Handbook of Finance: Investment Management and Financial Management

Chapter 51. Swaps for the Modern Investment Manager

STEVEN I. DYM, PhD

President, Mariner Capital Partners

Abstract: Active fixed income portfolio managers must choose degrees of interest rate, credit, and inflation exposures consistent with both their expectations for these parameters as well as their risk tolerance. The existing menu of cash instruments is restrictive. Many commonly desired combinations of interest rate, credit and inflation risk are simply unavailable. Swaps efficiently address this problem. Interest rate swaps exchange fixed for floating interest payments between the counterparties. Credit default swaps exchange premium payments for credit protection. Inflation swaps exchange actual inflation for expected inflation. Combining these derivatives with traditional cash instruments completes the menu of investment alternatives for the modern portfolio manager.

Keywords: investment horizon, Treasury bill, Treasury bond, commercial paper, corporate bond, short-term interest rate exposure, long-term interest rate exposure, floating versus fixed-rate exposure, fixed-coupon, floating-rate note, credit risk, roll over, corporate profits, interest rate swap, credit spread, London Interbank Offered Rate (LIBOR), synthetic, decoupling, credit default swap (CDS), credit protection, reference asset, unfunded credit exposure, default, real interest rate, inflation premium, Treasury inflation-protected security (TIPS), nominal bond, inflation swap, corporate inflation protected ...