Q42 Mock 2013 PM

Why is the answer A instead of C.

  • midcap underperform small cap - interest rates rise

Thus the idea is to - increase small cap exposure - reduce mid cap exposure - reduce duration

[Answer A] Swap 1: receive libor and pay midcap only addresses one item which is to reduce mid cap exposure. But but in receiving libor there is a minor increase in duration.

[Answer C] Swap 3: receive small cap and pay libor addresses two issues. Gain exposure to better performing small cap and pay libor to reduce duration.

Should’nt C be the better answer?

You don’t know how small caps perform relative to LIBOR

I think you know small caps outperform mid caps, but this doesnt mean small caps outperform LIBOR

Based on what the question gives you A would be correct

You want to receive LIBOR as rates are higher

Similary, we also don’t know how mid cap perform relative to LIBOR.

Somehow the question/answer seemed too ambiguous and is largely dependent on the performance of small/mid cap relative to libor. And also its difficult to quantity the relative performance b/w paying or receiving LIBOR vs paying/receiving midcap or small cap return.

I can see your point, however the question said that they already have exposure to the mid cap index and ask what approach they should take based on mid cap underperforming and interest rates increasing. The best way to alter an existing exposure from their current holding would be to reduce midcap exposure and increase LIBOR, hence A

or another way of looking at it. We know we don’t know what small caps is doing (we only know midcap underperform). But we do know interest rates are increasing - so we wouldn’t want to pay LIBOR and pay a higher amount

Thanks for clarifying. But I still feel the receive LIBOR part runs counter to the idea to reduce duration. But I guess the emphasis here is not to reduce duration and assuming LIBOR alters almost 0 duation.

Yes I agree. If you hold a bond and you think rates will increase you want to reduce duration. In a swap when receiving LIBOR you want LIBOR to increase