Morningstar Advisor - April/May 2009 - 38

Spotlight 1. Hunt down the derivatives and determine which elements of market exposure they affect: interest rates, credit, or currency. 2. Eurodollar futures, Treasury bond futures, interest-rate swaps, or “swaptions” (an option on a swap) are interest-rate derivatives. They are used to take a position on interest rates or to hedge other holdings. 3. Credit default swaps, which isolate credit risk from interest-rate risk, should be listed as such. If there are credit default swaps in the portfolio, attempt to reconcile their overall exposure. Credit Default Swap Contracts as of September 30, 2008 are as follows: Buy/Sell Credit Protection Notional Account (000s) Swap Counterparty Reference Entry Pay/Receive Fixed Rate Termination Date Upfront Payment Received (Paid) Value Barclays Bank plc: ABX.HE.AA. 06-2 Index American International Groups, Inc. American International Group, Inc. American International Group, Inc Capmark Financial Group Sell Sell Sell Sell Sell $9,090 $820 $1,390 $975 $875 0.170% 3.000% 4.000% 5.350% 5.000% 5/25/46 3/20/09 3/20/09 3/20/09 6/20/12 $7,032,186 — — — 245,000 ($7,028,975) ($22,018) ($30,728) ($15,309) ($300,372) Remember to concentrate only on the notional amounts. Value is mark-to-market value only, which usually resets to zero monthly or quarterly. Long exposure is incurred when protection is sold. Short exposure is incurred when protection is bought. Technically, any issue that is a “sold” position that is not offset by a “buy” position is a long exposure for that issue. You might prefer, however, to get a big-picture view of the overall exposures in the portfolio. To do this, reconcile the exposures by subtracting the notional amounts of the sells from the buys. If the number is positive and is not offset by a short-term position in the portfolio, consider it a long exposure to credit risk. 4. Be on the lookout for total return swaps. They should also be listed separately. Total Return Swap Contracts as of September 30, 2008 are as follows: Swap Counterparty Notional Amount Paid by the Fund Received by the Fund Termination Date Value Citibank NA: If credit spreads as represented by the Lehman Brothers U.S. CMBS AAA Index widen, pays the spread change plus 15 basis points* If credit spreads as represented by the Lehman Brothers U.S. CMBS AAA Index narrow, receives the spread change* $58,800,000 2/1/09 ($1,646,036) Historically, total return swaps transfer both credit and interest-rate risk, but recently many have been written as substitutes for credit-default-swap contracts and do not create interest-rate exposure. They also were extremely illiquid in 2008. If you come across a large notional exposure to total return swaps, regardless of whether you can reconcile them on your own, call the fund manager for an explanation. 38 Morningstar Advisor April/May 2009
Morningstar Advisor - April/May 2009

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