Susan Fairfax is president of Reston. She realizes that her $10 million holding of Reston stock presents a problem in terms of diversification and specific risk for her total portfolio of $12 million ($10 million in Reston stock plus a $2 million savings portfolio). A major brokerage firm has reviewed her situation and proposed an equity swap having the following features:
Term:....................................... 3 years
Notional principal:........................ $10 million
Settlement frequency: ................... Annual, commencing at end of year 1
Fairfax pays to broker: ................... Total return on Reston stock
Broker pays to Fairfax: .................. Total return on S&P 500 stock index
Ignore the tax consequences of the swap transaction, and assume that Fairfax plans to renew the contract at the expiration of its three-year term.
a. Justify advising Fairfax to enter into the swap, including in your response
i. A description of the swap's effect on Fairfax's total portfolio, and
ii. Two reasons why use of such a swap may be superior to an alternative strategy of selling a portion of the Reston stock.
b. Explain one risk to be encountered by Fairfax under each of the three following scenarios, assuming that she enters the swap at the beginning of year 1. Your answer must cite a different risk for each scenario.
i. At the end of year 1, Reston stock has significantly outperformed the S&P 500 index.
ii. At the end of year 1, Reston stock has significantly underperformed the S&P 500.
iii. At the end of year 3, Fairfax wants to negotiate a new three-year swap on the same terms as the original agreement, adjusted for the new market value of her Reston holding.