uses of swaps in portfolionmamnagement

Question 1

The three main uses of swaps include:

Answer 1

1. risk management – ie matching assets and liabilities 

   
   2. reducing the cost of borrowing 

   3. swapping exposure between different asset classes without disturbing the underlying assets. 


Question 2

Risk management

Answer 2

An organisation can use swaps to reduce risk by matching its assets and liabilities. For example a company which has short-term liabilities linked to floating interest rates but long-term fixed rate assets can use interest rate swaps to achieve a more matched position. Currency swaps would be used by a company with liabilities in one currency and assets in another.

The use of swaps to transform the nature of assets and liabilities in this way was discussed in detail in Chapter 3.
Hedging with currency swaps and/or currency forwards can also be used to make currencies an asset in their own right (ie to allow managers to separate currency and country investment decisions). Outright speculation on currency movements is also possible, but is often considered too risky for many institutional investors.

Question 3

The disadvantages of using currency swaps include:

Answer 3

 the extra cost of the bid-offer spread compared with a straight spot currency transaction 

 removing the possibility of favourable currency movements, ie market risk 

 the introduction of counterparty credit risk 

 mismatching real liabilities by eliminating purchasing power parity protection against unexpected inflation differentials 

 the difficulty of hedging unknown future income 

 they can only easily hedge a level income stream 

 they are only available on fairly large principal amounts.

The first five of the above apply equally to the use of forwards for currency hedging discussed in Section 4. However, swaps are generally available for longer terms than forward agreements. This makes swaps more useful for hedging longer-term liabilities, eg for pension funds and life offices.

Question 4

Interest rate risk 


Answer 4

The most common measure of interest rate risk is PV01 (“Present Value 01”) which represents the change in value of a stream of fixed payments under a 1 basis point move in interest rates (at all maturities). 
PV01 is sometimes called DV01 (“Dollar Value 01”), particularly in the USA. 
PV01 does not capture risks such as positive or negative convexity, and to establish the size of mismatches under these higher order risks other measures need to be used.

Question 5

Reducing the cost of borrowing

Answer 5

Another important use of swaps can be to reduce the cost of borrowing. This is possible if two companies are able to borrow on different terms in different financial markets. 
If one organisation has a comparative advantage in borrowing at a floating rate while another company has a comparative advantage in borrowing at a fixed rate, they can use an interest rate swap to reduce the total cost of financing and both benefit from a lower cost of debt. 
Note that comparative advantage here implies that the companies’ relative credit ratings are different in the long-term and short-term debt markets, assuming that the long-term and short-term markets operate principally in terms of fixed and floating rates respectively.

Question 6

if different companies enjoy a comparative advantage when borrowing in different currencies

Answer 6

If each borrows in the currency in which they enjoy the comparative advantage, they can then use a currency rate swap to reduce the total cost of financing and both benefit from a lower cost of debt. 


Question 7

Currency

Answer 7

An investor which holds investments in a currency other than that in which its liabilities are denominated is exposed to variations in the exchange rate as well as variability in the return achieved on the underlying investment. 
If the investor does not want to bear this exposure it can be hedged in various ways, for example by using forward currency contracts.

Question 8

Inflation swaps

Answer 8

An investor which holds an asset that has an income stream that is linked to an inflation index is exposed to variations in future expectations of the level of inflation, and for longer-dated inflation-linked payments this can be a source of significant market risk.
An inflation swap allows a receiver of inflation-linked payments to pay these to a counterparty in return for receiving a fixed payment. Typical payers of inflation under inflation swaps will include holders of loans with inflation-linked payments or leaseholders who receive inflation-linked rental income. Institutional investors such as pension funds, with inflation-linked liabilities, can use inflation swaps to receive inflation and thereby hedge the market risk from uncertain future inflation within their liabilities.
For some time now, pension schemes have been reducing their equity weightings and increasing their holdings of bonds and liability matching assets. A means of gaining exposure to index-linked bonds is by means of an inflation swap. They have been achieving this in two ways:
1. Real rate swaps 

2. Synthetic index-linked bonds

Question 9

Real rate swaps

Answer 9

A real rate swap can allow a pension scheme to capture a credit spread in excess of index-linked gilt returns and also tailor asset proceeds to match the incidence of the scheme’s liability cashflows. With this type of swap, the pension scheme is able to invest the assets in a portfolio of fixed-rate corporate bonds, and swap the fixed cashflows from the bond portfolio in return for cashflows that match the timing and inflation characteristics of the pension payments. This approach also allows the corporate bond portfolio to be managed separately from the inflation swap on an active or passive basis.

Question 10

Synthetic index-linked bonds

Answer 10

This is a variation of the real rate swap that has been used by some pension schemes. The scheme still holds fixed-interest corporate bonds, but in this case swaps the coupons and redemption payments for payments that are indexed with RPI in the same manner as the coupon and redemption payments on an index-linked gilt.
The only difference from the real rate swap, therefore, is that the asset flows are chosen to mirror the proceeds from a notional portfolio of index-linked gilts, rather than refined to match the actual liabilities of the scheme.

Question 11

1.7 Swapping exposure between different asset classes

Answer 11

Swaps can also be used to swap portfolio exposure between different asset classes. This is discussed in detail in Section 3.4.