Question

QUESTION 2: You have been provided with a side showing the calculation of adjusted exposure. Assume XYZ Company enters into an interest rate swap contract with Omega Bank that provides that XYZ will pay a floating rate of interest (assume LIBOR + 1%) and receive a 5% fixed rate of interest. This interest rate swap is intended to be a hedge of an XYZ floating rate liability.

1. Describe the methodology to calculate gross exposure for the interest rate swap. Hint: Discuss the concept of dynamic credit exposure as applied to interest rate swaps.

2. What are the “pros and cons” of using gross exposure vs. adjusted exposure in measuring credit risk on THIS TRANSACTION.

Answer 1

Answer a.

Gross exposure refers to the absolute level of a fund's investments. It takes into account the value of both a fund’s long positions and short positions and can be expressed either in dollar or percentage terms. Gross exposure is a measure that indicates total exposure to financial markets, thus providing an insight into the amount at risk that investors are taking on. The higher the gross exposure, the bigger the potential loss (or gain).
An interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products

Understanding Gross Exposure

Gross exposure is an especially relevant metric in the context of hedge funds, institutional investors, and other traders, who can short and long assets and use leverage to amplify returns. These types of investors are sometimes more sophisticated and have greater resources than regular, long-only investors.

b)

A low net exposure does not necessarily indicate a low level of risk since the fund may have a significant deal of leverage. For this reason, gross exposure (long exposure + short exposure) should also be considered.

Gross exposure indicates the percentage of the fund’s assets that have been deployed and whether leverage (borrowed funds) is being used. If gross exposure exceeds 100%, it means the fund is using leverage—or borrowing money to amplify returns.

The two measures together provide a better indication of a fund’s overall exposure. A fund with a net long exposure of 20% and a gross exposure of 100% is fully invested. Such a fund would have a lower level of risk than a fund with a net long exposure of 20% and a gross exposure of 180%, i.e., long exposure 100% less short exposure 80%, since the latter has a substantial degree of leverage.

Net Exposure

While a lower level of net exposure does decrease the risk of the fund’s portfolio being affected by market fluctuations, this risk also depends on the sectors and markets that constitute the fund’s long and short positions. Ideally, a fund’s long positions should appreciate while its short positions should decline in value, thus enabling both the long and the short positions to be closed at a profit. Even if both the long and short positions move up or down together—in the case of a broad market advance or decline respectively—the fund may still make a profit on its overall portfolio, depending on the degree of its net exposure.

Pros

• Measures fund manager's expertise, performance

• Indicates fund's vulnerability to volatility

Cons

• Should be considered alongside gross exposure

• May not reflect sector or other specific risks