Question 1

You enter into a two-year variable notional swap of equity returns for 6-month Libor with semi-annual payments on both legs. The initial swap notional is $100 million, the Libor rate at inception of the swap is 7.2%, and the realized raw equity returns during the first 6-month period is 6.3%. The first 6-month period has 183 days. The notional principal of the swap entering the second 6-month period is

Accepted Answer

D

Question 2

An equity swap may be used to time the markets. Given a current position in a $1,000 portfolio of 80:20 (equity:bonds), suppose you expect that bonds will perform relatively better than stocks and want to change the portfolio composition to 20:80, what swap would you enter into?

Accepted Answer

To change the portfolio composition from 80:20 to 20:80, you need to reduce your equity exposure and increase your bond exposure. By entering into an equity swap to pay the equity return and receive the bond return for a notional of $600, you effectively swap $600 worth of equity exposure for bond exposure, achieving the desired 20:80 allocation.

Question 3

Consider a five-year equity swap that pays the equity return in return for six-month Libor. Which of the following statements is most valid? Assume you are at the inception of the swap.

Accepted Answer

C

Question 4

A variable notional equity swap differs from a fixed notional equity swap in that

Accepted Answer

In a variable notional equity swap, the principal changes from period to period based on the actual returns on the underlying equity or equity index, unlike a fixed notional equity swap where the principal remains constant.

Question 5

Consider an equity swap of the equity index return versus six-month Libor. The current equity index is at 1100. The six-month Libor rate is currently 11.50%. There are 184 days in the given six month period. What should be the level of the index in 6 months for the net payment in six months to be zero?

Accepted Answer

For the net payment in six months to be zero, the return on the equity index must equal the return on the six-month Libor. The six-month Libor return can be calculated as follows: $1100 \times \left(1 + 0.115 \times \frac{184}{360}\right)$. This calculation gives a result of approximately 1165. Therefore, the level of the index must be 1165 for the net payment to be zero.

Question 6

Which of the following factors does affect the valuation of a fixed notional equity swap that pays the equity return in exchange for a fixed interest rate payment?

Accepted Answer

The valuation of a fixed notional equity swap is primarily affected by the interest-rate term structure, as it determines the present value of the fixed interest rate payments. Expected equity price growth and interest rate volatility structure do not directly impact the valuation of such a swap.

Question 7

You enter into an equity swap where you receive the US dollar return on the Nikkei index at prevailing exchange rates, and pay dollar Libor. Which of the following statements is most valid?

Accepted Answer

The correct answer is D because using a fixed exchange rate for the equity leg payment eliminates currency risk by locking in the exchange rate at which the returns on the Nikkei index are converted to dollars, regardless of future fluctuations in the actual exchange rate.

Question 8

Say we are in a country that does not permit corporations to have on balance-sheet exposure to equity market risk, so the company cannot, for example, take positions in equities or equity indices outright. How might a CFO of a company still take on such risks?

Accepted Answer

The CFO can enter into an equity swap to either pay or receive the equity index return while exchanging cash flows based on the Libor rate. This enables the company to achieve exposure to equity market risk without violating the country's regulations prohibiting on balance-sheet exposure to such risk.

Question 9

A fund that is all invested in U.S. equities seeks exposure to foreign equity markets. Which of the following is the most appropriate approach for the fund to take? (MSCI World is an index that tracks the performance of equity markets in 24 countries.)

Accepted Answer

Entering into an equity swap to pay the return on the S&P 500 and receive the return on the MSCI World index allows the fund to gain exposure to foreign equity markets by swapping its U.S. equity returns for a more globally diversified return, without having to sell its existing portfolio.

Question 10

Executives are often very heavily invested in their own stock. To mitigate the effects of this concentration, which of the following actions could they take?

Accepted Answer

All the options listed are strategies that executives can use to hedge against the risk of being heavily invested in their own company's stock. Equity swaps, whether for Libor returns or returns on a broad equity index, allow executives to diversify their exposure without selling their stock, which might signal a lack of confidence in their company. Buying collars, which involve purchasing put options and selling call options on the stock, can also protect against downside risk while potentially limiting upside gains.

Question 11

In a fixed notional equity-for-floating interest-rate swap, the theoretical fair swap spread (the spread over Libor paid by the equity return receiver) is

Accepted Answer

The theoretical fair swap spread is zero because the present value of the fixed notional equity payments should equal the present value of the floating interest rate payments.

Question 12

An equity swap favors the party that receives the equity return and pays Libor because

Accepted Answer

The answer of An equity swap favors the party that...

Question 13

Which of the following is not true of hedged cross-currency equity swaps?

Accepted Answer

Hedged-cross currency equity swaps pre-specify a fixed exchange rate at which all cash flows will be converted into the investor's currency, INCLUDING the principal. Therefore, the statement in option B is false.

Question 14

Executive compensation often comprises stock options. These options have vesting periods, and may not be exercised for a while. Which of the following actions might an executive take to help her mitigate the risk of her stock option grants?

Accepted Answer

The answer of Executive compensation often comprises stock options. These...

Question 15

An equity swap is an agreement to

Accepted Answer

An equity swap is an agreement to exchange returns on a specified equity or equity index periodically for a specified stream of returns (e.g., Libor or the return on another equity or equity index). A is incorrect because it refers to a stock swap, not an equity swap. B is incorrect because it refers to exchanging equity for debt, not an equity swap. D is incorrect because it refers to exchanging equity or an equity index for long-dated Treasury debt, not an equity swap.

Question 16

Consider an equity-for-Libor swap. The swap favors the party that receives the equity return and pays Libor because

Accepted Answer

The answer of Consider an equity-for-Libor swap. The swap favors...

Question 17

Executive compensation often comprises stock options. These options have vesting periods, and may not be exercised for a while. Which of the following actions could help executives mitigate the risk of their stock option grants?

Accepted Answer

Shorting call options on a broad market index or a competitor's stock, or shorting futures on a broad market index, can help hedge against the risk of a decline in the company's stock price, thereby protecting the value of the executive's stock options.

Question 18

A US-based investor enters into an unhedged cross-currency equity swap in which he pays returns on the S&P 500 index in dollars in exchange for receiving the returns on the FTSE 100 in pounds. At inception, the notional principal on the swap is $100 million, and the exchange rate is $1.60 = £ 1. Cash flows are exchanged every six months and the first six-month period has 182 days in it. At the end of the first six-month period, the raw returns on the S&P 500 are 8% and the raw returns on the FTSE 100 are 9%. The exchange rate at this point is $1.50 = £ 1. The investor's net cash flow on this first payment date is

Accepted Answer

The investor's net cash flow can be calculated by considering the returns on both indices and the change in the exchange rate. The investor pays the return on the S&P 500 in dollars and receives the return on the FTSE 100 in pounds, which then must be converted back to dollars at the new exchange rate.1. The investor pays 8% of $100 million for the S&P 500, which is $8 million.2. The investor receives 9% of £62.5 million (since the initial exchange rate was $1.60 = £1, and the notional principal was $100 million, the equivalent in pounds is $100 million / 1.60 = £62.5 million) for the FTSE 100, which is £5.625 million.3. The received amount in pounds is then converted back to dollars at the new exchange rate of $1.50 = £1, resulting in £5.625 million * 1.50 = $8.4375 million.The net cash flow is the difference between what the investor receives and pays, which is $8.4375 million - $8 million = $0.4375 million, or $0.438 million when rounded.

Question 19

It is March 15, and the next payment date in an equity swap is September 15. You contract through an equity swap ($100,000 notional) to receive Libor and pay the equity return. Libor payments use the money market convention, i.e., ACT/360. Suppose the equity index goes from 1011 to 1088 over this period. The six-month Libor on March 15 is 3%. What is your net cashflow on September 15?

Accepted Answer

The answer of It is March 15, and the next...

Question 20

Which of the following factors does not affect the valuation of a variable notional equity swap that pays the equity return in exchange for Libor?

Accepted Answer

All of the factors listed (expected equity price growth, equity volatility, and interest-rate term structure) can affect the valuation of a variable notional equity swap that pays the equity return in exchange for Libor. Therefore, none of the choices are excluded as a factor that affects the valuation.

Quiz 22: Equity Swaps

An equity swap may be used to time the markets. Given a current position in a $1,000 portfolio of 80:20 (equity:bonds) , suppose you expect that bonds will perform relatively better than stocks and want to change the portfolio composition to 20:80, what swap would you enter into?