Reading 40: Risk Management Applications of Swap Strategie principal, interest, achieve, desired, needed

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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 d: Determine the notional principal value needed on an interest rate swap to achieve a desired level of duration in a fixed-income portfolio.

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If a fixed-income portfolio manager wants to double the duration of a portfolio with a swap that has the same duration as the portfolio, then the notional principal would be:

A) twice the value of the portfolio.

B) half the value of the portfolio.

C) any positive value, and they would all work.

D) equal to the value of the portfolio.

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Answer and Explanation

If we let V and D equal the current value and duration of the portfolio respectively, then we see that:

NP = V * (2*D D) / D = V

NP = V * (2*D D) / D = V

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A manager of a $40 million dollar fixed-income portfolio with a duration of 4.2 wants to lower the duration to 3. The manager chooses a swap with a net duration of 2.1. What notional principal (NP) should the manager choose for the swap to achieve the target duration?

A) $70,000,000.

B) $22,857,143.

C) $56,000,000.

D) $28,888,888.

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Answer and Explanation

NP = $40,000,000 * (3 4.2) / -2.1

NP = $22,857,143

Since the manager wants to reduce the duration of his portfolio, he should take a receive-floating/pay-fixed position in the swap with that notional principal. Remember that a receive-floating swap has a negative duration, so we enter 2.1 in the equation.

NP = $22,857,143

Since the manager wants to reduce the duration of his portfolio, he should take a receive-floating/pay-fixed position in the swap with that notional principal. Remember that a receive-floating swap has a negative duration, so we enter 2.1 in the equation.

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A manager of a $2 million dollar fixed-income portfolio with a duration of 3 wants to increase the duration to 4. The manager chooses a swap with a net duration of 2. The manager should become a:

A) pay-floating counterparty in the swap with a notional principal of $2 million.

B) receive-floating counterparty in the swap with a notional principal of $1 million.

C) receive-floating counterparty in the swap with a notional principal of $2 million.

D) pay-floating counterparty in the swap with a notional principal of $1 million.

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Answer and Explanation

To increase duration, the manager should be a pay-floating/receive-fixed counterparty in the swap with a notional principal equal to:

NP = $2,000,000 * (4 3) / 2

NP = $1,000,000.

NP = $2,000,000 * (4 3) / 2

NP = $1,000,000.