Reading 40: Risk Management Applications of Swap Strategie equity, stocks, provide, domestic

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CFA Institute Area 8-11, 13: Asset Valuation
Session 13: Risk Management Applications of Derivatives
Reading 40: Risk Management Applications of Swap Strategies
LOS g: Explain how equity swaps can be used to diversify a concentrated equity portfolio, provide international diversification to a domestic portfolio, and alter portfolio allocations to stocks and bonds.

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An investor has a $5,000,000 investment in small-cap stocks. The investor enters into an equity index swap where the investor pays the return on the Russell 2000 and receives the return on the Dow Jones Industrial Average. The notional principal of the swap is $1 million. The resulting position is a synthetic mix of:

A) 16.67 percent large stocks and 83.33 percent small stocks.

B) 20 percent large stocks and 80 percent small stocks.

C) 25 percent large stocks and 75 percent small stocks.

D) 20 percent large stocks, 60 percent small stocks, and 20 percent cash.

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Answer and Explanation

After the swap, $1 million, or 20 percent of the portfolios exposure will be invested in the Dow Jones Industrial Average index of large stocks. $4 million, or 80 percent of the portfolio will remain invested in small stocks. The $1 million notional principal represents 20 percent of the position. That is the amount that has been synthetically transferred from one class of assets to the other.

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An investor who enters into a swap to exchange half the return on her 100,000 share position in a stock for the return on an equal value of the S& 500 would most likely be trying to:

A) diversify her portfolio.

B) increase the risk and return of her position.

C) lower taxes.

D) reduce systematic risk in the portfolio.

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Answer and Explanation

Entering into a swap to exchange the returns on the stock for those of the index would be way to create synthetic diversification in a portfolio. Note that the added diversification as a result of the swap would reduce unsystematic risk, but systematic risk will still exist.

tycoon

An investor has a $5,000,000 investment in small-cap stocks. The investor enters into an equity index swap where the investor pays the return on the Russell 2000 and receives the return on the Dow Jones Industrial Average. The notional principal of the swap is $1 million. The resulting position is a synthetic mix of:

A) 16.67 percent large stocks and 83.33 percent small stocks.

B) 20 percent large stocks and 80 percent small stocks.

C) 25 percent large stocks and 75 percent small stocks.

D) 20 percent large stocks, 60 percent small stocks, and 20 percent cash.

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Answer and Explanation

After the swap, $1 million, or 20 percent of the portfolios exposure will be invested in the Dow Jones Industrial Average index of large stocks. $4 million, or 80 percent of the portfolio will remain invested in small stocks. The $1 million notional principal represents 20 percent of the position. That is the amount that has been synthetically transferred from one class of assets to the other.