Question

III. DERIVATIVES

It is January 2020. You are a portfolio manager for a broadly diversified fixed income portfolio. Your portfolio management team is worried about a negative economic shock, similar to what we have recently experienced. Explain how you would utilize 2 of the following derivative securities to improve returns and / or reduce the risk in your portfolio. You only need to write a few sentences about each derivative security. Remember, you only need to choose 2.

1. Credit Default Swaps
   1. What risk(s) and / or securities would you be hedging?
   2. Explain whether you be long or short. Why?
   3. What would be the maturity in years? Why?
   4. What would be the underlying security or index? Why?
2. Interest Rate Swaps
   1. What risk(s) and / or securities would you be hedging?
   2. Explain whether you would receive fixed or floating. Why?
   3. What would be the maturity in years? Why?
   4. What would be the underlying security or index? Why?
3. Treasury Futures
   1. What risk(s) and / or securities would you be hedging?
   2. Explain whether you be long or short. Why?
   3. What would be the maturity in years? Why?
   4. What would be the underlying security or index? Why?

Answer 1

Credit Default Swaps:

Hedging under Credit default swaps: The Credit default swaps are used to hedge against the risk of default by the borrower or the issuer of the debt instruments, for example, the bond issuer.

Position under Credit default swaps: The portfolio manager has the responsibility to reduce the risk arising out of any economic shock, thus, he should be in a long position under the Credit default swaps contract.

Maturity of the contract: The Credit default swaps contract expires either on the expiration of the term of the contract or when the default is done by the risky borrower.

Underlying security: The underlying security in case of Credit default swaps would typically be the borrower's credit quality.

Interest Rate Swaps:

Hedging under Interest rate swaps: The Interest rate swaps are used to hedge against the risk of increasing/ decreasing the interest rates. In the given case, there is a situation pf expected economic shock, thus the portfolio manager will hedge against the risk of decreasing interest rates.

Position under Interest rate swaps: The portfolio manager has the responsibility to reduce the risk and increasing the returns arising out of any economic shock, thus, he should receive the fixed interest rates, because during the economic shock the interest rates would probably go down, and it may reduce the earnings of the portfolio.

Maturity of the contract: The Interest rate swap would preferably be taken for a maturity period of up to the expected period of the economic shock/ slowdown.

Underlying security: The underlying security in case of Interest rate swaps would typically be the 'LIBOR'.

Treasury Futures:

Hedging under Treasury futures: The treasury futures are used to hedge against the risk of decreasing prices of the treasury securities.

Position under the Treasury futures: The treasury futures would typically be used by the portfolio manager to reduce the risk of decreasing prices, thus, he would typically take a short position under the contract.

Maturity of the contract: The Treasury futures would preferably be taken for a maturity period of up to the expected period of the economic shock/ slowdown.

Underlying security: The underlying security in the case of Treasury futures would typically be the government treasury bond/bill.