Question

A portfolio manager entered a swap with a dealer. The swap's notional principal is $100, payments are to be made semi-annually, and the swap allows netting of payments. The dealer agrees to pay a fixed annual rate of 4%, while the asset manager agrees to pay the return on SP500 index. The SP500 index at the initiation is 200. If SP500 six months later becomes 135, how much would be the payment from the dealer to the asset manager should be? Note: You should use a positive number to represents the amount the dealer pays to the dealer. You should use a negative number represents the amount that the dealer receives from the manager.

Answer 1

Solution:

The example is of Equity Swap.

Notional Principal : $100

Portfolio Manager pays: Returns on S&P500 index

Dealer pays: Fixed Annual Rate of 4% (semi annual) i.e. 2% for six months.

As swap allows netting of the payments, the difference is paid by the party whose payout is higher to the other party.

Before going into the solution, lets understand the two possible scenarios.

Scenario I: SP500 gives positive return in six months

In this case, Portfolio Manager pays $100 * return of SP500 index to Dealer. The dealer pays $100*2% to the Portfolio manager. Actually the net amout will be paid by higher payout party.

Scenario II: SP500 gives positive return in six months

In this case, Portfolio Manager pays NOTHING (as the returns are negative). The dealer pays $100*2% + $100 * Absoute value of SP500 returns to the Portfolio manager

Now, coming to the example, the SP500 after six months is 135 so it has given returns of -32.5%. So, we have scenario II.

a) Portfolio Manager pays NOthing

b) Dealer pays :   $100*2% + $100 *32.5% = 2+ 32.5 = $34.5

After netting Dealer pays to Portfolio Manager $34.5.

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