Index swaps are used by investors to:
1) replicate or and enhance the total return of a specific sector of the fixed income market; and
2) hedge market risk. The following sample trades illustrate the some common uses:
■ Examples
• Achieving diversified exposure. An insurance company desires diversified exposure to the high yield bond market. Cash market purchases, however, are
inefficient, expensive and difficult to accomplish in size for many individual issues. The insurance company enters into a six-month swap with Merrill Lynch where Merrill Lynch pays quarterly the total return on the High Yield Master index and the insurance company pays a LIBOR-based spread. The insurance company pays a LIBOR-based "funding spread" (which varies according to market demand for each index swap) but does not pay any bid/offer costs on the 829 underlying high yield bonds and does not put any assets on their GAAP balance sheet.
• Hedging systemic market risk. A fund has the mandate to generate returns above LIBOR by investing in a variety of investment grade fixed income assets and can buy asset swaps or overlay swaps to achieve its objective. The fund manager buys investment grade corporate bonds using the in-house expertise in the fund manager's credit department and then enters into an index swap with Merrill Lynch where the fund manager pays the total return on the Corporate Master index and receives a LIBOR-based spread. The manager has historically outperformed the index and if he continues to do so would generate a return above LIBOR with reduced systemic corporate market risk.
• Managing execution risk. Similar to the use of S&P futures by equity money managers, fixed income investors may pay or receive on index swaps to immediately subtract or add risk to the broader corporate market. The index swap is then unwound as suitable bids and offerings are sourced on desired underlying issues.
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