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.

Q1. A manager of a $300 million bond portfolio consisting of $50 million in investment-grade corporate bonds and $250 million in U.S. Treasuries wants to re-weight to a 50/50 mix. This can be done with a bond-index swap with a notional principal of:

A)   $275 million.

B)   $100 million.

C)   $250 million.

Q2. 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% large stocks and 83.33% small stocks.

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

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

Q3. 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)   reduce systematic risk in the portfolio.

B)   increase the risk and return of her position.

C)   diversify her portfolio.

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. fficeffice" />

Q1. A manager of a $300 million bond portfolio consisting of $50 million in investment-grade corporate bonds and $250 million in U.S. Treasuries wants to re-weight to a 50/50 mix. This can be done with a bond-index swap with a notional principal of:

A)   $275 million.

B)   $100 million.

C)   $250 million.

Correct answer is B)

The swap would exchange the return on $100 million in U.S. Treasuries for the return on $100 million of the corporate bonds. This would create a synthetic mix of $150 million in each position.

Q2. 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% large stocks and 83.33% small stocks.

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

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

Correct answer is B)

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

Q3. 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)   reduce systematic risk in the portfolio.

B)   increase the risk and return of her position.

C)   diversify her portfolio.

Correct answer is C)

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.

Thx!