ASET April 2014 Question 5(ii)

[wyatt.krs]

Hi all,

I would really appreciate it if someone can please explain to me the following comments in diagram format:

1. To carry out this switch using total return swaps, the investor would probably arrange one swap whereby the investor pays the total return on the UK index-linked bond market in return for UK LIBOR, or a UK fixed rate.

2. Then the investor would have a swap to receive the total return on the US-linked market in return for US LIBOR or a US fixed rate.

3. In addition, the investor would then need a total return swap that whereby the investor pays the US fixed rate return for the UK fixed rate (or LIBOR rates if that was the other arm of the swaps).

I have drawn the diagram below with the investor labelled as A but it doesn’t make sense to me.

 

[Gresham Arnold]

Hi

I think the cashflows in point 3 above (and hence swap 3 in the diagram) are the wrong way round?

So, in order to swap exposure from UK inflation linked bonds to US inflation linked bonds, you could have three total return swaps as follows:

Swap i: Pay TR on UK inflation linked and receive UK LIBOR

Swap ii: Pay UK LIBOR and receive US LIBOR

Swap iii: Pay US LIBOR and receive TR on US inflation linked bonds

Hope that helps?
Gresham

 

[wyatt.krs]

Thank you, Gresham.

I agree with your explanation. Perhaps I misinterpreted the explanation in ACTED point 3 above where it says the investor pays the US fixed rate return for the UK fixed rate.

 

[Gresham Arnold]

I've just looked at the ASET; as you correctly point out, this is an error in the ASET solution. Please accept my apologies for this, I will arrange for it to be corrected for the future. Thanks for your help!

Gresham