Swaps, Forwards, Futures Strategies

Question 1

Show the mechanics of the following transaction:
Company issues $1M in bonds at LIBOR + 50bps
Enters Fixed-for-floating
Swap Rate = 1.25%

Answer 1

Draw

Question 2

How can you use interest rate swaps to change duration?

Answer 2

A received fixed is a positive duration instrument, so it can be used to lengthen. You can enter a pay fixed if you want to reduce duration.

Question 3

How do swaps introduce basis risk?

Answer 3

Swap rates are based on interbank rates whereas assets and liabilities are usually based on T Bills or Corps.

Question 4

How do you calculate the notional value of an interest rate swap to bring portfolio to a desired duration?

Answer 4

Notional = Target Duration - Current Duration/Swap Duration

Question 5

How do eurodollar futures contracts relate to interest rates?

Answer 5

Eurodollar futures are priced as 100-reference rate. Therefore, you make money when rates drop.

Question 6

What is the preferred way to hedge bond positions?

Answer 6

Fixed income futures

Question 7

What is the duration of a fixed income futures contract?

Answer 7

It will be the duration of the cheapest to deliver bond

Question 8

How do you determine the hedge ratio for fixed income futures?

Answer 8

Notional = BPV Target - BPV Portfolio/BPV Future all * CF

Question 9

How do you calculate BPV?

Answer 9

BPV is the Duration * MV of a bond * 0.0001

Question 10

How do you calculate the BPV of a fixed income future?

Answer 10

Duration * MV * 1000 * 0.0001

Question 11

What is a cross currency basis swap? Draw the framework:

Answer 11

This is a contract where two firms exchange currencies (spot rate), pay periodic interests, and exchange back in the future.

Question 12

What is the benefit of a cross currency basis swap to a US investor when USD demand is high?

Answer 12

When USD demand is high, you can shave bps off of the rate that you will pay the counterparty in the swap, therefore increasing your return above the local interest rate.

Question 13

What is the difference between a cash or physically settled total return swap?

Answer 13

Cash settled is simply exchanging cash, physical settlement you actually give the equity position at the end of the period and receive the amount valued at the beginning

Question 14

How do you calculate the notional value of an equities future contract?

Answer 14

Value of the futures * the multiplier (often 250)

Question 15

How do you determine the notional amount of equity futures needed to adjust the beta of a portfolio?

Answer 15

Notional = Target Beta - Portfolio Beta/Futures Beta * (Portfolio Value/Futures value(F*multiplier))

Question 16

What is cash equitization and how do you do it?

Answer 16

This is when you want your cash to act like equity via futures. The notional number of long futures:
Notional = Beta Target/Beta futures * Portfolio Cash/Futures value

Question 17

What is the VIX based on?

Answer 17

It is based on the price of near dates calls and puts on the index. The VIX reading is the implied annualized standard deviation of the index. For example, if VIX is 15, over next 30 days the SD of returns on the index is 15 annualized (need to make it monthly)

Question 18

What does contango actually mean?

Answer 18

Contango is an upward sloping curve where expected spot prices are less than futures prices. The spot price is pulling the futures price down.

Question 19

What does backwardation actually mean?

Answer 19

This is a downward sloping curve where expected spot is higher than futures and is dragging up the futures curve.

Question 20

What is negative roll and when would you have it on a future contract?

Answer 20

Futures contracts must converge to spot prices over time. When the curve is in contango, futures prices are higher than expected spot prices. If you buy a future a month out where the futures price is higher than expect spot prices, when approaches maturity you have two choices - buy the asset at the futures price or sell the contract. Most people will sell the contract and receive the value, which will converge to spot. However, because the futures prices are upward sloping in contango, you end up paying more per unit to roll it over.

Question 21

What do call options on the VIX mean? What do put options mean?

Answer 21

This means you are betting on high vol, and kind of a bet on equities going down. Put options are the opposite.

Question 22

What is the notional amount on a variance swap?

Answer 22

Notional = Vega notional/2* strike

Question 23

What is the settlement amount of a variance swap?

Answer 23

= Notional * (Realized variance - strike variance)

Question 24

How do we find the value of a variance swap?

Answer 24

= Notional * (t/T * Realized Variance + T-t/T * Implied Variance - Strike^2) *(PFV)
Implied vol is the strike on a new contract

Question 25

How do they come up with a strike price on a variance swap?

Answer 25

Strike is approx IV of a put such that putstrike/indexprice = 90%

Question 26

What can you imply from fed funds futures?

Answer 26

1) Effective FF rate implied = 100-expected rates

2) Probability of rate hikes

Question 27

How do we calculate the probability of a rate hike?

Answer 27

Probability = Implied FF rates - Current mid rate/Expected Hike rate mid point - Current mid point