Deck 22: Equity Swaps

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

A) $103.15 million.
B) $103.20 million.
C) $103.66 million.
D) $106.3 million.

Answer 1

$106.3 million.

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?

A) An equity swap to receive the equity return and pay the bond return for a notional of $1,000.
B) An equity swap to pay the equity return and receive the bond return for a notional of $1,000
C) An equity swap to receive the equity return and pay the bond return for a notional of $600.
D) An equity swap to pay the equity return and receive the bond return for a notional of $600

Answer 2

An equity swap to pay the equity return and receive the bond return for a notional of $600

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.

A) The interest-rate duration of the swap is five years.
B) The interest-rate duration of the swap is six months irrespective of the correlation between interest rates and equity returns.
C) The interest-rate duration of the swap is greater than six months if the equity return is positively correlated with interest rates.
D) The interest-rate duration of the swap is greater than five years if the equity return is negatively correlated with interest rates.

Answer 3

The interest-rate duration of the swap is greater than six months if the equity return is positively correlated with interest rates.

Question 4

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

A) The variable notional swap involves a principal that, like an amortizing swap, decreases from period to period in a predetermined manner.
B) The variable notional swap involves a principal that changes from period to period depending on realized returns on the underlying equity or equity index.
C) The variable notional swap involves a principal that changes from period to period depending on realized Libor rates during the receding period.
D) In a variable notional swap, the receiver of equity returns can choose whether to pay Libor or the returns on a specified broad market index on each payment date.

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?

A) 1100.
B) 1165
C) 1227
D) 1422

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?

A) Expected equity price growth.
B) Interest rate volatility structure.
C) Interest-rate term structure.
D) All of the above.

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?

A) Because the equity leg is paid in dollars there is no exchange-rate exposure in this transaction.
B) There is no currency risk in this transaction only if the correlation of the Nikkei index with the dollar/yen exchange rate is zero.
C) There would be no currency risk in this swap if the interest rate leg were in yen.
D) There would be no currency risk in this swap if the equity leg payment were computed using a fixed 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?

A) Enter into an equity swap to pay the equity index return and receive Libor.
B) Enter into an equity swap to receive the equity index return and pay Libor.
C) Both (a) and (b).
D) Neither (a) nor (b).

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.)

A) Enter into an equity swap to pay the return on the S&P 500 and receive the return on the MSCI World index.
B) Enter into an equity swap to receive the return on the S&P 500 and pay the return on the MSCI World index.
C) Go short forward contracts on the MSCI World index.
D) Enter into forward exchange contracts to sell the dollar and buy euros.

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?

A) Enter into an equity swap to pay the returns on their own stock in exchange for receiving Libor.
B) Enter into an equity swap to pay the returns on their own stock in exchange for receiving the returns on a broad equity index.
C) Buy collars on the stock.
D) All of the above.

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

A) Greater than zero because equity returns are generally higher than Libor rates.
B) An increasing function of equity market volatility.
C) A decreasing function of expected equity market returns.
D) Zero.

Question 12

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

A) Equity returns are on average higher than Libor returns.
B) The probability that equity markets beat the bond markets is greater than 50%.
C) Equities are less risky in the long run.
D) None of the above.

Question 13

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

A) The hedged-cross currency equity swap pre-specifies a fixed exchange rate at which all cash flows (including principal) will be converted into the investor's currency.
B) The hedged-cross currency equity swap pre-specifies a fixed exchange rate at which all cash flows (except the principal) will be converted into the investor's currency.
C) In a hedged currency swap, the investor is fully hedged against exchange rate changes.
D) None of the above.

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?

A) Enter into an equity swap where she receives the company's share price returns in exchange for paying Libor.
B) Short futures on a broad market index.
C) Short her own company's stock.
D) Buy put options on her own stock.

Question 15

An equity swap is an agreement to
(a) Exchange one stock for another on a specified date in the future.
(b) Exchange equity in a company for debt in the same company.
(c) 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).
(d) Exchange the equity of a given company or an equity index for long-dated Treasury debt.

Question 16

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

A) Equity returns are on average higher than Libor returns.
B) The probability that equity markets beat the bond markets is greater than 50%.
C) Equity markets are more volatile than interest-rate markets.
D) None of the above.

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?

A) Short call options on a broad market index.
B) Short call options on a competitor's stock that is highly correlated with the company's own stock.
C) Short futures on a broad market index.
D) All of the above.

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

A) $-$ $1million.
B) $+$ 0.165 million.
C) $+$ 0.438 million.
D) $+$ 1 million.

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?

A) $+ 1,533.33$
B) $- 7,616.22$
C) $- 6,082.89$
D) $+ 3,113.33$

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?

A) Expected equity price growth.
B) Equity volatility.
C) Interest-rate term structure.
D) All of the above.

Question 21

Consider a $100 notional equity-for-equity swap on two stocks where the price of the stocks at inception was $40 and $50, respectively. At the present time, sixty-one days after inception, the two stock prices are $39 and $51, respectively. If you pay the return on the first stock and receive the return on the second stock, what is your valuation of the equity swap after sixty-one days? Assume that the Libor interest rate on an ACT/360 basis from now till the next settlement date is 10% for the remaining 122 days.

A) $- \$ 2.00$
B) Zero
C) $+ \$ 4.35$
D) $+ \$ 4.50$

Question 22

Consider a 5-year $100 fixed notional equity-for-Libor swap, where the stock price at inception was $35. The swap is based on semi-annual payments on both legs, with an Actual/360 convention for the Libor leg. Two years after inception, on the fourth reset date, the stock price is $40. Assume that the number of days in the next period is 183, and the six-month Libor rate on this reset date is 10%. What is the value of the swap from the point of view of the receiver of equity return?

A) $- 14.29$
B) Zero.
C) $+ 4.29$
D) $+ 14.29$

Question 23

Consider a fixed notional equity-for-floating rate swap. The fair price of the swap is to exchange equity for Libor plus a spread $x$ , where the spread $x$ is

A) Greater than zero if the Libor payer has a lower rating than the equity return payer.
B) Greater than zero if the equity return payer has a lower rating than the Libor payer.
C) Always less than zero because the Libor leg has lower volatility than the equity leg.
D) Zero regardless of credit rating considerations.

Question 24

Consider a $100 fixed notional, equity for Libor swap, where the stock price at inception was $35. Two years later, on the stock price was $40. The swap is based on semi-annual payments on both legs, with an ACT/360 convention for the Libor leg. Assume that the number of days in the next period is 183, and the six-month Libor rate was 10%. Of these 92 have elapsed. The 91-day Libor rate for the remaining period is 9% and the stock price is $41. What is the value of the swap from the point of view of the receiver of equity return?

A) $- 2.16$
B) $- 4.66$
C) Zero.
D) $+ 4.66$