Reading 30 Risk Management Applications of Swap Strategies FinQuiz.com FinQuiz.com CFA Level III Item-set - Solution Study Session 15 June 2018 Copyright © 2010-2018 FinQuiz.com All rights reserved Copying, reproduction or redistribution of this material is strictly prohibited info@finquiz.com FinQuiz.com © 2018 - All rights reserved Reading 30 Risk Management Applications of Swap Strategies FinQuiz.com FinQuiz Level III 2018 – Item-sets Solution Reading 30: Risk Management Applications of Swap Strategies Question ID: 9281 Correct Answer: B By borrowing pounds indirectly through the swap contract, S-Tech assumes the credit risk that the swap dealer will default on his/her swap payments Had it borrowed directly in the U.K market by issuing debt in pounds, it would face no credit risk Question ID: 9282 Correct Answer: A S-Tech will have to pay the swap dealer 0.05(₤32,190,000) = ₤1,609,500 and will receive 0.08($37,000,000) = $2,960,000 from the swap dealer It will also have to pay $37,000,000(0.095) = $3,515,000 on the loan it took in the U.S market This means, that in addition to the pound interest it pays, it will have to pay additional interest of: $3,515,000 – $2,690,000 = $555,000 Question ID: 9283 Correct Answer: B The credit risk premium (the additional $555,000 paid by S-Tech) is present because S-Tech cannot borrow dollars at the same rate as the fixed rate on the swap S-Tech will have to pay this premium regardless of whether it borrowed directly in the pound market or indirectly through the swap Question ID: 9284 Correct Answer: A If after sometime, the fixed pound obligation needs to be changed to a floating rate one, STech should enter into a plain vanilla interest rate swap in pounds as the floating rate payer It would pay the counterparty interest in pounds at a floating rate and receive interest in pounds at a fixed rate This transaction would shift the pound interest obligation to floating Question ID: 9285 Correct Answer: C S-Tech will have to pay the swap dealer 0.05(₤32,190,000) = ₤1,609,500 and will receive 0.08($37,000,000) = $2,960,000 from the swap dealer It will also have to pay $37,000,000(0.095) = $3,515,000 on the loan it took in the U.S market The net cash flow paid by S-Tech will equal: ₤1,609,500 + $3,515,000 – $2,960,000 = ₤1,609,500 + $555,000 FinQuiz.com © 2018 - All rights reserved Reading 30 Risk Management Applications of Swap Strategies FinQuiz.com Question ID: 9286 Correct Answer: B Currency swaps are designed for the purpose of managing exchange rate risk They also play a role in managing interest rate risk, but only in cases in which exchange rate risk is present Also, currency swaps deal with payments in two different currencies However, not all currency swaps involve the payment of notional principal (like in cases where currency swaps are used to lock in the exchange rate at which foreign cash flows are converted to the domestic currency) Question ID: 9269 Correct Answer: A To convert the dollar denominated loan to a euro denominated one, IMM should enter into the swap contract as the euro interest payer and dollar interest receiver This will result in IMM making a net payment in euros Question ID: 9270 Correct Answer: B At initiation of the swap, IMM will pay $50 million and receive 50,000,000/(0.75) = €66,666,667 At the maturity of the swap, IMM will receive $50,000,000 and pay €66,666,667 to the swap dealer Question ID: 9271 Correct Answer: C At the end of each year, IMM will owe 0.055(50,000,000) = $2,750,000 on the dollar denominated bond The interest due on the swap will equal (0.065)(66,666,667) = €4,333,333 The interest received by IMM on the swap will equal (0.04)(50,000,000) = $2,000,000 The net interest due equals: $2,750,000-$2,000,000 + €4,333,333 = $750,000 + €4,333,333 10 Question ID: 9272 Correct Answer: C As can be seen in question 3, IMM has to pay an additional $750,000 in addition to euro interest payments because it cannot borrow at the same rate as the fixed rate on the swap This is because its credit rating is not as good as the rating implied in the LIBOR market term structure Hence, this additional interest of $750,000 can be viewed as a credit risk premium 11 Question ID: 9273 Correct Answer: A One of the most common reasons for engaging in a currency swap is to gain the advantage of borrowing indirectly in another currency IMM may have borrowed euros in this way because it is well known as a creditor in the U.S and hence finds it easier to issue a dollar denominated bond and then convert it to a euro one Also, it may be that IMM has to pay a higher interest rate if it borrows euros directly in the European market than if it borrows indirectly through the swap Hence option A is correct FinQuiz.com © 2018 - All rights reserved Reading 30 Risk Management Applications of Swap Strategies FinQuiz.com 12 Question ID: 9274 Correct Answer: B The credit risk premium inherent in the position is paid by IMM and equals the additional $750,000 that it pays on the position This is a ‘credit risk premium’ because IMM cannot borrow in the U.S market at the same rate as the fixed rate on the swap This is because IMM is more credit risky than high-quality London banks (the swap fixed rate is the rate that a London bank would pay if it issued a par bond); hence it pays a rate greater than the swap fixed rate 13 Question ID: 9079 Correct Answer: A HML’s loan payment on July will equal: 30,000,000[(0.044+0.0320)(91/360)] = $576,333.34 HML’s swap payment will equal: 30,000,000[(0.045)(91/360)]= $341,250 HML’s swap receipt will equal: 30,000,000[(0.044)(91/360) = $333,666.67 The total interest cost equals: 576,333.34+341,250 – 333,666.67 = $583,916.67 14 Question ID: 9080 Correct Answer: B HML’s loan payment on October will equal: 30,000,000[(0.046+0.0320)(92/360)] = $598,000 HML’s swap payment will equal: 30,000,000[(0.045)(92/360)]= $345,000 HML’s swap receipt will equal: 30,000,000[(0.046)(92/360) = $352,666.67 The total interest cost equals: 598,000+345,000 – 352,666.67 = $590,333.34 FinQuiz.com © 2018 - All rights reserved Reading 30 Risk Management Applications of Swap Strategies FinQuiz.com 15 Question ID: 9081 Correct Answer: B HML has effectively converted its floating rate loan into a fixed rate loan The total rate will equal: Total payment = loan payment + swap payment – swap receipt Loan payment = LIBOR + 0.0320 (D/360) Swap payment = (0.045) (D/360) Swap receipt = LIBOR (D/360) Therefore, the net payment equals: Net rate = 0.045 + 0.0320 (D/360) Or the annual rate equals = 7.7% 16 Question ID: 9082 Correct Answer: C LML’s loan payment on January next year will equal: 30,000,000[(0.07)(92/360)] = $536,666.67 HML’s swap payment will equal: 30,000,000[(0.05)(92/360)]= $383,333.34 HML’s swap receipt will equal: 30,000,000[(0.045)(92/360) = $345,000 The total interest cost equals: 536,666.67+383,333.34 – 345,000 = $575,000 17 Question ID: 9083 Correct Answer: C LML has converted its fixed rate loan into a floating rate using the swap The net cost to LML at each settlement date equals: NP (loan rate-swap rate + LIBOR)(D/360) This equals: NP (7%-4.5% +LIBOR)(D/360) Hence, LML will have to make quarterly payments at a rate of LIBOR + 2.5% FinQuiz.com © 2018 - All rights reserved Reading 30 Risk Management Applications of Swap Strategies FinQuiz.com 18 Question ID: 9084 Correct Answer: C No calculations are necessary for this question By entering into the swap HML has converted its floating rate loan into a fixed rate loan with quarterly fixed payments at a rate of 4.5%+3.2%=7.7% There will only be a slight variation in payments due to the difference in days per quarter However, since the last two periods have the same number of days (92), the last two net payments (October and January next year) will be equal 19 Question ID: 9086 Correct Answer: A To convert the fixed rate loan into a floating rate one, BSBank should enter into the swap as the fixed rate payer (receive floating) It will receive 8% on the loan it extended and pay 9.5% on the swap Hence, the net rate it will receive will be: LIBOR +8%- 9.5% = LIBOR – 1.5% Hence, the bank will receive an effective floating rate that is 1.5% less than LIBOR 20 Question ID: 9087 Correct Answer: B The bank will receive an effective rate of: LIBOR – 1.5% Given a notional principal of $50 million and 90 days in each settlement period, the overall interest the bank will receive will equal: 50,000,000 (6% – 1.5%)(90/360) = $562,500 21 Question ID: 9088 Correct Answer: C The swap indeed does convert the floating rate loan into a fixed rate loan However, even though LCL does not appear to be exposed to the uncertainty of changing LIBOR, it is still exposed This is because converting a floating rate loan into a fixed rate loan will protect LCL against rising interest rates but if rates fall, LCL will not be able to take the advantage since it has locked a fixed rate on its loan Hence, there is an opportunity cost to taking this position, and LCL is exposed to this cost (in other words, LCL has stabilized its cash outflows but increased the risk of the company’s market value) FinQuiz.com © 2018 - All rights reserved Reading 30 Risk Management Applications of Swap Strategies FinQuiz.com 22 Question ID: 9089 Correct Answer: B By entering into the swap as the fixed rate payer, LCL is effectively paying a fixed rate on its loan The net payment by LCL will equal: NP(swap fixed rate + loan spread) (D/360) Given a notional principal of $20 million, a swap fixed rate of 5%, a loan spread of 200 basis points and 90 days in each settlement period, the net payment will equal: 20,000,000[(5%+2%)(90/360)] = $350,000 23 Question ID: 9090 Correct Answer: C The average duration of a quarterly settlement, floating rate loan from the holder’s perspective (lender) is 0.125 Since LCL is the issuer of the loan (borrower) the duration of the position is – 0.125 The duration of the swap for LCL will equal: Duration for pay fixed swap = Duration of floating leg – duration of fixed leg = 0.125-0.75 = -0.625 Hence, the overall duration of the position (loan + swap) will equal: – 0.125 – 0.625 = – 0.75 LCL has increased the duration from 0.125 to 0.75 (about six times) The negative sign means that LCL will benefit if interest rates rise 24 Question ID: 9091 Correct Answer: A The duration of the swap for LCL will equal: Duration for pay fixed leg = Duration of floating leg-duration of fixed leg = 0.125 – 0.75 = – 0.625 FinQuiz.com © 2018 - All rights reserved ... (0.065)(66,666,667) = €4 ,33 3 ,33 3 The interest received by IMM on the swap will equal (0.04)(50,000,000) = $2,000,000 The net interest due equals: $2,750,000-$2,000,000 + €4 ,33 3 ,33 3 = $750,000 + €4 ,33 3 ,33 3 10 Question... will equal: 30 ,000,000[(0.07)(92 /36 0)] = $ 536 ,666.67 HML’s swap payment will equal: 30 ,000,000[(0.05)(92 /36 0)]= $38 3 ,33 3 .34 HML’s swap receipt will equal: 30 ,000,000[(0.045)(92 /36 0) = $34 5,000 The... $34 1,250 HML’s swap receipt will equal: 30 ,000,000[(0.044)(91 /36 0) = $33 3,666.67 The total interest cost equals: 576 ,33 3 .34 +34 1,250 – 33 3,666.67 = $5 83, 916.67 14 Question ID: 9080 Correct Answer: