RE: Item Set Questions on Mock Exam. Watanbe

Q3, in order to adjust the allocation from 50-50 equipty-bond to 60-40, a swap could be used.

Receive LIBOR and pay return on bond performance.

Why receive LIBOR? Should it be receiving equity performance instead?

read the question carefully.

currently portfolio is 50% bond, 50% equity. needs to become 60% equity, 40% bond.

so you enter into a series of swaps - to

a. Pay 10% bond return, receive Libor in return.

b. Pay Libor, receive 10% equity return.

Answer choices provided

Which of these is most likely to be a characteristic of one of the two swaps Watanabe describes to Sato?

A. Receive return on Nikko Bond Performance Index

B. Pay return on Nikkei 225 Index

C. Receive Libor

a - incorrect - because you need to pay Bond return.

b. incorrect - because you need to receive equity return.

so only C - receive LIBOR will be a characteristic of the swap.

Ok, but wouldn’t he just swap 10% np bond for equity index return? Swapping a bond return for libor makes no sense. Why would you swap one bond for LIBOR in order to gain equity exposure?

Or is it becasue we have assume that you can only swap libor for equity, and therefore he needs to convert the bond to libor first…

u need 2 swaps one for bond, other for euity.

His mom: such a swap may not be available. For the sake of this test you are usually going to see one side be LIBOR (or some other vanilla int. rate). In this itemset that’s certainly the case.

The key statement is that a series of swaps is being used, which involves one paying LIBOR, and one receiving LIBOR. If the vignette mentioned only a single swap was required, it would be a different story.

Sorry for digging this up, so technically you can not swap bond return for equity return (you’ll have to excuse me, I have no experience with derivative products) ? Libor here is just a medium to get more exposure to equity return, am I right? Thanks.

LIBOR’s an intermediary step.

The point is that there is no bond/equity swap available, so you have to use two swaps. The question asks you to determine what one of the swaps will be.

Exactly, I think everything has been said here.

Just to add one concluding remark: just keep in mind that you will have to deal separately with whatever change you want to bring to your equity exposure and whatever change you want to bring to your bond exposure. So if you reduce your equity exposure to increase your bond exposure, you have to split your reasoning into two steps (because of two swaps):

  • First reduce your equity exposure to a risk free exposure

  • Then turn this risk free exposure to a bond exposure

(maybe “risk free” is not the exact proper wording for this intermediary step. There is always a bit of risk, like maybe counterparty risk linked to the swap. Somebody correct me if you have a better wording).

If I may add something, analyzing the question from the angle:

“what Sato will pay or receive in a potential swap?”

If he have to pay or receive something, the only correct solution is here to receive Libor.

Anyway, this reasonment oblige to make the assumption “what Sato will pay or receive”.

Wording, wording…