jawz

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&P 500 would most likely be trying to:

A) reduce systematic risk in the portfolio.

B) diversify her portfolio.

C) increase the risk and return of her position.

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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.

jawz

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.

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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.

jawz

A borrower who is also the owner of a swaption that gives the holder the right to become a fixed-rate payer and floating-rate receiver would most likely do which of the following? Exercise the swaption when interest rates:

A) increase to convert a fixed-rate loan to a floating-rate loan.

B) increase to convert a floating-rate loan to a fixed-rate loan.

C) decrease to convert a floating-rate loan to a fixed-rate loan.

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The owner will benefit when interest rates increase because the owner has the right to pay a fixed rate and receive the floating rate, which will be higher with the increase in interest rates. Receiving the floating rate and paying the fixed rate can turn a floating-rate loan to a fixed-rate loan.

jawz

A firm contracts to borrow $5 million in one year. The firm enters into a one-year swaption where the swap maturity and notional principal match that of the planned loan. The swaption gives the firm the right to be a floating-rate payer. This hedging strategy would be most effective if the loan contract specifies a:

A) variable rate and interest rates decline.

B) variable rate and interest rates increase.

C) fixed rate and interest rates decline.

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A firm that has contracted to borrow at a fixed rate in the future would want a hedge against interest rates falling and being stuck paying a higher-than-market rate. A swaption to become a floating-rate payer benefits the owner when interest rates decline. The firm will receive a “high” fixed rate and pay “low” variable rates, and this will offset the higher-than-market rate in the contract.

jawz

A firm has most of its liabilities in the form of floating-rate notes with a maturity of two years and a quarterly reset. The firm is not concerned with interest rate movements over the next four quarters but is concerned with potential movements after that. Which of the following strategies will allow the firm to hedge the expected change in interest rates?

A) Go long a payer’s swaption with a 1-year maturity.

B) Enter into a 2-year, quarterly pay-fixed, receive-floating swap.

C) Go short a payer’s swaption with a 2-year maturity.

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The firm will want to receive floating payments to offset the volatility of its floating-rate obligations. A payer’s swaption allows the firm to become a fixed-rate payer/floating-rate receiver in a swap. The one-year maturity corresponds to the start of the period of concern.