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CFA Institute Exam CFA-Level-II Topic 3 Question 88 Discussion

Actual exam question for CFA Institute's CFA Level II Chartered Financial Analyst exam
Question #: 88
Topic #: 3
[All CFA Level II Chartered Financial Analyst Questions]

Paul Durham, CFA, is a senior manager in the structured bond department within Newton Capital Partners (NCP), an investment banking firm located in the United States. Durham has just returned from an international marketing campaign for NCP's latest structured note offering, a series of equity linked fixed-income securities or ELFS. The bonds will offer a 4.5% coupon paid annually along with the annual return on the S&P 500 Index and will have a maturity of five years. The total face value of the ELFS series is expected to be $200 million.

Susan Jacobs, a fixed-income portfolio manager and principal with Smith & Associates, has decided to include $10 million worth of ELFS in her fixed-income portfolio. At the end of the first year, however, the S&P 500 Index value is 1,054, significantly lower than the initial value of 1,112 set by NCP at the time of the ELFS offering. Jacobs is concerned that the four remaining years of the ELFS life could have similar results and is considering her alternatives to offset the equity exposure of the ELFS position without selling the bonds, Jacobs decides to offset her portfolio's exposure to the ELFS by entering into an equity swap contract. The LIBOR term structure is shown below in Exhibit 1.

After hearing of her plan, one of the other partners with Smith & Associates, Jonathan Widby, feels it is necessary to meet with Jacobs regarding her proposed strategy. Mr. Widby makes the following comments during the meeting:

"You should also know that I am quite bullish on the stock market for the near future. Therefore, as an alternative strategy, I recommend that you establish a long position in a 1 x 3 payer swaption. This strategy would allow you to wait and see how the market performs next year but will give you the ability to enter into a 2-year swap with terms that can be established today should the market have another down year.

If, however, you choose to proceed with your strategy, know that credit risk for an equity swap is greatest toward the end of the swap's life. Thus, analysts tracking your portfolio will not be happy with the added credit risk (hat your portfolio will be exposed to as the swap nears the end of its tenor. You should think about what credit derivatives you can use to manage this risk when the time comes."

To offset any credit risk associated with the equity swap, Widby recommends using an index trade strategy by entering into a credit default swap (CDS) as a protection buyer. Widby's strategy would involve purchasing credit protection on an index comprising largely the same issuers (companies) included in the equity index underlying the swap. Widby suggests the CDS should have a maturity equal to that of the swap to provide maximum credit protection.

Evaluate, in light of the appropriate equity swap strategy for Jacobs's portfolio, Mr. Widby's comments regarding the credit risk and use of swaptions in Jacobs's portfolio.

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Suggested Answer: C

Credit risk in a swap is generally highest in rhe middle of the swap. At the end of the swap there are few potential payments left and the probability of either party defaulting on their commitment is relatively low. Therefore, Widby's first comment is incorrect. It Jacobs wants to delay establishing a swap position, a swaption would potentially be an appropriate investment. However, Jacobs should buy a receiver swaption, not a payer swaption. In a payer swaption, Jacobs would pay the fixed-rate and receive the equity index return. The swap underlying a payer swaption would not offset Jacobs's current position. (Study Session 17, LOS 6l.f,i)


Contribute your Thoughts:

Evelynn
18 days ago
So, Widby's comments on credit risk and swaptions seem relevant for Jacobs's portfolio.
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Sina
20 days ago
Widby mentioned using a credit default swap to manage that risk.
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Matthew
20 days ago
Widby's got a point about the credit risk, but I'm not convinced the swaption is the best way to go. Seems like it might just add more complexity than necessary.
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Ricki
7 days ago
Jacobs: Widby, I appreciate your input on managing credit risk, but I'm not sold on the swaption idea.
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Selma
23 days ago
But what about the credit risk associated with the equity swap?
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Evelynn
26 days ago
I agree, it could provide flexibility in uncertain market conditions.
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Juliana
1 months ago
Haha, Widby must be a real market guru to be 'quite bullish' on the stock market. I wonder if he has a crystal ball or something.
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Corazon
1 months ago
I'm not sure about the swaption recommendation though. Seems a bit complicated and unnecessary, given the goal is to offset the equity exposure of the ELFS.
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Marica
10 days ago
Jacobs: I see your point, but I still think it may be unnecessary in this case.
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Nenita
14 days ago
Widby: Swaptions can be useful to manage risk in uncertain market conditions.
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Amber
20 days ago
Jacobs: I'm not sure about the swaption recommendation. Seems a bit complicated.
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Destiny
1 months ago
Widby's comment about the credit risk is spot on. As the swap nears its end, the credit risk will definitely increase, and Jacobs should consider using credit derivatives to manage that risk.
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Gabriele
15 days ago
Widby: We should also think about managing credit risk with credit derivatives when the swap nears its end.
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Huey
18 days ago
Jacobs: That could be a good option to wait and see how the market performs.
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Dorothea
20 days ago
Widby: I recommend a long position in a 1 x 3 payer swaption as an alternative strategy.
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Detra
21 days ago
Jacobs: I'm considering using an equity swap to offset the exposure of the ELFS.
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Sina
2 months ago
I think Widby's suggestion of using a swaption is interesting.
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