Subject 1. Changing Risk Exposures with Swaps, Futures and Forwards

Interest Rate Swap/Futures

Because interest rate swaps and futures are interest-sensitive instruments, they can be used to change the risk exposure of a portfolio to interest rates.

An interest rate swap can be used to alter the duration of a fixed-income portfolio. However, adding such a swap may introduce counterparty risk to the portfolio. Alternatively, interest rate futures contracts can be used for the same purpose without counterparty risk. This is because the duration of interest rate futures contracts is consistent with the forward behavior of the underlying bond.

Currency Swap/Futures

A currency swap can be used to manage exposure to foreign exchange risk or to access a cheaper capital market. The types of currency swaps include fixed/fixed, fixed/floating, and floating/floating. Unlike an interest rate swap, the notional value of a currency swap may be exchanged at the beginning and end of the swap's life.

As with interest rate swaps, currency swaps allow a company to arrange to make interest payments on either a fixed or floating basis, effectively altering its interest rate risk exposures.

Foreign currency futures can be used to manage exposure to foreign exchange risk and interest risk without introducing counterparty risk. For example, let's say that a US exporter is expecting to receive €5m in three months' time and that the current exchange rate is US$/€ = 1.24. Assume that this rate is also the price of US$/€ futures. The US exporter will fear that the exchange rate will weaken over the three months, say, to US$/€ = 1.10 (fewer dollars for a euro). If that happened, then the market price of the future would decline too, to around 1.1. The exporter could arrange to make a compensating profit on buying and selling futures: sell now at 1.24 and buy later at 1.10. Therefore, any loss made on the main currency transaction would be offset by the profit made on the futures contract.

Equity Swap/Futures

An equity swap allows one party to trade the return on a stock portfolio for the return on another asset. It can be used to modify the risk and return of an equity portfolio in a similar way. For example, a fixed income portfolio manager wants the portfolio to have exposure to the equity markets. He could enter into a swap in which he would receive the return of the S&P 500 and pay the counterparty a fixed rate generated from his portfolio.

Stock index futures can be used for hedging or investments. For example, investing via the use of stock index futures could involve exposure to the equity market without having to actually purchase shares directly.

Practice Question 1

A portfolio manager is managing a fixed-income portfolio which currently has a duration of 5 years. She wants to increase the duration to 8 years without buying or selling any of the securities. One way to achieve this would be to ______.

A. enter a pay-fixed, receive-floating swap
B. enter a receive-fixed, pay-floating swap
C. sell futures contracts that are based on bonds in the portfolio
Correct Answer: B

Strategies A and C would reduce the duration of the portfolio.

Practice Question 2

A currency swap CANNOT be used to mitigate ______ risk.

A. interest rate
B. foreign exchange
C. counterparty
Correct Answer: C

It is an over-the-counter derivative that is subject to counterparty risk.

Practice Question 3

A brokerage firm, which has $10 million in S&P 500 stocks, enters into an equity swap with a pension fund which currently has $10 million in a short-term savings account earning LIBOR. If these two entities were to arrange a proper equity swap, in which payments are to be made annually, what would be the net payment for a period that saw the S&P 500 net 12% and LIBOR set at 8%?

A. Brokerage firm makes a net payment of $400,000.
B. Pension plan makes a net payment of $400,000.
C. Pension plan makes a net payment of $200,000.
Correct Answer: A

A proper swap would involve the brokerage firm making payments equal to S&P 500 returns in exchange for LIBOR.

Brokerage pays 12% of $10 million = $1,200,000. Pension pays 8% of $10 million = $800,000. Net payable (broker's perspective): $400,000.

Practice Question 4

Assume you are managing a well-diversified equity portfolio of $100 million. One S&P 500 stock index futures contracts is standardized as $250 times the index level. A one-month futures contract trades at $2,000. To hedge your equity exposure, you plan to buy 200 contracts. Suppose the S&P stock index rises by 1% in 1 month; your total return would be ______.

A. 0
B. $1 million
C. $2 million
Correct Answer: C

This question is partially taken from the reading. However, you would actually increase your equity exposure by 100% by buying stock index futures!

Practice Question 5

The duration of an interest rate futures contract is the same as the duration of the underlying bond. True or False?
Correct Answer: False

The futures price moves consistently and proportionately with the yield of the underlying bond, but they are in general not the same.

Practice Question 6

A portfolio manager wants to increase the duration of her fixed-income portfolio from 5 years to 7 years. She is planning to use a receive-fixed interest rate swap to accomplish her goal. The duration of the interest rate swap needs to be _____.

A. less than 5 years
B. more than 5 years but less than 7 years
C. more than 7 years
Correct Answer: C

The duration of the swap has to be higher than 7 years to bring up the duration of the portfolio to 7 years.

Practice Question 7

If you enter a currency swap you MAY increase ______ risk.

I. interest rate
II. foreign exchange
III. counterparty

A. I and II
B. III only
C. I, II and III
Correct Answer: C

You can use a currency swap to manage (reduce/increase) your exposure to interest rate and foreign exchange risk. You will always introduce counterparty risk when entering a currency swap.