Section 4.3 “Changing an asset allocation between stocks and bonds” takes us through an example where Tactical Money Management (TMM) wants to change their portfolio allocation impacting both the proportion of stock vs. bonds and the make-up of those classes. The example concludes with with a swap that has TMM receiving returns on 2 stock indices and paying returns on two bond indices.
Following this pattern, I would have thought that in Example 10, you would construct a swap where the portfolio manager would receive return on $2 million in domestic stock index, receive return on $3 million in foreign stock index, and pay return on $5 million in domestic bond index.
Instead, they don’t follow the TMM pattern. The swap only involves domestic stock and bond indices.
In order to accomplish the change in desired allocation to foreign stocks, they say, “The $5m return based on a domestic equity index should be allocated such that $2 million is based on domestic stock and $3 million is based on foreign stock.”
I have no idea what that means. Let’s say my return is $500,000 on the $5m in domestic equity index. Are they saying go out and buy stock? In which case, I ask, wasn’t the point to do this synthetically through swaps as a temporary allocation change? Plus, let’s say foreign stock was doing much better so that $2 million in domestic stock and $3 million in foreign stock would give me a return of $600,000. Telling me to make the domestic equity index return to look like its actually a domestic/foreign mix just does not make sense to me.
Please tell me why the TMM set-up doesn’t apply here.
is this in CFAI or is it schweser? ill look when i get home
It’s in the CFAI text, Volume 5.
I think they are referring not to the actual return, but to the return on the notional of…
So, to get to 50% eq and 50% bond exposure from the current 1/3 eq and 2/3 bonds, with a 30M port:
50/50 = 15M in equity and 15M in bond exposure.
Currently there is 10M in eq and 20M in bond exposure - so they have to gain additional exposure to the returns on domestic equities using a notional amount of 5M. With the swap to receive the return on 5M notional of equities, added to the the existing 10M in equity exposure - the portfolio would behave as if it were actually holding 15M of equities (from a return perspective).
The same logic then applies to the fixed income exposure: they have 20M in fixed income exposure, and they need to reduce it to behave as if they have only 15M in exposure - so they swap away the returns on 5M of the fixed income portfolio (notional).
Since both swaps (likely) have LIBOR as the opposite leg, the LIBOR legs cancel out and the swap is:
- Receive returns on a 5M portfolio of equities
- Pay returns on a 5M portfolio of bonds
Wow, that was a stupid response…for a couple of reasons:
- I failed to specifically address your concern regarding the dom/for exposure of the 5M of equity exposure they desire to capture. But, if you follow the logic of the equity/fixed income exposure changes I plodded through, you can further extend that to the 5M of equity exposure - just have 2M be tired to a dom index and 3M to a for index.
- They probably wouldn’t have 2 swaps, each with a Libor leg, they would probably use a single swap with one leg paying the fixed income returns the other receiving the equity returns. But, I’m not a swap wizard, and my brain hurts from all this cr*p, so in lieu of thinking it through, I’ll just say that hell, by entering into two separate swaps with different dealers, they diversify their counter party risks.