describe with an example how a swap can be viewed as a portfolio of two bonds.

Expert Solution

When a investor engages in a bond swap, he simply replacing a bond in their portfolio with another bond use the sale proceeds from the longer held bond. There are a number of reasons investor will swap bonds in his portfolio, one of which is to realize tax benefits. To do this, a bondholder will swap bonds close to year-end by taking a loss on the sale of a depreciated bond and using that loss to offset capital gains on their tax returns. This bond swap strategy is referred to as a tax swap.The investor can write-off the losses from the bond he or she sold to lower his or her tax liability, as long as s/he does not purchase a nearly identical bond as the one sold within 30 days of selling the previously held bond

For example, a company paying a variable rate of interest may swap its interest payments with another company that will then pay the first company a fixed rate. Swaps can also be used to exchange other kinds of value or risk like the potential for a credit default in a bond.

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