPLICATIONSFOR MANAGING EQUITY MARKET RISK Equity swap ⇒ swap where one party is obligated to pay an equity index or on an individual stock in exchange for a fixed rate, floating rate or the return on another index Equity swaps can be used to: Make necessary portfolio adjustments Exploit restrictions of short selling Lower transaction costs & to avoid losses To avoid risk associated with a concentrated position Limitation⇒ renewal required (limited swap life) F.I Swap V/S Equity Swaps Similarities Difference Total return based payment Total return is not known until the end of settlement period When capital gain is –ve, the overall payment will also be-ve FI swaps ⇒ interest payment represents major portion of total return Equities ⇒ dividend represents small amount of capital gains Risk Inherent in Equity & F.I Swaps Tracking Error Mismatch b/w performance of portfolio & indices that are used as proxy & on which swap payments are based Cash Flow Problem If FI payments > equity receipts, the investor faces the CF problem In case of swapping stock return for index return, net outflow may be required if stock outperforms the index Copyright © FinQuiz.com All rights reserved 2018 Study Session # 15, Reading # 30 STRATEGIES AND APPLICATIONSUSING SWAPTIONS Swaption ⇒ an option to enter into a swap ( ) exercise rate, the more expensive the receiver (payer) Swaption Method used to exercise a Swaption is predetermined by the parties Types of Swaption Payer Swaption Receiver Swaption Allows the holder to enter into a swap as fixed rate payer Similar to put option on a bond Allows the holder to enter into a swap as fixed rate receiver Similar to call option on a bond 5.1 Using an Interest Rate Swaption in Anticipation of a Future Borrowing Swaption gives the flexibility to the buyer to enter into a swap at an attractive rate (option is in-the-money) 5.2 Using an Interest Rate Swaption to Terminate a Swap By Entering an Offsetting Swap Terminate an existing swap by entering into an offsetting swap with a different counterparty Terminate an existing swap by entering into an offsetting swap with the original counterparty By Buying a Swaption If IR is expected to ( ) a borrower should use receiver (payer) Swaption to convert its pay fixed (floating) position to a pay floating (fixed) position 5.3 Synthetically Removing (Adding) a Call Feature in Callable (Non-callable) Debt 5.3.1 Synthetically Removing the Call from Callable Debt Receiver swaption is similar to call option on a bond Call option can synthetically be removed by selling receiver swaption (also called monetizing a call) Swaption will not cancel the bond’s call features & both options will remain in place 5.3.2 Synthetically Adding a Call to Non-callable Debt Call option can synthetically be added to a non-callable bond by buying a receiver swaption When rates , issuer starts receiving interest on receiver swaption & effectively cancel out its current fixed rate obligation on a non-callable bond An investor can: Synthetically add a call feature in a non-callable bond by selling a receiver swaption Remove a call feature in a callable bond by buying a receiver swaption Copyright © FinQuiz.com All rights reserved 2018 Study Session # 15, Reading # 30 Payer Swaptions (Add or Remove Put Options) For Issuers For Investors Add a put to an otherwise non-putable bond by selling a payer Swaption Synthetically remove a put option from a putable bond by buying a payer Swaption Synthetically add (remove) a put in (from) a non-putable (putable) bond by buying (selling) a payer Swaption 5.4 A Note on Forward Swaps Forward Swaps V/S Swaptions Forward Swaps Commitment to enter into a swap No upfront cash required at contract initiation Swaptions Option to enter into a swap Upfront premium is paid by the buyer to the seller Copyright © FinQuiz.com All rights reserved ... floating for floating swap as FC floating rate payer Copyright © FinQuiz. com All rights reserved 2018 Study Session # 15, Reading # 30 3. 2 Converting Foreign Cash Receipts into Domestic Currency... outflow may be required if stock outperforms the index Copyright © FinQuiz. com All rights reserved 2018 Study Session # 15, Reading # 30 STRATEGIES AND APPLICATIONSUSING SWAPTIONS Swaption ⇒ an option... in a callable bond by buying a receiver swaption Copyright © FinQuiz. com All rights reserved 2018 Study Session # 15, Reading # 30 Payer Swaptions (Add or Remove Put Options) For Issuers For