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.



        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.



(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.  



        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.