Reading 7: Swap, Forward, Future strategies

Cross - currency basis swap’s objective

• Hedge currency risk

• Synthetic borrowing (at favourable rate)

Purpose of using forward, future to alter beta in equity

• Tactical allocation

• Diversification

• Exposure to international market

• Make directional bets

Basis risk of forward/ future in equity

• Hedge asset & underlying asset are different

• Timing not matched

• Rounding the number of contracts

• Future pricing not based on cash & carry arbitrage

  → Effective beta = change in Value/ change in Index

Benefit of equity swap compared to physically owning of stock

(+) benefit when market is restricted

(+) advoid tax (stamp duty), custody fee, monitoring fee

Disadvantage of equity swap compared to physically owning of stock

(-) typically requires collateral

(-) illiquid → due to OTC

(-) not convey voting rights

(-) if index is not passive trackers → mismatch

Underlying of volatility index

Implied volatility on S&P500 over next 30 days

Not actual volatility because:

1. cost-of-carry model not work

2. use expected → call fear index/ fear gauge

3. pure-pay bets on volatility

Rule of thumb in volatility

1. Volatility < 20% → Low risk environment

   But if too low → excessively bullish

2. Volatility > 30% → High risk environment

   But if too high → excessively bearisj

Characteristic of volatility index

• Negative correlation with stock return: if volatility increase → Stock return decrease

• Mean reversion

Contago in VIX future

• Negative basis ( because Basis = S - F < 0) → Buying basis = Buy bond + Short future

• Roll yield for long position is negative

If expect downturn → expect volatility increase → what should we do?

1. Long volatility future

2. Long volatility call

Variance swap

• No pricipal exchange, no interim settlements

• Notional of variance = N vega / (2*K)

• Vega notional always > Variance notional

Convexity of volatility

1. If volatility > K → P/O increase at increasing rate → gain of variance swap > gain of volatility derivative

2. If volatility < K → P/O decrease at decreasing rate → loss of variance swap < loss of volatility derivative

   => Favourable for long party

Position of FRA

1. Borrower → Long FRA or Short bond future

2. Lender → Short FRA or Long bond future

Position in Eurodollar future

1. Borrower → Short Eurodollar future

2. Lender → Long Eurodollar future

Quote price of Eurodollar future

100 - annualized forward rate

Profit for long position of Eurodollar future

(Quote price new - Quote price) * $25 * $100 * Number of futures

Characteristic of FI future for Long term

• Good liquidity → most closed out before settlement

• $100/ contract or $200 for shorter maturity

• Future settle by delivery ( Trading at FT, not Fo because P/L is M2M daily)

Underlying of FI future

Notional Governemtn bond with coupon = 6%

What is conversion factor?

Con version factor is clean price of $1 face discounted at YTM = 6%

→ assume flat term structure at 6%

→ imperfect compuation → CTD

Hedging (immunize) portfolio is not perfect because

• CTD changes

• Duration ignores convexity

• Duration not capture nonparallel changes

Objective of IRS

• To convert floating exposure to fixed

• To alter duration