an asset manager wishes to reduce his exposure to fixed-income securities and in

Question

an asset manager wishes to reduce his exposure to fixed-income securities and increase his exposure to large-cap stocks. He seeks to do so using an equity swap. He agrees to pay a dealer the fixed rate of 4.5% and the dealer agrees to pay the manager the return on a large-cap index. For each of the scenarios listed below, calculate the overall payment 6 months later and indicate which party makes the payment. Assume that payments are made semi-annually (180 days per period) and there are 365 days in a year. The notional principle is $25 million.

a.       The value of the large-cap index starts off at 578.50 and six months later is at 622.54

b.      the value of the large-cap index starts off at 578.50 and six months later is at 581.35

Explanation / Answer

a) so the return on large cap stock in 6 months= (622.54-578.50)/578.58= 7.61%

considering 4.5% is an annual so therefore for six months=4.5/2= 2.25%

so the dealer will have to make the payment in this case which is equal to the difference between the return on large cap and the fixed rate= $25million( 7.61-2.25)/100=$1.34 million

b)

so the return on large cap stock in 6 months= (581.35-578.50)/578.58= 0.49%

considering 4.5% is an annual so therefore for six months=4.5/2= 2.25%

so the manager will have to make the payment in this case which is equal to the difference between the return on large cap and the fixed rate= $25million( 2.25-0.49)/100=$0.44 million

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