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