Define Revision and the Cost

Revision and the Cost

With the passage of time the stocks which were attractive once may turn out to be less attractive in terms of return. The investor’s attitude towards risk and return also may change and the forecast regarding the market also may undergo change In this context, the necessary revision is thought of by the portfolio manager. In revision of traded volumes the portfolio manager has to incur brokerage commission, price impact and bid-ask spread. Price impact means the effects on the price of stock. In simple terms, if the size of the trade is heavy on the buying side, the prices of the stock may increase. The bid-ask spread is the difference between the price that the market maker is willing to buy and sell the stock. These costs may be higher in small size stocks and the benefits of revision may be nullified by it. Usually revision is done with the view of either increasing the expected return of the portfolio or to reduce the risk (standard deviation) of the portfolio.

SWAPS

Swap is a contract between two parties to exchange a set of cash flows over a pre-determined period of time. The two parties are known as counter parties. In an equity swap one counter party, say ‘A’, agrees to pay cash based on the rate of return of an agreed stock market index to the second counter party ‘B’. Since the payments are based on the market index, they vary according to index movements. The second counter party B agrees to pay the fixed amount of cash payments based on the current interest rate to the first counterparty A. Thus, the payment depends upon the underlying security. This agreement means that A has sold stocks and bought bonds while B has sold bonds and bought stocks. Here, they have restricted their portfolios without the transaction costs, even though they have to pay the swap fee to the swap bank that set up the contract between the two parties.

This can be explained with the help of an example. Consider Mr. Hope, a portfolio manager having an expectation of upward trend in the stock market for the year and Mr. Despair, another portfolio manager who feels that there would be downward trend in the market for the next year. Mr. Hope wants to sell ` 10 lakhs worth of bonds and to invest it in the stock market, whereas Mr. Despair wants to dispose off ` 10 lakhs worth of stocks to be invested in the bond market. Selling and buying of bonds or stocks involve transaction cost. Hence, they approach the Swap bank. A contract has been set up between Mr. Hope and Mr. Despair by the swap bank. The contract payments have to be made for every quarter. At the end of each quarter, Mr. Despair has to pay Mr. Hope an amount equal to the rate of return on the NSE-Nifty for every quarter in terms of the basic principal amount. At the same time, Mr. Hope has to pay an amount equal to 3% of the principal. The agreed notional principal amount is ` 10 Lakhs. The contract lasts for an year. They pay fees to the swap bank.

Let us assume that the rates of return of NSE-Nifty are 5%, - 2%, 3% and 6% for the four quarters. Mr. Hope has to pay ` 30,000 to Mr. Despair each quarter, the payments Mr. Despair has to make to the Mr. Hope are as follows:

The results can be summarised

The amount paid by Mr. Despair shows what would have transacted if Mr. Despair had sold stocks and bought bonds. Likewise the payments made by Mr. Hope indicates what would have happened if he had sold bonds and bought stocks. The equity swaps could be modified based upon the index and the prevailing interest rates.