Question

A portfolio has a total market value of $105,000,000. Th e portfolio is allocated as follows: $65,000,000 is invested in a broadly diversified portfolio of domestic stocks, and $40,000,000 is invested in the stock of the JK Corporation. Th e portfolio manager wishes to reduce exposure to JK stock by $30,000,000. Th e manager plans to achieve this objective by entering into a three-year equity swap using the S&P 500. Assume that settlement is made at the end of each year. Also assume that after one year the return on JK stock is 4% and the return on the S&P 500 market index is −3%.

1. Explain the structure of the equity swap.

2. Calculate the net cash flow for the swap at the end of one year

Answer 1

1) Equity swap is the exchange of the future cash flow at prespecified time intervals.

Equity swap would involve exchange of return on JK Corporation with the return on S&P 500

The portfolio manager will receive the return on S & P 500 for $ 30 M and pay the return on JK Corporation ON $ 30 M

2)

Cashflow to be paid on JK Corporation = 4 % on 30 M

= $1.2 M

Cashflow to be paid on the negative return on the S&P 500 = 3% of 30 M

= $0.9 M

Total amount to be paid = 1.2 + 0.9 = $2.10 M