Achieving int'l diversification with swaps leads to tracking error

CFA Level III
#1

They can catch us out with this in a multiple choice.

Also the use of equity swaps can lead to negative cash flows if the received return is negative. So the investor who was not trying to sell the portfolio may have to sell it in the end.

#2

How does it lead to TE?

#3

Because when you internationally diversify you

  1. Receive the return from your domestic portfolio and

  2. Pay the return from a domestic index and receive the return from a foreign index

Because you do not exactly pay the return from your domestic portfoio but rather from the domestic index, this leads to tracking error. between the domestic index and the domestic portfolio

#4

you talking about fixed vs. floating interest rate swaps for TE or currency swaps? i can imagine it can happen either way, wherever you have some kind of basis risk

#5

But then even if there were no swap, your portfolio would still have TE because portfolio return isn’t equal to domestic index return.