Schweser practice exam 4 (morning session) - Question 44 - Derivatives

CFA Level II
#1

Relevant fraction of the problem:

"AHI also manages a growth portfolio, currently valued at $10,000,000. The growth portfolio is very similar in composition to the S&P 500 Index, which currently stands at 2,250. Due to an uncertain political climate, AHI is concerned that this portfolio might experience a high degree of volatility over the next 12 months. As a result, the firm is considering using derivatives to hedge the portfolio’s exposure.

Ramiro suggests two possible approaches to hedge the risk:

Approach 1

Enter into a one-year total return equity swap, with quarterly settlement dates paying the equity return and receiving 90-day LIBOR. Payments on the swap would be netted, except in the case where the equity reference portfolio falls in value. In this case, AHI would have to pay 90-day LIBOR plus the fall in equity value."

Question related to the problem:

Approach 1 to hedging the growth portfolio is most likely described:

Correct answer:

incorrectly as AHI would need to enter as the floating rate receiver.

Explanation:

To hedge the return on an equity portfolio, AHI would pay equity and receive the floating rate (LIBOR). However, if the return on the equity portfolio was negative, it would receive this return (i.e., “pay” a negative return) and also receive 90-day LIBOR.

MY CONFUSION:

doesn’t he give up ALL returns (negative or positive) in favor of receiving libor? Why does he pay with positive returns, but has to bear the negative ones too? Where is his benefit?

Or do I simply not understand the explanation…?

#2

The explanation is in terms of the swap – not in terms of holding other equity asset that may offset the position of the swap. You can pretty much view the equity swap as a naked equity swap.

#3

Right, and you have to think about what he’s currently holding and what he’s trying to do. He is currently long the index and he wants to hedge in case it falls. In order to hedge his current position, he has to make sure he gets a return when the index falls. So he wants to be short the equity return, i.e., he collects a return when the index falls in value. So he would be on the side of the swap receiving a payment and paying the return; however, he gets paid the floating payment AND the negative return if the index falls. So he is hedged on the downside while effectively giving up the upside via the swap in return for floating payments. As such he position is hedged.