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1、CHAPTER 24SWAP CONTRACTS, CONVERTIBLE SECURITIES,AND OTHER EMBEDDED DERIVATIVESAnswers to Questions1. CFA Examination III (1994)l(a). An interest rate swap is a customized riskmanagement vehicle. In a pension portfolio (i.e., investment) context, an interest rate swap would be represented by an agre
2、ement between two parties to exchange a series of interest money cash flows for a certain period of time (term) based on a stated (notional) amount of principal. For example, one party will agree to make a series of floatingrate coupon payments to another party in exchange for receipt of a series of
3、 fixedrate coupon payments (or vice versa, in which case the swap would work in reverse). No exchange of principal payments is made.l(b). Strategies using interest rate swaps to affect duration or improve return in a domestic fixedincome portfolio can be divided into two categories:Duration modifica
4、tion. Swapping floating for fixedrate interest payments increases portfolio duration (and vice versa, decreases duration when the portfolio is the floatingrate recipient). This method of modifying duration can be used either to control risk (e.g., keep it within policy guidelines/ranges) or to enhan
5、ce return (e.g., to profit from a rate anticipation bet while remaining within an allowed range).Seeking profit opportunities in the swap market. Opportunities occur in the swap market, as in the cash markets, to profit from temporary disequilibrium between demand and supply. If, in the process of e
6、xploiting such opportunities, portfolio duration would be moved beyond a policy guideline/range, it can be controlled by using bond futures contracts or by making appropriate cashmarket transactions.If a strategy calls for a large-scale reorientation of the portfolios characteristics in a manner tha
7、t swaps could achieve, their use for implementation of the strategy would act to reduce transaction costs (thus improving portfolio return) and might also permit transactions to be effected more quickly or completely than through conventional trading mechanisms.2.An interest rate swap is an agreemen
8、t to exchange a series of cash flows based on the difference between a fixed interest rate and a floating interest rate on some notional amount. A fixed rate receiver would get the difference between a fixed rate and a floating rate if the fixed rate was above the floating rate, and pay the differen
9、ce if floating was above fixed. The fixed rate is set so that no cash changes hands upon initiation of the deal. This can be thought of as:i. A series of forward contracts on the floating rate because forward contracts also have no initial cash flow and will net the difference between the floating r
10、ate and the forward rate (which acts like a fixed rate). To make the analogy precise, only one forward rate is chosen but it is chosen such that the sum of the values of all the contracts are zero. The fixed rate receiver is like the short position in the interest rate forwards, because if interest
11、rates go up, she loses.ii. A pair of bonds, one with a floatingrate coupon the other with a fixed-rate coupon (both selling at par with the same face value and maturity). Being the fixed-rate receiver in the swap is the same as being long the fixed-rate bond and short the floating-rate bond. As long
12、 as the floating rate is less than the fixed rate, the coupon payment from the fixed-rate bond will cover the interest due on the floating rate bond and the difference is profit. If the floating rate is above the fixed rate then the fixed-rate receiver must make up the difference. Since the bonds ar
13、e of the same face amount, there is no net cash flow at the beginning or end of the agreement.3.To have zero value at origination, the present vale of the expected cash flows from the swap must be zero. This implies that if there is an upward sloping yield curve, the expected cash flows to the float
14、ing payer will come at the beginning of the swap and be offset by expected payments by the floating payer at the end of the swap. The only way this is possible is if the fixed rate is somewhere between the current floating rate (low) and the implied floating rate later in the contract (high).4.You a
15、re essentially holding a two-year swap agreement that requires you to pay 7% in exchange for floating. Since the market rate for the same swap is 6.5%, if your counterparty defaulted you would be able to replace the swap at a lower rate. Thus, it would be to your benefit for your counterparty to def
16、ault, and you would realize an economic gain.5.You have created an off-market swap where you are paying a fixed rate of 7%. This is seen by analyzing the portfolio of long a 7% cap and short a 7% floor. If interest rates are above 7%, then the cap pays the difference between 7% and the floating rate, and the floor is out-of-the money. If interest rates are below 7%, then you must pay the difference between floating and
