Reading 16: Swaps, Forwards, and Future Strategies

Question 1

Volatility Vs Variance Swaps

Answer 1

The payoff on variance swap is based on implied volatility verses realised volatility. The payoff on a variance swap is the difference between implied variance and realised variance. Volatility swap generates linear payoff while variance swap generates a convex payoff (attractive feature that can offset tail risk).

Question 2

Cheapest to Deliver Bond

Answer 2

The Treasury bond with the lowest basis will typically have the highest implied repo rate and be the cheapest-to-deliver. Basis is defined as the spot price less futures price. This is the cash and carry model.

Question 3

Cross Currency Basis

Answer 3

Make sure that you subtract the negative basis from the non-US dollar interest payments.

Question 4

Euro Dollar Futures

Answer 4

Selling futures is notional borrowing, where as buying futures is notional lending.

Question 5

Hedging

Answer 5

Hedging a portfolio with Eurodollar futures (interest rate futures) is appropriate when the position is no more than 2-3 years to maturity. They have greater liquidity than bond futures, but liquidity decreases as tenor extends. Bond futures have better liquidity for longer tenors.

Question 6

Using Derivatives to Increase or Decrease Asset Allocation

Answer 6

The target beta will be zero if you are decreasing, the portfolio beta will be zero if you are increasing.

Question 7

Interest Rate Swaps

Answer 7

A payer swap pays fixed which decreases duration, a receiver swap receives fixed which increases duration. As interest rates increase the fixed payer will not have to increase payments.

Question 8

Short Term Interest Rate Futures (STIR)

Answer 8

The futures price is forward interest rate on deposits starting at expiration for 30 days. Based on $1m deposit and priced using IMM Index Convention (100 - annualised forward rate). Future prices will rise and forward rates fall, which is the opposite to long FRAs. One BP change in forward rate will cause a $25 change in contract value.

Question 9

Fixed Income Futures

Answer 9

There is a basket of bonds that the short can deliver, each assigned a conversion factor to reflect its value relative to the notional bond in contract.

Question 10

Interest Rate Risk Hedging

Answer 10

Hedge is not always perfect as its uses the CTD bond, if level or slope of term structure rates change the CTD bond may change; duration is not a perfect measure of interest rate changes as it ignores convexity; MD only captures risks of parallel moves in yield curve.

Question 11

Cross Currency Basis Swaps

Answer 11

Where the notional is swapped at beginning and end. Covered interest rate parity does not hold anymore due to stricter capital adequacy, high demand for USD loans. Meaning basis does exist. Most currencies show negative basis against the dollar since the financial crisis, meaning a USD borrower must accept lower foreign currency interest payment is receives.

Question 12

Negative Basis

Answer 12

USD fixed income investor can benefit when foreign currencies have negative basis verse the USD. They swap USD for foreign currency and invest in foreign currency bonds using a currency swap to convert returns back to USD.

Question 13

Equity Swap V Physical Swap

Answer 13

Equity swap gain exposure when using physical markets is prohibited, can avoid tax on ownership, avoid custody fees. But equity swaps typically require collateral, swaps are illiquid, and do not convey voting rights. Sell futures to reduce equity exposure, buy futures to increase equity exposure. Actual futures price is the quoted futures price times the multiplier.

Question 14

Cash Equitisation

Answer 14

Holding cash balances so purchasing index futures to replicate the portfolio. High liquidity and low transaction costs relative to direct investments. Also known as cash securitisation or cash overlay.

Question 15

VIX Index

Answer 15

Measures implied volatility inferred from S&P500 over forward period of 30 days. VIX of 20 indicates the S&P will stay within -+20% range over one year with a 68% confidence. Lower than 20 indicates low risk and above 30 indicates high risk, VIX is mean reverting. Investors cannot directly invest in the VIX, but can use VIX futures and options.

Question 16

VIX Futures

Answer 16

If volatile increases, VIX futures would increase in value, selling VIX futures creates a short position on volatility. Long futures position in contango (increasing) will have negative roll yield. Short futures position in contango will have positive roll yield. Long futures position in backwardation will have positive roll yield, short futures in backwardation will have negative roll yield.

Question 17

Variance Swaps

Answer 17

One makes fixed payment based on implied variance that is known at initiation and the other makes a variable payment which is unknown at initiation and is the actual realised variance. The long variance swap will benefit if the realised variance is higher than the implied variance. The value is zero at initiation, there is no notional swapped and the payment occurs at the expiry.

Question 18

Swaps

Answer 18

A payer swap reduces duration (has negative duration) and a receiver swap increases duration. The duration of each will be the same but the payer swap duration will be negative.