Reading 30 Risk Management Applications of Swaps Strategies FinQuiz.com FinQuiz.com CFA Level III Item-set - Question 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 Swaps Strategies FinQuiz.com FinQuiz Item-set ID: 9280 Questions 1(9281) through 6(9286) relate to Reading 30 Swift Technology Ltd (S-Tech) Case Scenario Swift Technology Ltd (S-Tech) is a U.S firm planning to initiate a digital imaging project in U.K Richard Marx is the CEO of the firm and has estimated that the project would cost $37 million which he plans to borrow immediately The current exchange rate is ₤0.87/$, and S-Tech can borrow dollars at a rate of 9.5% Marx is planning to enter into a swap contract as the pound rate payer The swap is a fixed-for-fixed swap with pound and dollar fixed rates of 5% and 8%, respectively During a discussion with the finance department of the firm, Marx made the following comments: Statement 1: “By entering into the swap contract, our company will avoid the credit risk it would have faced had it borrowed directly in the U.K market.” Statement 2: “By entering into the swap contract, our company will have to pay additional interest of $555,000 on the position.” Marx is considering the possibility of changing the fixed rate pound obligation to a floating rate one sometime in the future based on changing interest rate expectations He posed the following question to the head of the finance department, Tim McGuire: “If after sometime I want to change my fixed pound obligation into a floating one, what will be the best way to achieve my objective?” FinQuiz Question ID: 9281 With respect to statement 1, Marx is most likely: A correct B incorrect, because the company faces credit risk that it would not have faced had it borrowed directly C incorrect, because the company faces no credit risk in either case FinQuiz Question ID: 9282 With respect to statement 2, Marx is most likely: A correct B incorrect, because the company will have to pay additional interest of $600,000 C incorrect, because the company will have to pay additional interest of ₤482,850 FinQuiz.com © 2018 - All rights reserved Reading 30 Risk Management Applications of Swaps Strategies FinQuiz.com FinQuiz Question ID: 9283 The credit risk premium will most likely be inherent in the position S-Tech took: A only if the company borrowed pounds indirectly through the swap B regardless of whether the company borrowed pounds directly or indirectly through the swap C only if the company borrowed pounds directly in the pound market FinQuiz Question ID: 9284 The most appropriate response to Marx’s question is that the change can be brought about: A by entering into a plain vanilla interest rate swap in pounds as the floating rate payer B by entering into another currency swap with floating for fixed payments C issuing a dual currency bond that pays interest in pounds based on a floating rate FinQuiz Question ID: 9285 The net cash flow paid by S-Tech, on each annual settlement date, will be closest to: A $555,000 B ₤2,092,350 C ₤1,609,500 + $555,000 FinQuiz Question ID: 9286 Which of the following about currency swaps is least accurate? A All currency swaps are used in cases where exchange rate risk is present B All currency swaps require the exchange of notional principal C All currency swaps deal with payments in atleast two different currencies FinQuiz.com © 2018 - All rights reserved Reading 30 Risk Management Applications of Swaps Strategies FinQuiz.com FinQuiz Item-set ID: 9268 Questions 7(9269) through 12(9274) relate to Reading 30 Imperial media Management (IMM) Case Scenario Imperial Media Management (IMM) is a U.S firm operating in the advertisement industry The firm is currently considering expansion in the European market, and has estimated that the expansion would cost them $50 million It therefore, plans to issue a bond worth $50 million in the U.S market Borrowing $50 million in the U.S market can be done at a rate of 5.5% The current exchange rate is $0.75/€ IMM is planning to enter into a currency swap contract to convert the dollar denominated loan into a euro denominated one The swap contract has a fixed rate of 6.5% on euros and 4% on dollars Both the swap and the loan have annual interest settlements FinQuiz Question ID: 9269 To convert the dollar denominated loan to a euro denominated one, IMM should most likely enter into the swap as the: A dollar interest receiver B euro interest receiver C dollar interest payer FinQuiz Question ID: 9270 The principal cash flows received by IMM and the swap dealer at the maturity of the swap will be closest to: IMM A €66,666,667 B $50,000,000 C €66,666,667 Swap dealer $50,000,000 €66,666,667 €66,666,667 FinQuiz Question ID: 9271 The net interest due by IMM at each settlement date is closest to: A €4,333,333 B $3,250,000 C $750,000 + €4,333,333 FinQuiz.com © 2018 - All rights reserved Reading 30 Risk Management Applications of Swaps Strategies FinQuiz.com FinQuiz Question ID: 9272 10 What is the amount of credit risk premium inherent in the position and who is it paid by? Credit risk premium A $0 B €1,000,000 C $750,000 Paid by Nobody Swap dealer IMM FinQuiz Question ID: 9273 11 Which of the following can be a likely reason for IMM to convert its euro denominated loan to a dollar denominated one? A IMM can borrow directly in the European market at 7% B IMM has been downgraded recently by a U.S credit rating agency C IMM is well known as a creditor in the European market FinQuiz Question ID: 9274 12 The most likely reason for the inherent credit risk premium is that: A the swap dealer cannot borrow euros in the European market at a rate less than it receives by IMM B IMM cannot borrow in the U.S market at a rate equal to that paid by London banks C IMM can borrow euros directly in the European market at a rate lower than that it pays in the swap contract FinQuiz.com © 2018 - All rights reserved Reading 30 Risk Management Applications of Swaps Strategies FinQuiz.com FinQuiz Item-set ID: 9078 Questions 13(9079) through 18(9084) relate to Reading 30 Richard Castillo Case Scenario Richard Castillo is analyzing an interest rate swap agreement between two companies; High Manufacturers Ltd (HML) and Low Manufacturers Ltd (LML) HML has also recently borrowed $30 million at LIBOR plus 320 basis points from a multinational bank Based on interest rate expectations, HML wants to convert this floating rate loan to a fixed rate loan by entering into the swap agreement as a fixed rate payer Just like the loan, the swap has quarterly settlement dates with LIBOR as the underlying Low Manufacturers has entered the swap as a floating rate payer to offset the risk of a fixed rate loan of $30 million it just took at a rate of 7% The swap fixed rate is 4.5% and the settlements for the loan and the swap will be on April 1, July 1, October 1, and January The LIBOR rates on the settlement dates are given below: Exhibit Date LIBOR January 4.0% April 4.4% July 4.6% October 5.0% January (next year) 5.5% FinQuiz Question ID: 9079 13 The total interest cost to HML on July will be closest to: A $583,917 B $1,251,250 C $568,750 FinQuiz Question ID: 9080 14 The net payment by HML on October will be closest to: A $628,667 B $590,333 C $583,917 FinQuiz.com © 2018 - All rights reserved Reading 30 Risk Management Applications of Swaps Strategies FinQuiz.com FinQuiz Question ID: 9081 15 The total annual rate that HML will effectively pay on each settlement date is closest to: A LIBOR + 320 basis points B 7.7% C 1.925% FinQuiz Question ID: 9082 16 The total interest cost to LML on January next year will be closest to: A $613,333 B $562,500 C $575,000 FinQuiz Question ID: 9083 17 Which of the following about the net interest cost to LML is most accurate? A The net cost to LML translates into a fixed rate of 2.5% B LML has a floating rate liability at a spread of 300 basis points above LIBOR C LML has a floating rate liability at a spread of 250 basis points above LIBOR FinQuiz Question ID: 9084 18 For which of the following settlement dates will the net payments for HML be equal? A April and July B July and October C October and January of next year FinQuiz.com © 2018 - All rights reserved Reading 30 Risk Management Applications of Swaps Strategies FinQuiz.com FinQuiz Item-set ID: 9085 Questions 19(9086) through 24(9091) relate to Reading 30 Randy Gonzalez Case Scenario Randy Gonzalez works at BSBank as the Chief Executive Officer The bank just extended a $50 million loan to a large multinational firm for expansion purposes The loan has a fixed rate of 8% Gonzalez believes that interest rates are going to rise in the future and hence wants to convert the fixed rate loan into a floating rate one A swap with the same settlements and maturity as the loan has a fixed rate of 9.5% While talking to his colleagues Gonzalez made the following comment: Statement 1: “The effective floating rate that we will receive on this loan will be less than LIBOR.” BSBank has also extended a loan to Landmark Company Ltd (LCL), a firm that operates in the construction industry The loan is worth $20 million and is based on a floating rate of 90 day LIBOR plus 200 basis points LIBOR is currently 4% LCL has entered into a swap contract as a fixed rate payer to offset the risk of the loan The swap contract has LIBOR as the underlying for the floating rate payments, a fixed rate of 5%, a one year maturity and quarterly settlements just like the loan While analyzing LCL’s scenario, Gonzalez made the following comment: Statement 3: “By entering into the swap contract, LCL has converted the floating rate loan to a fixed rate loan Hence, LCL is now no more exposed to the uncertainty of changing LIBOR.” Statement 4: “Assuming that the duration of a fixed rate bond is 75% of its maturity, by entering into the swap contract, LCL has decreased the absolute value of the duration of its loan.” FinQuiz Question ID: 9086 19 With respect to statement 1, Gonzalez is most likely: A correct B incorrect, because the effective floating rate will be greater than LIBOR C incorrect, because the effective floating rate will depend on the LIBOR at the settlement dates FinQuiz.com © 2018 - All rights reserved Reading 30 Risk Management Applications of Swaps Strategies FinQuiz.com FinQuiz Question ID: 9087 20 On the loan extended to the multinational firm, assuming quarterly settlements and 90 days in each quarter, the overall interest that the bank will receive on the second settlement date, if LIBOR is 6% on the first settlement, will be closest to: A $937,500 B $562,500 C $1,437,500 FinQuiz Question ID: 9088 21 With respect to the comment related to LCL’s swap contract, is Gonzalez most likely correct? A yes B no, because the swap does not convert the floating rate loan to a fixed rate loan C no, because the swap does not remove the uncertainty of changing LIBOR FinQuiz Question ID: 9089 22 Assuming 90 days in each settlement period, the net payment by Landmark Company Ltd to the swap counterparty on each settlement date will be closest to: A $300,000 B $350,000 C $450,000 FinQuiz Question ID: 9090 23 With respect to statement 4, Gonzalez is most likely: A correct B incorrect, because the duration has increased to 0.625 C incorrect, because the duration has increased to 0.75 FinQuiz Question ID: 9091 24 The duration of the swap to LCL is closest to: A –0.625 B –0.75 C –0.50 FinQuiz.com © 2018 - All rights reserved ... €66,666,667 FinQuiz Question ID: 9271 The net interest due by IMM at each settlement date is closest to: A €4 ,33 3 ,33 3 B $3, 250,000 C $750,000 + €4 ,33 3 ,33 3 FinQuiz. com © 2018 - All rights reserved Reading. . .Reading 30 Risk Management Applications of Swaps Strategies FinQuiz. com FinQuiz Item- set ID: 9280 Questions 1(9281) through 6(9286) relate to Reading 30 Swift Technology Ltd... contract FinQuiz. com © 2018 - All rights reserved Reading 30 Risk Management Applications of Swaps Strategies FinQuiz. com FinQuiz Item- set ID: 9078 Questions 13( 9079) through 18(9084) relate to Reading