Reading 38

Risk Management Applications of Swap Strategies

Created for Alchemists Academy by MacLaneWilkison

Introduction

Swaps can be viewed as combinations of forward contracts

Converting Floating and Fixed Rates

Net effect: BorrowCo pay 7% + 4% = 11% fixed

Adjusting Duration with Swaps

Negative duration (pay fixed to receive floating)
Terms (maturity/payment frequency)
Notional principal: NP = B[(MDUR_T-MDUR_B)/MDUR_S]

For example, to adjust the duration of a $100MM portfolio from 6.00 to 3.75 using a swap with MDUR of -.50, the NP will be: $100MM(3.75-6.00)/-.50 = $450MM

Structured Notes

Leveraged floater

Net effect: ArbitrageCo earns 1.5(ci-FS)(FP) fixed

Structured Notes (cont'd)

Inverse floater

Net effect: ArbitrageCo earns FP(FS+ci-b) fixed

Converting a Loan to Another Currency

converting a loan in one currency into a loan in another currency illustration

Converting Cash Receipts into Domestic Currency

Current spot exchange rate of ¥120/$

converting foreign cash receipts into domestic currency illustration

Net effect: BorrowCo converts its quarterly ¥500MM into ~$5.83MM at a fixed rate

Managing Dual-Currency Bonds

Diversifying a Concentrated Portfolio

Net effect: InvestCo pays the return on XYZ stock and receives the return on the specified index

Achieving International Diversification

Net effect: InvestCo earns the return on the domestic stock and enters a swap paying that domestic return and receiving the return on an international index

Changing Asset Allocation

changing an asset allocation illustration

Net effect: InvestCo changes its asset allocation to weight equities more heavily

Reducing Insider Exposure

Net effect: The insider effectively sells his exposure and receives a return of an equivalent amount in equity and/or bonds

Swaptions

Payer vs. receiver swaptions
American vs. European swaptions
Strategies/applications:

Anticipating future borrowing
Terminating a swap
Synthetically removing (adding) a call feature in callable (noncallable) debt

A payer swaption gives the holder the option to enter into a swap as the fixed-rate payer, floating-rate receiver. A receiver swaption gives the holder the option to enter into a swap as the fixed-rate receiver, floating-rate payer. A European-style swaption can only be exercised at expiration. An American-style swaption can be exercised at any time up to and including the expiration. Swaptions can be used in anticipation of future borrowing (i.e. a company anticipates taking out a loan at a future date and purchases a swaption that gives it the flexibility to enter a swap at an attractive rate), to terminate a swap (i.e. a company enters a swap and purchases a swaption that gives it the option to enter into an offsetting swap in the event interest rate movement are not favorable), and to synthetically add (remove) calls in callable (noncallable) debt (i.e. to synthetically remove a call, sell a receiver swaption and to synthetically add a call, purchase a receiver swaption.