24.4.8, 28997 Growth of Porfolo Swaps: Fundamentals the Appeal and Wnat You Need to Know - Derivsource AARKETSMEDIAGRD. Trading ClawingCotatrel_ Reguatan Rik PoseTiede Olga! ESG_—_Newstt yin Search, DERI SOURCE Webinars News Features Commentary /Q8A Podcasts Resources About Us Growth of Portfolio Swaps: Fundamentals, the Appeal and What You Need to Know By Subbiah Subramanian | on September 24, 2010 The use of portfolio swaps Is growing among investment managers. Subbiah ‘Subramanian of Eagle Investment Systems explains the appeal and potential pitfalls in sing portfolio swaps. As investment managers try to understand the post financial crisis landscape and ‘the new normal, the industry as a whole is seeing a rise in usage of portfolio swaps. Fundamentally, portfolio swaps allow managers to gain exposure to assets without Physically holding them in their portfolio. The portfolio manager can create a basket of assets (assets can be either long or short) and have a counterparty hold the basket. This, basket will be held and treated operationally as any other portfolio by the counterparty. As a part ofthe deal, the manager enters into a swap with the counterparty to receive the: return on the basket and in tum pay a negotiated financing cost in addition to a spread. ‘The manager will hold the swap but economically itis equivalent to holding the basket. As far as the counterparty goes, they will pass on any gair/loss from the basket (including dividends) to the investment manager. The counterparty charges a finance costifees for ‘administering the basket. They have no direct financial risk in this deal other than the. counterparty risk (addressed later in the article). The financing cost is calculated based on the outstanding value (referred to as swap notional) ofthe basket at the end of the day. Since there is generally active trading inthe basket, the notional amount can change on a daily basis. Drivers of portfolio swap: UCITS Il approved the use of short exposure (typically via the use of derivatives) to manage down side risk and to help generate alpha, This has driven traditional ong only’ asset managers to use portfolio swaps in order to gain short exposure. Portollo swaps Provide them the flexibility to invest in short postions without actually having to own them fn their books. In the example of a UCITS fund, the manager holds long assets and the portfolio swap. The combined effect is equivalent to holding both long and shor positions directly in the fund. Please note that UCITS stipulates limitation on the percentage of ‘exposure allowed with a single counterparty. The actual amount varies from 5% to 10% of notional depending on the type of the derivative instrument and the institution acting as counterparty, Portfolio swaps are well sulted to meet this requirement as each deal can be structured to exactly meet individual needs. ntps:ifdervsource.con2010109/24/growh-oF-portfoli-swaps-fundamertals-the-appea-and-what-you-need-o-know! 1824.4.8, 28937 Growth of Ponfolo Swaps: Fundamentals the Appeal and What You Need to Know - Derivsource ee) ‘Another driver for use of portfolio swaps is increased popularity of 130/90 funds and market neutral strategy funds. In the case of the 130/30 strategy, a manager will short poor performing stocks and use the proceeds to buy long asses. Portfollo swaps allows ‘radtional ‘ong only managers' to implement this strategy without needing a separate infrastructure to trade and account for short positions. Therefore, a 130/30 fund will hold 100% long positions and a portfolio swap. This swap provides managers with exposure to 30% short assets, Portfolio swaps are evolving inthe market, with wide ranging application in risk management and alpha generation space. For example, if fund managers want to alter the duration oftheir portfolios and stay within certain credit bands, they can enter into @ Portfolio swap based on a basket of fixed income instruments. Since they are in control of the basket, they can achieve their target with laser-lke precision. What makes portfolio swaps attractive? Business flexibility ‘The holder of a portfolio swap not only constructs the basket of assets, but they can actively rade the basket components on a daily basis. The counterparty can either ‘execute the trade on the manager's behalf or replicate the trade with other derivatives. “This helps a holder of the portfolio swap to dynamically maintain the basket to ‘accommodate changing market conditions and strategies. This is one of the biggest differences between a traditional total return swap (TRS) and a portfolo swap, ATRS is ‘typically based on a single instrument or market index. This limits the abilly of the portfolio manager to exactly match individual needs. Anather hindrance to using TRS on an index is the unavailability of a particular index to match the needs in terms of Industry/Sector/Country exposure, This constrains the manager's abilty to attain the exposure they set out to achieve, ‘Terms and conditions of a traditional TRS are generally governed by standardized agreements. For example, the exchange of payments typically happens monthly or quarterly, This leaves the holder of the swap open to counter party risk. In the case of @ portfolio swap, cash low exchanges (typically called a reset) are triggered by accumulated gain/loss on the retum lag. This helps keep counterparty risk in check. For example, a portflio swap can be structured to reset every time the gain is over 10% of the notional amount. Operational Flexibility: {As noted eartie, a traditional long only’ manager might not have the system and ‘operational infrastructure to handle short positions, Portfolio swaps move the operational overhead of managing short postions to the counterparty. However the holder ofthe ‘swap is sill responsible for providing trading instructions to the counterparty. What you should be aware of? ntps:ifdervsource.con2010109/24/growah-of-portfoli-swaps-fundamentals-he-appea-and-what-you-need-o-know!24.4.8, 28997 Growth of Porfolo Swaps: Fundamentals the Appeal and Wnat You Need to Know - Derivsource (One main pitfall of portfolio swaps is what Eagle refers to as “hidden risk’, Since the fund does not direcly hold the short postions, the risk involved is not very apparent. Nevertheless, the fund is exposed to the same risks involvad in directly holding short positions. Appropriate risk management processes should be put in place to provide full transparency into the short basket held by the counterparty, Risk management should not only be from a market valuation perspective, but should also consider other risk measures lke sector, county, currency and interest rate exposure (if basket contains bonds). This is key to the success of portfolio swaps. General counterparty risk, which exists with other derivatives, also exists with portfolio swaps. However this risk is magnified because portfolo swaps are often central toa manager's strategy. To mitigate this risk, portfolio swaps are structured to trigger an exchange of payments ifthe outstanding gain is greater than a certain threshold. Regulators all around the world are taking a close look at derivative markets. In the United States, a major tax change was passed as a part ofthe HIRE Act (Hiring Incentives to Restore Employment) of 2010. Dividends of US stocks that are part of an equity swap will be subject to Internal Revenue Service (IRS) tax withholding. This poles to deals where at least one of the parties is based in the US, One of the goals of this legislation isto tax the dividends at a higher 30% tax rate. These changes have to be considered closely before entering into @ portfolo swap, Conclusion ‘Though precise trading volume figures are not available, ths isa fast growing market. As the portfolio swap market evolves, itis expected that operational standardization will make it more transparent, Risk management is also maturating rapidly to handle some of the hidden risks associated with portfolio swaps, With appropriate controls and risk management in place, a portfolio swap can be a great tool for managers looking to implement their investment strategies in an efficient way. Recent Posts Market Structure sto Blame for Slow Growth of, European ETDs Markets Apr, 2024 -0 Comment Clearwater Analytics to Parner with Wilshire and ‘Acquire Sophisteated Rsk and Performance Models Apr 3, 2024-0 Comment [CME Group €STR Options to Launch on May 20, ‘Apr 3, 2024-0 Comment Author Description Head of Instrument Engineering, Eagle Investment Systems, a BNY Melion Asset Servicing Company(SM) With more than 15 years experience in the investment industry, Subbiah ‘Subramanian heads up Eagle Investment Systems’ Instrument Engineering team. His prior experiences includes the development and management of efiical portfolio management, pricing and security data warehouse systems. Having experience in the areas of quantitative research, trade execution, accounting and performance attribution, Mr. ntps:ifdervsource.cony2010109/24/growah-of-portfoli-swaps-fundamentals-the-appea-and-vhat-you-need-o-know!24.4.8, 28997 Growth of Porfolo Swaps: Fundamentals the Appeal and What You Need to Know - Derivsource ‘Subramanian brings a unique perspective in solving business problems, H investment management software coupled with his knowledge of current n around derivatives adds tremondous value to Eagle's software developme Comments are closed. Sign up for our newsletter Join our maiing list to receive the monthly e-newsletter and alerts about future events and webinars. 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