Question

You manage an index fund of the Dow Jones Index. You believe the Dow Jones Index will take a drop in the next year and do not want to take the risk. You do not want to liquidate your portfolio due to transaction costs and you think the Dow will rebound after the one-year period. You wish to enter into a swap with Apex investment bank that is willing to take the Dow risk for a fixed amount. You have agreed with Apex to swap a fixed return for the Dow Index return. Your fund has $100 million invested in the Dow Index and you agree to an equity swap for the full amount with Apex. The agreement is signed on December 31, 2014. The Dow Index is 17,823.07 on December 31, 2014. One swap payment will be made at the end of the year on December 31, 2015. Apex agrees to pay 5%.

a. What is your return, if the Dow Index is at 19,000 on December 31, 2015? What is Apex’s return?

b. What is your return, if the Dow Index is at 18,000 on December 31, 2015? What is Apex’s return?

with steps plz

Answer 1

Notional Amount that is Invested in Dow = 100 million USD

As per swap condition, you get the fixed 5% of notional amount from Apex Investment bank in return for accepting the floating return on the Dow Jones Index

Therefore, Your return in both cases

A.

Amount Received = 5% Return on notional amount

Amount Paid = Return on Dow Jones Index = (19000-17823.07)/17823.07 = 6.603%

Therefore Your Net return = 5% - 6.603% = -1.603%

Apex Return will be just opposite to your return because of netting the eventual payment

Therefore Apex Return = 6.603% - 5% = 1.603%

B.

Amount Received = 5% Return on notional amount

Amount Paid = Return on Dow Jones Index = (18000-17823.07)/17823.07 = .9927% return

Therefore Your Net return = 5% - 0.9927% = 4.0073%

Apex Return will be just opposite to your return because of netting the eventual payment

Therefore Apex Return = .9927% - 5% = -4.0073%