CFA 2018 r30 risk management applications of swap strategies

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 Por

Contents

1 Introduction

2 Strategies and Applications for Managing Interest Rate Risk

3 Strategies and Applications for Managing Exchange Rate Risk

4 Strategies and Applications for Managing Equity Market Risk

5 Strategies and Applications Using Swaptions

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1 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

2 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

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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

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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

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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

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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

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Solution to A

Solution to B

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2.3 Using Swaps to Create and Manage the Risk of

Structures Notes

Not mentioned in the learning objectives

From perspective of party which issues the structured note

Do examples 2 and 3 if you want to be diligent

3 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 Manage the Risk of a

Dual-Currency Bond

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

ROTEC is a British company which

plans to expand in Europe and

needs euros

Alternative 1: Issue a euro bond

This will be expensive because the

company is not know in Europe

Alternative 2: issue a

pound-denominated bond and use a

currency swap to convert into a

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3.2 Converting Foreign Cash Receipts into Domestic Currency

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COLS is a U.S company which

sells in Japan

Expects to transfer 300 million yen

at the end of every quarter for four

quarters; concerned about

exchange rate variation

Fixed rate on plain vanilla interest

rate swaps in Japan = 6.0%

Fixed rate on plain vanilla interest

rate swaps in America = 6.8%

Current exchange rate = 132

What is the solution?

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COLS faces credit risk

Also faces risk that Japanese operations will not generate 300

million yen per quarter

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

Dual-Not mentioned in learning objectives

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If you want to be diligent go over Exhibit 7 and Example 7

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4 Strategies and Applications for Managing Equity Market Risk

4.1 Diversifying a Concentrated Portfolio

4.2 Achieving International Diversification

4.3 Changing an Asset Allocation between Stocks and Bonds

4.4 Reducing Insider Exposure

4.1 Diversifying a Concentrated Portfolio

4.2 Achieving International Diversification

USRM has a $500 million portfolio

invested in U.S stock

Benchmark: Russell 3000

Wants to invest 10% internationally

Option 1: Sell $50 million and invest

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4.3 Changing and Asset Allocation between Stocks and Bonds

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

asset allocation

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LIBOR cancels out

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4.4 Reducing Insider Exposure

Not mentioned in learning objectives

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5 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

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

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BCHEM will need to borrow 10 million euro after 1 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 1 and ending at year 3

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A

B

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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 = 0 Payer or receiver swaption? What is the cost and benefit?

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IMS is no longer

concerned about rising

interest rates and would

like to return to status of

floating-rate borrower

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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 do exist These are called

forward swaps

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

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Conclusion

• Swaps are particularly important for two reasons

 Heavily used in developed financial markets

 Many examples and practice questions in the curriculum