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Contents
Introduction ...........................................................................................................................................................................2
Portfolio and Benchmark Example .......................................................................................................................................3
Swap Attributes, Terms and Conventions, and Market Valuation ........................................................................................3
Swap Analytics .....................................................................................................................................................................6
Total Return Calculations .....................................................................................................................................................7
Attribution of Portfolio and Benchmark Returns .................................................................................................................10
Summary and Conclusions.................................................................................................................................................11
Introduction
Interest rate swaps (i.e., IRS or swaps) were introduced in the 1980s by commercial money center banks to help their
clients manage interest rate risk. The swaps market quickly became an attractive alternative to the newly established
exchange-traded interest rate futures markets. Clients who were reluctant to trade futures or were prohibited from doing
so looked instead to banks for IRS positions to hedge interest rate risks, alter their asset-liability mix, or otherwise
manage interest rate exposures. In turn, the banks typically offset their swap exposures in the futures markets. For
instance, a bank would quote Eurodollar swap rates based on strips of Eurodollar futures contracts, in effect acting as an
intermediary between the bank’s client and the futures exchange. The client could go long or short over-the-counter
swaps, taking a position similar to going long or short futures contracts without having to establish futures margin
accounts or marking to market futures positions. Over time, the swaps market became widely used and equally as liquid
as exchange-traded futures.
Today, the interest rate swaps market constitutes the largest and most liquid part of the global derivatives market. The
focus of this paper is on plain vanilla swaps, which constitute the vast majority of the over-the-counter swap market.
The outline of the paper follows. First, a sample portfolio and benchmark are introduced. Next, EUR and USD swaps are
added to the portfolio to change its interest rate sensitivity relative to the benchmark. Terms and conventions of the
swaps are then described. This is followed by swap analytics, swap total returns, and the attribution of swaps in the
context of portfolio and benchmark returns. There are examples based on the sample portfolio and benchmark illustrated
throughout the paper as appropriate.
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Portfolio and Benchmark Example
The sample portfolio includes multi-currency global bonds and is benchmarked against a multi-currency global index. It
consists of U.S. and European government and corporate bonds denominated in USD, EUR, and GBP currencies. At the
beginning of the analysis period, the portfolio contained 104 securities and was characterized by the distributions shown
in Table 1.
The benchmark is defined to include USD, EUR, and GBP fixed-rate securities with final maturities of one year or longer
and minimum par amounts outstanding of $300 million for USD securities, €300 million for pan-European securities, and
£200 million for GBP securities. The benchmark included 12,156 securities and was characterized by the distributions in
Table 2.
Compared to the benchmark, the portfolio has a lower allocation to USD and a higher allocation to EUR and GBP. On a
weighted average basis, the portfolio has a lower overall quality rating, a higher yield to maturity, and a higher option-
adjusted spread (OAS) than the benchmark. The effective duration of the portfolio is 0.31 shorter than the benchmark
due primarily to the portfolio’s concentration of shorter duration EUR denominated securities. Portfolio exposures relative
to the benchmark are summarized in Table 3.
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In Table 3, you can infer several portfolio strategy bets based on the relative exposures. First, the portfolio’s percentage
allocations suggest that the GBP and EUR sectors are favored at the expense of USD. Second, an implicit quality bet
favors lower-rated securities. Third, the relative durations suggest an expectation that EUR rates will increase and USD
rates will decline.
For purposes of introducing swaps into the portfolio described above, suppose that portfolio management decides to
“neutralize” the effective duration bets by implementing EUR and USD plain vanilla swap strategies. The swap positions
that neutralize the relative effective duration bets in the EUR and USD sectors are shown in Table 4.
Paying Leg
Receiving Leg
To lengthen the portfolio duration of the EUR sector by 1.26, the portfolio receives an annual fixed coupon rate of 2.15%
and pays 6-month EURIBOR on a €9,900,000 notional amount. Likewise, to shorten the portfolio duration of the USD
sector by 0.14, the portfolio pays a semi-annual fixed coupon of 3.12% and receives 3-month LIBOR on a $2,000,000
notional amount. Both swaps have a maturity of 10 years, and the trade date and effective dates are assumed to be
identical.
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Swap Attributes, Terms and Conventions, and Market Valuation
As shown in Table 4, a plain vanilla swap is represented as one security with two legs. One leg represents the cash flows
associated with the fixed rate of interest and the other leg represents the cash flows associated with the floating rate of
interest. The fixed coupon on the EUR swap is 2.15% (i.e., the 10-year EUR swap rate) and the floating leg reference
benchmark is the 6-month EURIBOR. The fixed coupon on the USD swap is 3.12% (i.e., the 10-year USD swap rate)
and the floating leg reference benchmark is the 3-month LIBOR. The day count basis for the fixed leg of both swaps is
30/360 and the day count convention for the floating rate leg of both swaps is ACT/360. The swap prices, accrued
interest, and market values for the EUR and USD swaps are shown in Table 5.
Table 5: Swap Prices, Accrued Interest & Market Values (EUR) – End of Day 1
EUR Swap
USD Swap
In Table 5, the notional amount of the EUR swap fixed leg is positive (€9,900,000), reflecting the fact that the portfolio is
long the fixed coupon payments, while the notional amount of the floating leg is negative (-€9,900,000) to reflect that the
portfolio is short the floating rate payments. The reverse is true for the USD swap.
The market value of the EUR swap at the point of trade execution is zero. FactSet revalues swaps daily to determine
new market values and the profit and loss of the swaps due to the passage of time and changes in market conditions.
The market value of the EUR swap at the end of Day 1 is calculated as follows:
(100.097 + 0.0)
= ∗ 9,900,000 = €9,900,619(𝑅𝑒𝑐𝑒𝑖𝑣𝑒 𝑓𝑖𝑥𝑒𝑑 𝑙𝑒𝑔, 𝑟𝑜𝑢𝑛𝑑𝑒𝑑)
100
(99.731+0.0)
= ∗ −9,900,000 = €9,873,375 (𝑃𝑎𝑦 𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑔, 𝑟𝑜𝑢𝑛𝑑𝑒𝑑)
100
The net value of the swap at any given time is calculated by computing the difference in the market values of each leg of
the swap.
The net value of €36,244 suggests that the EUR swap is profitable because the value of the fixed rate payments
(received) exceeds that of the floating rate payments (paid). The market value and net amount of the USD swap are
calculated in a similar fashion.
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Table 6 shows the swap prices, accrued interest, and market values 31 days after the initial valuations shown in Table 5.
Table 6: Swap Prices, Accrued Interest & Market Values (EUR) – Day 31
Notional Clean Price Accrued Interest Full Price FX Rate Full Market
(Local) (%) (Local) Value (EUR)
EUR Swap
USD Swap
In Table 6, the net value of the EUR swap is calculated again by taking the difference between the full market value of
each leg:
(102.545 + 0.179)
= ∗ 9,900,000 = €10,169,664(𝑅𝑒𝑐𝑒𝑖𝑣𝑒 𝑓𝑖𝑥𝑒𝑑 𝑙𝑒𝑔, 𝑟𝑜𝑢𝑛𝑑𝑒𝑑)
100
(99.767 + 0.033)
= ∗ 9,900,000 = €10,169,664(𝑃𝑎𝑦 𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑔, 𝑟𝑜𝑢𝑛𝑑𝑒𝑑)
100
The Profit & Loss (P&L) for the EUR swap over the period is the change in the net values from
Day 1 to Day 31:
Swap Analytics
Fixed Income Portfolio Analysis calculates swap analytics, including effective durations, key rate durations, and effective
convexities. These attributes are shown in Table 7 for the EUR and USD swaps.
Table 7: Swap Analytics in Fixed Income Portfolio Analysis - Day 1 Swap Trade Date
EUR Swap
USD Swap
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Although not shown in Table 7, Fixed Income Portfolio Analysis also calculates the contribution to effective duration and
convexity, computed as the product of market value percent and the duration/convexity statistics. Contribution to duration
and contribution to convexity show how each leg of the swap impacts the sensitivities of the portfolio. As reflected in
Table 7, the portfolio is long the fixed payments leg and is short the floating payments leg of the EUR swap, and the
converse is true for the USD swap. The contribution to ending portfolio effective duration of each leg of the EUR swap is:
5.88
= ( ) ∗ 8.93 = 0.53 (𝑅𝑒𝑐𝑒𝑖𝑣𝑒 𝑓𝑖𝑥𝑒𝑑 𝑙𝑒𝑔)
100
5.86
= ( ) ∗ 0.48 = −0.03 (𝑃𝑎𝑦 𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑔)
100
The EUR swap contributes 0.50 to the effective duration of the portfolio.
You can perform a similar calculation to determine the swaps’ contribution to effective duration of the sector in which it
resides. The weights are scaled to reflect the percentages each swap leg represents in its sector. For instance, the EUR
swap contributes 1.26 to the EUR sector’s effective duration, making the EUR sector duration equal to the benchmark’s
EUR sector effective duration. The effect is to neutralize that sector’s relative sensitivity to changes in EUR rates.
At the portfolio level, the impact of the EUR and USD swaps is illustrated in Figure 1 and Figure 2. Figure 1 illustrates
Fixed Income Portfolio Analysis output where the swaps are excluded from the portfolio and Figure 2 represents similar
output when the swaps are included in the portfolio.
In Figure 1, there is a discrepancy in the ending effective durations of the EUR and USD sectors, -1.26 and 0.14
respectively. In the portfolio example, the EUR and USD swaps were included in the portfolio specifically to neutralize
these discrepancies. Figure 2 shows the results when including the swaps.
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Figure 2: Portfolio Including Swaps Versus Benchmark
Figure 2 shows that including the swaps in the portfolio eliminated the effective duration difference in the EUR and USD
sectors. The portfolio is now duration neutral versus the benchmark with respect to EUR and USD interest rates.
However, the effective duration is 0.11 longer than the benchmark at the portfolio level because the portfolio is
overweighted in GBP and EUR. Also, the effective durations of those sectors is longer than the effective duration of the
USD sector, which is underweighted.
(𝑃𝑒 − 𝑃𝑏 )
𝑃𝑟𝑖𝑐𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 = ∗ 100
(𝑃𝑏 + 𝐴𝐼𝑏 )
Where:
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The currency return is the difference between the total return in the reporting currency and the total return in
local currency.
To calculate total return in a reporting currency other than local currency, Fixed Income Portfolio Analysis applies
exchange rate adjustments to both the local price and local coupon returns as follows:
(𝑃𝑒 − 𝑃𝑏 ) 𝐹𝑋𝑒
𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦 − 𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑃𝑟𝑖𝑐𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 = ∗( )
(𝑃𝑏 + 𝐴𝐼𝑏 ) 𝐹𝑋𝑏
Where:
The currency-adjusted total return for an interest rate swap is calculated as the sum of price and coupon return:
In the multi-currency portfolio example, a reporting currency is selected and the local returns are converted to reporting
currency returns. This is shown in Figure 3 for the portfolio, excluding the swaps. The holding period is 31 days, the price
and coupon returns are in local currency and the total returns and variations versus the benchmark are in EUR.
The left section of Figure 3 shows the total return components of the portfolio, including portfolio price return, portfolio
coupon return, and portfolio currency return. The middle section shows total returns for the portfolio and benchmark as
well as the contributions to total returns by currency sector. Finally, the difference in total return between the portfolio and
the benchmark is shown in the final column. For the 31-day holding period, the portfolio total return was one basis point
less than the benchmark total return. Positive relative contribution from the EUR sector was more than offset by negative
relative contribution from the GBP and USD sectors.
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Figure 4: Portfolio Including Swaps Versus Benchmark
Figure 4 shows that with swaps included, the portfolio total return for the holding period was 3.09%, which is up 12 basis
points from the 2.97% shown in Figure 3. The total return performance of the portfolio relative to the benchmark also
increased by the same amount. The swaps increased portfolio total return, but how? To answer this question, we turn to
the attribution of portfolio and benchmark performance.
Portfolio Strategy Strategy Variable Attribution Factor (Effect) Calculated For Swaps
The attribution factors include shift, twist, allocation, selection, and currency. For a full explanation of FactSet’s attribution
methodology, reporting configurations, and calculation details, see “A Flexible Benchmark Relative Method of Attributing
Returns for Fixed Income Portfolios.”1 One advantage of FactSet’s approach is that a common methodology and set of
calculations are used for all security types, including interest rate swaps.
1 Kwasniewski, Stanley J., CFA 2013. “A Flexible Benchmark‐ Relative Method of Attributing Returns for Fixed Income Portfolios”.
http://www.factset.com/websitefiles/PDFs/whitepapers/fixed-income-model.
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For swaps, the most relevant attribution factors are shift and twist return because swap returns are largely a function of
yield curve movements. Shift return is calculated as:
2
𝑆ℎ𝑖𝑓𝑡 𝑅𝑒𝑡𝑢𝑟𝑛 = −1 ∗ 𝐸𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 ∗ 𝛥𝑆ℎ𝑖𝑓𝑡 𝑃𝑜𝑖𝑛𝑡 + 1⁄2 ∗ 𝐸𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 ∗ (∆𝑆ℎ𝑖𝑓𝑡𝑃𝑜𝑖𝑛𝑡 )
Where:
Residual returns represent the portion of unexplained total return. It includes return components such as spread, income,
paydown, carry (accretion and roll down), volatility, and inflation.2
Residual returns are used to quantify allocation and selection effects, both of which are calculated relative to the
benchmark, as follows:
2 These components comprise the optional factors in FactSet’s fixed income attribution model. Clients who wish to analyze the full range of total return
components can add these additional attribution factors to their analysis. For a full description of this methodology, please see “A Flexible Benchmark
Relative Method of Attributing Returns for Fixed Income Portfolios.”
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Where:
Over the holding period, the portfolio total return in EUR was 2.97%, one basis point less than the total return of the
benchmark. The attribution results indicate that the shift (-0.10), twist (0.05), allocation (0.01), selection (0.14), and
currency effects (-0.10) were largely offsetting in the aggregate.
As previously described, the EUR swap was added to the portfolio to lengthen the EUR duration by 1.26 and the
USD swap was added to shorten USD duration by 0.14. Figure 6 shows the total return and attribution results,
including the swaps.
During the holding period, the 5-year point on the Euro curve declined by 35 basis points and 5-year point on the U.S.
Treasury curve declined by 25 basis points. By comparing Figure 5 (without swaps) to Figure 6 (with swaps), the impact
of the swaps is evident. Portfolio total return increased relative to the benchmark due to including swaps.
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The interpretation from a portfolio manager’s perspective is that the EUR swap added 36 basis points (2.52 – 2.16) to the
total return of the EUR sector, while the USD swap subtracted 6 basis points (1.28 – 1.34) from the USD sector. At the
portfolio level, the net result was to increase the local currency total return by 11 basis points (1.84 – 1.73), which the
attribution shows. The shift effect of the EUR sector increased by 12 basis points (0.06 – -0.06) because receiving the
fixed leg of the EUR swap added duration and EUR rates declined. Conversely, the shift effect of the USD sector
increased to -0.08 basis points (from -0.07) because the USD swap shortened the duration of the USD sector and USD
rates declined. At the portfolio level, the weighted average shift effect increased by 10 basis points (0.00 – -0.10). The
original purpose of adding the swaps – relative duration neutrality in the EUR and USD sectors – paid off. Despite
changes in EUR and USD benchmark rates of 35 and 25 basis points, respectively, there was no resulting impact at the
portfolio level relative to the benchmark due to changes in rates.
Further analysis of Figure 5 and Figure 6 reveals that the twist effects at the currency sector level were minor and
offsetting, resulting in no change in twist effect at the portfolio level relative to the benchmark. Likewise, the allocation
effect did not change at the portfolio level relative to the benchmark because the market value weight of each leg of each
swap is largely offsetting to the other and has minimal impact on the portfolio sector weights. The selection effect of the
EUR sector increased slightly as a result of adding the EUR swap because the swap earned income over the period.
In summary, the attribution indicates no impact from shift effect as a result of declining EUR and USD rates when swaps
are included in the portfolio. The swaps effectively “neutralized” the relative interest rate exposures.
As this paper shows, the attribution of relative portfolio performance can be computed and reported at a basic level that
relates the factors of attribution to primary investment strategies or on a more advanced level by enabling a high degree
of user choice and configuration of attribution factors.
Whichever approach is taken, FactSet accurately measures and accounts for the impact of plain vanilla swaps within the
context of portfolio analysis and performance attribution.
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