Level II Derivatives item sets

Grace Adeyemi is the chief investment officer of Meridian Municipal Pension, a defined benefit plan for employees of a mid-sized US city. The plan uses derivatives to manage interest rate and equity exposure without trading large amounts of the underlying securities. Paul Novak, a derivatives specialist at an independent consulting firm, reviews the plan's positions each quarter and reports their values to the board.

One year ago, Meridian Municipal Pension entered into a three-year interest rate swap with a notional principal of $50 million. Under the swap, the plan pays a fixed rate of 2.80% and receives a floating rate, with annual settlement in arrears. The plan entered the swap to hedge the floating-rate payments on a $50 million credit facility it uses to fund benefit payments. The facility's floating rate resets annually on the swap's settlement dates, so the swap fixes the plan's borrowing cost for the life of the swap. A settlement has just been made, so the swap now has exactly two years and two annual payments remaining. Since the swap began, interest rates have risen across the curve.

Novak values the swap using the current discount factors in Exhibit 1, which are derived from the market's term structure of interest rates. He explains to the board that the fixed rate on a new swap is set so that the present value of the fixed payments equals the present value of the floating payments at initiation, so the swap has zero value when it begins. Its value changes afterwards as market rates move. He calculates the fixed rate that a new two-year swap would carry today and then uses it to value the plan's existing position. He assumes that the floating leg would be worth par at the next settlement date, and that counterparty credit risk is negligible because the swap is fully collateralised.

Adeyemi is also considering a forward contract on a broad US equity index to increase the plan's equity exposure for nine months while it waits for an allocation to a new active manager to be funded. Exhibit 2 gives the market data. The index pays a single dividend of 30 index points in three months. Novak explains that the no-arbitrage forward price is the price at which a buyer is indifferent between buying the index now with borrowed money and buying it forward. Because the buyer of a forward does not receive the dividends paid before delivery, those dividends reduce the forward price. The plan's dealer quotes rates with annual compounding, and Novak uses the same convention.

Adeyemi enters into a long position in the nine-month forward at the no-arbitrage price. Four months later, after the dividend has been paid, the index stands at 4,350. Novak is preparing the quarterly report and must report the value of the forward position per unit of the index at that date, using the same risk-free rate. He notes that the forward has five months left to run.

Novak also reminds the board that the value of a forward position at any time before expiry is not the same as the gain that would be realised at expiry, because the forward price is paid only at delivery and must be discounted back to the valuation date. He plans to include a short note explaining this point in his report, so that board members can interpret the figures correctly.

Adeyemi asks Novak to repeat the valuation of both positions each quarter. She wants the board to see how the values change as interest rates and equity prices move, and to understand the collateral the plan may have to post if either position moves against it.