sm24 - CHAPTER 24 SWAP CONTRACTS, CONVERTIBLE SECURITIES,...

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CHAPTER 24 SWAP CONTRACTS, CONVERTIBLE SECURITIES, AND OTHER EMBEDDED DERIVATIVES Answers to Questions 1. CFA Examination III (1994) l(a). An interest rate swap is a customized risk-management vehicle. In a pension portfolio (i.e., investment) context, an interest rate swap would be represented by an agreement between two parties to exchange a series of interest money cash flows for a certain period of time (term) based on a stated (notional) amount of principal. For example, one party will agree to make a series of floating-rate coupon payments to another party in exchange for receipt of a series of fixed-rate coupon payments (or vice versa, in which case the swap would work in reverse). No exchange of principal payments is made. l(b). Strategies using interest rate swaps to affect duration or improve return in a domestic fixed-income portfolio can be divided into two categories: Duration modification. Swapping floating- for fixed-rate interest payments increases portfolio duration (and vice versa, decreases duration when the portfolio is the floating-rate recipient). This method of modifying duration can be used either to control risk (e.g., keep it within policy guidelines/ranges) or to enhance return (e.g., to profit from a rate anticipation bet while remaining within an allowed range). Seeking profit opportunities in the swap market. Opportunities occur in the swap market, as in the cash markets, to profit from temporary disequilibrium between demand and supply. If, in the process of exploiting such opportunities, portfolio duration would be moved beyond a policy guideline/range, it can be controlled by using bond futures contracts or by making appropriate cash-market transactions. If a strategy calls for a large-scale reorientation of the portfolio’s characteristics in a manner that swaps could achieve, their use for implementation of the strategy would act to reduce transaction costs (thus improving portfolio return) and might also permit transactions to be effected more quickly or completely than through conventional trading mechanisms. 2. An interest rate swap is an agreement to exchange a series of cash flows based on the difference between a fixed interest rate and a floating interest rate on some notional amount. A fixed rate receiver would get the difference between a fixed rate and a floating rate if the fixed rate was above the floating rate, and pay the difference if floating was above fixed. The fixed rate is set so that no cash changes hands upon initiation of the deal. This can be thought of as: i. A series of forward contracts on the floating rate because forward contracts also have no initial cash flow and will net the difference between the floating rate and the forward rate (which acts like a fixed rate). To make the analogy precise, only one 24 - 1
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forward rate is chosen but it is chosen such that the sum of the values of all the contracts are zero. The fixed rate receiver is like the short position in the interest rate
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This note was uploaded on 05/20/2010 for the course FIN 5DLS taught by Professor Leejohn during the One '10 term at La Trobe University.

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sm24 - CHAPTER 24 SWAP CONTRACTS, CONVERTIBLE SECURITIES,...

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