Explanation

Let's analyze each swap position when the equity index return is -5%:

A. Pay-equity, receive-fixed swap:

• Pays: Equity return = -5% (receives payment since return is negative)
• Receives: Fixed rate (positive)
• Net cash flow: Receives equity payment + receives fixed = Positive cash flow

B. Pay-equity, receive-floating swap:

• Pays: Equity return = -5% (receives payment since return is negative)
• Receives: Floating rate (positive)
• Net cash flow: Receives equity payment + receives floating = Positive cash flow

C. Receive-equity, pay-floating swap:

• Receives: Equity return = -5% (pays since return is negative)
• Pays: Floating rate (positive)
• Net cash flow: Pays equity payment + pays floating = Negative cash flow

Analysis:

• For options A and B, the party is paying the equity return. When the equity return is negative (-5%), this means they actually receive a payment from the counterparty.
• For option C, the party is receiving the equity return. When the equity return is negative (-5%), this means they must pay the counterparty.

Therefore, the holder of a receive-equity, pay-floating swap (option C) will incur a negative cash flow because:

1. They must pay the negative equity return to the counterparty
2. They also pay the floating rate

Both payments result in negative cash flow.

Correct Answer: C

The party receiving the equity return bears the risk of negative equity performance, as they must pay when the equity return is negative.