Pension fund XY has a large investment portfolio comprising

Pension fund XY has a large investment portfolio comprising bonds and equity. The trustees are concerned about a fall in value over the next year as economies worldwide emerge from the Covid-19 pandemic crisis.

 

The trustees are considering two main strategies:

·     Reduce equity price risk by lowering the beta of the equity portfolio.

·     Purchase Credit Default Swaps (CDSs) to reduce credit risk in the bond portfolio.

 

a)     The equity portfolio is currently valued at $500 million and the S&P 500 index futures contract is trading at $445,000. The trustees have asked for the equity portfolio beta to be reduced from 1.45 to 0.90.

 

Required:

        Calculate the number of S&P index futures required to change the equity portfolio beta from 1.45 to 0.90 and explain the rationale behind the formula and approach you use in this calculation.

 

b)

(i)     Explain what a Credit default swap (CDS) is and how CDSs can be used by financial institutions such as pension funds to manage credit risk

(ii)    The pension fund has purchased a CDS on $900,000 nominal of a bond at an annual premium of 320 basis points, payable quarterly in arrears.  

 

Required:

        Calculate the net payoff due to the pension fund under the CDS immediately after a default event that occurs after 3 years and 1 month assuming the bond was trading at 60/par immediately after default.