2019 CFA level 3 qbank reading 34 risk management applications of swap strategies answers

10/12/2018 Learning Management System Question #1 of 44 A rm has outstanding oating rate debt on which they pay LIBOR + 200 basis points, and management expects interest rates to increase in the very near future In order to create synthetic xed-rate debt, the best strategy for the rm is to enter into a swap in which they: A) pay oating and receive xed B) pay xed and receive oating C) receive oating and pay oating .in Explanation bo ok c (Study Session 17, Module 34.1, LOS 34.c) en tre To create synthetic xed-rate debt, the rm should pay xed and receive oating in a swap The oating rate payment they receive in the swap will partially o set the oating rate they pay on their debt Any portion of the oating rate on the debt that remains (assume 100bps) will add to the xed rate they pay on the swap Their net position on the debt and the swap will be pay xed + 100 bps = xed rate Related Material m SchweserNotes - Book o Question #2 of 44 w w A borrower who is also the owner of a swaption that gives the holder the right to become a xed-rate payer and oating-rate receiver would most likely which of the following? Exercise w the swaption when interest rates: A) decrease to convert a oating-rate loan to a xed-rate loan B) increase to convert a xed-rate loan to a oating-rate loan C) increase to convert a oating-rate loan to a xed-rate loan Explanation The owner will bene t when interest rates increase because the owner has the right to pay a xed rate and receive the oating rate, which will be higher with the increase in interest rates Receiving the oating rate and paying the xed rate can turn a oating-rate loan to a xed-rate loan (Study Session 17, Module 34.4, LOS 34.h) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 1/28 10/12/2018 Learning Management System Related Material SchweserNotes - Book Question #3 of 44 An investor who enters into a swap to exchange half the return on her 100,000 share position in a stock for the return on an equal value of the S&P 500 would most likely be trying to: A) reduce systematic risk in the portfolio .in B) increase the risk and return of her position en tre C) diversify her portfolio Explanation bo ok c Entering into a swap to exchange the returns on the stock for those of the index would be way to create synthetic diversi cation in a portfolio Note that the added diversi cation as a result of the swap would reduce unsystematic risk, but systematic risk will still exist (Study Session 17, Module 34.3, LOS 34.g) Related Material o m SchweserNotes - Book w w Question #4 of 44 A borrower with a $4 million oating rate loan pays LIBOR plus 200 basis points on the loan w Payments are semiannual The borrower wishes to convert this obligation to a xed-rate loan The borrower uses a swap with a xed rate equal to 5.6%, oating rate equal to LIBOR, and notional principal equal to $4 million Which of the following most closely approximates the semiannual payments made by the borrower on the loan and the swap? A) $72,000.00 B) $152,000.00 C) $76,000.00 Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 2/28 10/12/2018 Learning Management System The borrower will enter into the swap to receive LIBOR and pay 5.6% The LIBOR payment e ectively passes from the counterparty through to the lender while the 200 basis point spread remains an obligation of the borrower Thus, the borrower pays (0.056 + 0.02) / on $4 million each six months = $152,000 (Study Session 17, Module 34.1, LOS 34.a) Related Material SchweserNotes - Book in Question #5 of 44 en tre Which of the following positions results in synthetically issuing oating-rate debt? A) A long position in a xed-rate bond combined with a pay- xed interest rate swap B) A short position in a xed-rate bond combined with a receive- xed interest rate swap bo ok c C) A long position in a xed-rate bond combined with a receive- xed interest rate swap Explanation m The receive- xed part of the interest rate swap o sets the xed rate payments the short bond position requires Therefore, a synthetic oating-rate debt position is created Related Material o (Study Session 17, Module 34.1, LOS 34.c) w w w SchweserNotes - Book Jacobs Management Inc (JMI) is in the process of hiring a new bond manager The JMI xed income department uses swap contracts to accomplish several di erent investment management goals To gauge each candidate's experience with swaps, JMI has developed a four-part assessment tool for use in the interview process Two of the nalists for the position are Gary Larson and George Hicks JMI management knows that neither Larson nor Hicks have extensive backgrounds in derivative securities, but have been impressed with their intelligence and general xed income acumen While handing out the swap problems, Sonia Johnson, a member of the interview team, asks them a question about the duration of a oating rate borrower versus the duration of a receive- oating/payxed swap Hicks answers by saying "I believe the duration of the oating rate borrower is close https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 3/28 10/12/2018 Learning Management System to zero but not negative, while the duration of the receive- oating/pay- xed swap is less than zero." Larson, responds, "I don't think that's true The duration of the oating rate borrower is negative and the duration of the receive- oating/pay- xed swap is less than zero."Johnson does not comment on their answers; instead she directs them to begin working on the quiz Hicks and Larson are each given a copy of Table A, to be used to answer questions about four situations Table A details the number of days in various periods, as well as the LIBOR rate at the beginning of each period Period Starting Days in Period LIBOR 3.2 90 July 91 October 92 bo ok c April en tre January in Table A: JMI Applicant Quiz January 92 Situation 1: 4.0 4.4 5.0 Cash ows are exchanged quarterly and the reference rate is 3-month LIBOR plus 50 basis points The xed rate of the swap is 4.3 percent; the notional principal is $200 million w w Situation 2: o m 1-year Plain Vanilla Interest Rate Swap 3.4 w Swap Duration Situation 3: Changing Duration Situation 4: Leveraged Floater At the inception of a three-year swap, the duration of the xed payments equals 1.9 and the duration of the oating payments equals 0.25 JMI is investing in a $50 million xed income portfolio with a duration of 6.3 The rm wants to lower the duration of the portfolio to JMI chooses a swap that has a net duration of 2.9 JMI has issued a $12 million leveraged oater with semi-annual interest payments The rate is 1.2 times LIBOR The rm is planning to hedge the risk of this note with a bond paying percent and a swap with a xed rate of 4.4 percent https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 4/28 10/12/2018 Learning Management System Question #6 of 44 In Situation 1, what is the net cash ow that will exchange hands on April 1? The: A) receive- xed position receives $300,000 B) receive- oating position receives $300,000 C) receive- xed position receives $200,000 Explanation The swap's xed payment is based on the xed rate at the initiation of the swap $200,000,000 × 0.043 × (90/360) = $2,150,000 in The pay- xed side of the swap pays: The pay- oating side of the swap pays: en tre The swap's oating payment is based on the previous quarter's LIBOR $200,000,000 × (0.032 + 0.005) × 90/360 = $1,850,000 bo ok c Therefore, the pay- oating/receive- xed portion of the swap receives: $2,150,000 − $1,850,000 = $300,000 (Study Session 17, Module 34.1, LOS 34.a) Related Material w w o m SchweserNotes - Book Question #7 of 44 w In Situation 1, what is the net cash ow that will be exchanged on January 1? The: A) xed receives $66,111 B) oating receives $613,331 C) oating pays $306,667 Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 5/28 10/12/2018 Learning Management System The swap's xed payment is based on the xed rate at the initiation of the swap The pay- xed side of the swap pays: $200,000,000 × 0.043 × (92/360) = $2,197,778 The swap's oating payment is based on the previous quarter LIBOR The pay- oating side of the swap pays: $200,000,000 × (0.044 + 0.005) × 92/360 = $2,504,444 Therefore, the pay- xed/receive- oating portion of the swap receives: $2,504,444 − $2,197,778 = $306,667 in (Study Session 17, Module 34.1, LOS 34.a) Related Material bo ok c Question #8 of 44 en tre SchweserNotes - Book In Situation 2, the duration of the swap is closest to: A) 1.9 m B) w w Explanation o C) 1.65 This is a straightforward calculation Simply subtract the duration of the oating from the duration of the xed w Duration of the swap = 1.9 − 0.25 = 1.65 (Study Session 17, Module 34.1, LOS 34.a) Related Material SchweserNotes - Book Question #9 of 44 With regard to the question about the duration of a oating rate borrower versus the duration of a receive- oating/pay- xed swap that Johnson asked Hicks and Larson: https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 6/28 10/12/2018 Learning Management System A) Hicks’ statement is correct; Larson’s statement is incorrect B) Hicks’ statement is incorrect; Larson’s statement is incorrect C) Hicks’ statement is incorrect; Larson’s statement is correct Explanation The oating rate borrower has a short duration that is very close to but is negative because any outstanding liabilities like a oating rate note or issued bond will have a negative duration from the issuer's point of view The duration of the receive oating/pay xed swap will be less than because the oating side is less than the xed side DReceive Floating = DFloating − DFixed in (Study Session 17, Module 34.1, LOS 34.a) Related Material bo ok c Question #10 of 44 en tre SchweserNotes - Book Calculate the notional principal for Situation and recommend the type of swap that should be used to achieve the target duration m A) $86,206,890 notional principal; receive- oating/pay- xed swap .o B) $22,413,793 notional principal; receive- xed/pay- oating swap w w C) $22,413,793 notional principal; receive- oating/pay- xed swap Explanation w The notional principal: (V) × [(MDTARGET - MDV)/MDSWAP] = $50,000,000 × [(5 − 6.3)/(−2.9)] = $22,413,793 Since the goal is to reduce the duration of the portfolio, a receive- oating/pay- xed swap is appropriate A receive- oating swap has a negative duration, therefore MDSWAP is entered in the above equation as a negative number (Study Session 17, Module 34.1, LOS 34.a) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 7/28 10/12/2018 Learning Management System Question #11 of 44 In Situation 4, which of the following statements is least accurate? JMI is: A) paying oating and receiving xed in the swap B) earning a positive spread on the di erence between the bond they purchased and the xed rate in the swap C) using the payments received in the swap to pay on the bond issued Explanation en tre in In Situation JMI has issued a leveraged oater which is an outstanding bond liability in which they will have to pay 1.2 x LIBOR x value of the oater To hedge the risk of interest rates increasing they have entered into a swap as the xed rate payer and oating rate receiver using the LIBOR payments received in the swap to pay on the leveraged oater Since the payment on the leveraged oater is 1.2 x LIBOR, the notional principal of the swap and the bond purchased would have to be 1.2 x value of the leveraged oater issued or 1.2 x 12,000,000 They are earning a positive spread on the swap by purchasing a bond that pays 6% in which they use that payment to pay the 4.4% xed in the swap The following is not required by the LOS but is for understanding purposes only The net cash ow to JMI is: bo ok c Net cash ow = multiplier × VFloater × (CBond - Swap Fixed Rate) Net cash ow = 1.2 × 12,000,000 × [(0.06 / 2) − (0.044 / 2)] = $115,200 (Study Session 17, Module 34.1, LOS 34.a) w w o SchweserNotes - Book m Related Material w Question #12 of 44 For a plain-vanilla interest-rate swap with annual reset, which of the following is closest to the duration for the oating side of the swap? A) 0.50 B) 0.75 C) 1.00 Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 8/28 10/12/2018 Learning Management System The duration of the oating side is 1/2 the time until the next reset date Since this is an annual pay swap the duration of the oating side is x = or divided by = The duration of the xed side of a swap is approximately 75 to the time until maturity If we take a di erent example of a year swap with semi-annual payments the duration of the xed side would be 75 x = and the duration of the oating side is / = 25 (Study Session 17, Module 34.1, LOS 34.b) Related Material SchweserNotes - Book in Question #13 of 44 en tre If a xed-income portfolio manager wants to double the duration of a portfolio with a swap that has the same duration as the portfolio, then the notional principal would be: A) equal to the value of the portfolio bo ok c B) twice the value of the portfolio C) half the value of the portfolio Explanation m The number of contracts to change the DD of a portfolio is the (DTarget – Dcurrent)/DD of instrument used o Since we use only one contract with swaps, we set the number of contracts equal to 1.0: w w = (DDTarget – DDcurrent)/DDswap Then convert dollar duration, DD, into value times duration, D: w = [DTarget(VP) – Dcurrent(VP)] / DS(NP) → (VP) (DTarget – Dcurrent) / DS(NP) If we then rearrange the equation by moving NP to the other side we get NP = (VP)(DTarget – Dcurrent) / DS With the target duration = X current portfolio duration with the swap having the same duration as the current portfolio we then have NP = (VP)(2DTarget – Dcurrent) / DS NP = (VP)(D) / D NP = VP (Study Session 17, Module 34.1, LOS 34.d) Related Material https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 9/28 10/12/2018 Learning Management System SchweserNotes - Book Question #14 of 44 A U.S rm that wishes to convert its annual cash ows of €20 million each to dollars upon receipt The exchange rate is currently €0.9/USD, and the swap rates in the U.S and Europe are both 6.1 percent Appropriately using a xed-for- xed currency swap that does not exchange principal, what would be the annual dollar cash ow to the rm? in A) $22,222,222 C) $10,980,000.00 Explanation en tre B) $32,786,885 At current interest rates, the €20 million per year translates to a notional principal of: NP = €327,868,852 bo ok c NP = 20,000,000 / 0.061 The corresponding dollar amount is $364,298,725 = €327,868,852 / (€0.9/$) The annual interest payments on this amount would be $22,222,222 = $364,298,725 × 0.061 .o Related Material m (Study Session 17, Module 34.2, LOS 34.f) w w w SchweserNotes - Book Question #15 of 44 A rm has most of its liabilities in the form of oating-rate notes with a maturity of two years and a quarterly reset The rm is not concerned with interest rate movements over the next four quarters but is concerned with potential movements after that Which of the following strategies will allow the rm to hedge the expected change in interest rates? A) Go long a payer’s swaption with a 1-year maturity B) Go short a payer’s swaption with a 2-year maturity C) Enter into a 2-year, quarterly pay- xed, receive- oating swap https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 10/28 10/12/2018 Learning Management System A rm contracts to borrow $5 million in one year The rm enters into a one-year swaption where the swap maturity and notional principal match that of the planned loan The swaption gives the rm the right to be a oating-rate payer This hedging strategy would be most e ective if the loan contract speci es a: A) variable rate and interest rates increase B) variable rate and interest rates decline C) xed rate and interest rates decline Explanation (Study Session 17, Module 34.4, LOS 34.h) SchweserNotes - Book m Question #22 of 44 bo ok c Related Material en tre in A rm that has contracted to borrow at a xed rate in the future would want a hedge against interest rates falling and being stuck paying a higher-than-market rate A swaption to become a oating-rate payer bene ts the owner when interest rates decline The rm will receive a "high" xed rate and pay "low" variable rates, and this will o set the higher-than-market rate in the contract .o A European rm can borrow at 8% in the U.S and at 7% in Europe A U.S rm can borrow at 7% in the U.S and at 8% in Europe If the U.S rm needs euros and the European rm needs w w dollars, then a currency swap could save each counterparty: A) up to 1% (maximum) in a loan on the foreign currency w B) a minimum of 1% in a loan on the foreign currency C) a minimum of 2% a loan on the foreign currency Explanation The European rm can borrow euros at 7% and lend them at that rate to the U.S rm who then saves 1% The American rm, in turn, can borrow dollars at 7% and lend them at that rate to the European rm who then also saves 1% It could also be possible for the American rm to re-lend the dollars at, say 7.5%, and still get the Euros at a lower rate, say 7.1% Such an arrangement would mean the net rate on the loan is less than 7% for the American rm and more than 7% for the European rm Such a discrepancy is unlikely, however, and the 1% (maximum) savings each is the only possible answer (Study Session 17, Module 34.2, LOS 34.e) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 14/28 10/12/2018 Learning Management System Related Material SchweserNotes - Book Question #23 of 44 Which of the following statements about debt is least accurate? A) To create synthetic dual currency debt, the portfolio manager can issue domestic debt and enter into a xed-for- xed currency swap where notional principal is in d i i i B) To create synthetic callable debt from existing noncallable debt, the portfolio en tre manager can enter into a receiver's swaption C) The all-in-cost is another way of saying "the internal rate of return of a nancing alternative." Explanation bo ok c To create synthetic dual currency debt, the portfolio manager can issue domestic debt and enter into a xed-for- xed currency swap where notional principal is NOT swapped at origination (Study Session 17, Module 34.1, LOS 34.a) w w o SchweserNotes - Book m Related Material w Question #24 of 44 Sheila manages a $100 million xed-income portfolio The portfolio duration is currently 4.9 and she would like to increase it to 5.7 She selects a swap with a net duration of 6.1 Based only on the information provided, which of the following statements is least likely correct? A) Sheila should have a receive- oating/pay- xed position in the swap B) Sheila should have a pay- oating/receive- xed position in the swap C) Sheila should select a swap with a notional principal of approximately $13 million to achieve the desired duration Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 15/28 10/12/2018 Learning Management System Because Sheila wants to increase the duration of the portfolio, she should have a payoating/receive- xed position in the swap with a notional principal of $13,114,754 as computed below: Notional principal = $100,000,000 x [(5.7 – 4.9) / 6.1] = $13,114,754 (Study Session 17, Module 34.1, LOS 34.d) Related Material SchweserNotes - Book in Question #25 of 44 en tre A rm has most of its liabilities in the form of oating-rate notes with a maturity of two years and quarterly reset The rm is concerned with interest rate movements over the next eight quarters but is not concerned with potential movements after that Which of the following strategies will allow the rm to hedge the expected change in interest rates? bo ok c A) Buy a swaption that allows the rm to be the xed-rate payer upon exercise In other words, go long a payer’s swaption with a 2-year maturity B) Enter into a 2-year, quarterly pay- oating, receive- xed swap C) Enter into a 2-year, quarterly pay- xed, receive- oating swap m Explanation w w o The rm should receive oating to o set the oating-rate obligation Given its goals, the rm should enter into the swap to hedge the immediate risk and not the future risk o ered by the swaption (Study Session 17, Module 34.1, LOS 34.a) w Related Material SchweserNotes - Book Question #26 of 44 Which of the following positions results in synthetic xed-rate debt? A) A long position in a oating-rate note combined with a pay- xed interest rate swap B) A short position in a oating-rate note combined with a pay- xed interest rate swap https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 16/28 10/12/2018 Learning Management System C) A long position in a oating-rate note combined with a receive- xed interest rate swap Explanation The receive- oating part of the interest rate swap o sets the oating rate payments the short-bond position requires Therefore, a synthetic xed-rate debt position is created (Study Session 17, Module 34.1, LOS 34.a) Related Material in SchweserNotes - Book en tre Question #27 of 44 Which of the following statements is most accurate? The duration of a long-position in a oating-rate note is: bo ok c A) close to zero and is una ected by the addition of a receive- oating position in a swap B) close to zero but increases with the addition of a pay- oating position in a swap position in a swap .o Explanation m C) equal to its maturity but decreases to near zero with the addition of a pay- oating w w A oating-rate note's value will be relatively stable because the payments vary with changes in the interest rates For the long position (the lender), adding a pay- oating position will produce a synthetic xed-rate position whose value will change with changes in interest rates w (Study Session 17, Module 34.1, LOS 34.c) Related Material SchweserNotes - Book Question #28 of 44 A U.S rm that borrows dollars and uses a plain-vanilla currency swap to obtain euros for an investment in Europe is most likely trying to: https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 17/28 10/12/2018 Learning Management System A) increase the duration of the position B) create a synthetic pay- xed dollar loan C) lower borrowing costs Explanation Swaps can lower overall borrowing costs by allowing rms to borrow at a lower rate within their own country rather than paying a higher rate by borrowing directly in the foreign currency For example, a U.S borrower needing euros would have to pay a higher rate than a counterparty in Europe The European counterparty can borrow at a lower rate and pass the savings on to the U.S borrower who passes similar savings back via borrowing dollars in the U.S and exchanging them for the euros None of the other answers make sense .in (Study Session 17, Module 34.2, LOS 34.e) Related Material bo ok c Question #29 of 44 en tre SchweserNotes - Book Lockwood Co (Lockwood) operates in the U.S and will be receiving future cash ows of CAD4 million every six months for the next two years The swap rates in Canada and the U.S are 4% and 3%, respectively The current USD/CAD exchange rate is 0.78 and is expected to increase to m 0.82 over the next two years Based on the information provided, what amount in USD will w w A) 2,340,000 .o Lockwood receive periodically from the swap dealer B) 2,460,000 w C) 4,160,000 Explanation For the CAD, the notional principal = CAD4,000,000 / (0.04 / 2) = CAD200,000,000 The corresponding USD amount is CAD200,000,000 x 0.78 USD/CAD = USD156,000,000 Lockwood will give the swap dealer CAD4,000,000 every six months over the life of the swap in exchange for USD156,000,000 x (0.03 / 2) = USD2,340,000 It is only the current exchange rate that matters in determining the notional amount at the outset of the swap The future or expected exchange rate is irrelevant The Canadian swap rate of 4% (not 3%) applies in calculating the CAD notional principal and the U.S swap rate of 3% (not 4%) applies in calculating the periodic amount in USD that Lockwood receives from the swap dealer (Study Session 17, Module 34.2, LOS 34.f) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 18/28 10/12/2018 Learning Management System Related Material SchweserNotes - Book Question #30 of 44 The duration of a pay- oating swap is obtained by: A) adding the duration of the oating-rate payments to the duration of the xed-rate payments .in B) subtracting the duration of the oating-rate payments from the duration of the xed-rate payments en tre C) dividing the duration of the oating-rate payments by the duration of the xed-rate payments Explanation bo ok c The duration of a pay- oating swap is the di erence between the duration of the payments Expressed as the formula: DPay- oating = DFixed-rate payments – DFloating-rate payments Related Material w w o SchweserNotes - Book m (Study Session 17, Module 34.1, LOS 34.b) w Question #31 of 44 A U.S rm that wishes to convert its annual cash ows of €10 million each to US$ upon receipt The exchange rate is currently 0.9€/$, and the swap rates in the U.S and Europe are 5.4% and 5% respectively Appropriately using a xed-for- xed currency swap that does not exchange principal, what would be the annual dollar cash ow to the rm? A) $12,000,000 B) $22,222,222.00 C) $11,111,111.00 Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 19/28 10/12/2018 Learning Management System At current interest rates, the €10 million per year translates to a notional principal of: NP = 10,000,000 / 0.05 NP = €200,000,000 The corresponding dollar amount is $222,222,222 = €200,000,000 / (0.9€/$) The annual interest payments on this amount would be $12,000,000 = $222,222,222 × 0.054 (Study Session 17, Module 34.2, LOS 34.f) Related Material in SchweserNotes - Book en tre Question #32 of 44 To create synthetic xed-rate debt from a oating-rate obligation, a portfolio manager can which of the following? bo ok c A) Pay variable and receive xed in a swap B) Pay xed and receive variable in a swap C) Sell interest rate caps Explanation o m To create synthetic xed-rate debt, a portfolio manager can pay xed and receive variable in a swap w w (Study Session 17, Module 34.1, LOS 34.a) Related Material w SchweserNotes - Book Question #33 of 44 From the borrower's perspective, a plain-vanilla currency swap can create a synthetic xed-rate euro loan when entered into as a: A) oating-rate receiver and combined with a oating-rate dollar loan B) xed-rate receiver and combined with a xed-rate dollar loan C) oating-rate receiver and combined with a xed-rate dollar loan https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 20/28 10/12/2018 Learning Management System Explanation The borrower has borrowed dollars and pays a oating rate Becoming the oating-rate receiver in the swap will mean swapping the dollars and getting the oating-rate payments on the dollars to pass through to the original lender The borrower will then pay xed on the euros received (Study Session 17, Module 34.2, LOS 34.e) Related Material SchweserNotes - Book in Question #34 of 44 en tre A manager of a $2 million dollar xed-income portfolio with a duration of wants to increase the duration to The manager chooses a swap with a net duration of The manager should become a: bo ok c A) pay- oating counterparty in the swap with a notional principal of $2 million B) receive- oating counterparty in the swap with a notional principal of $1 million C) pay- oating counterparty in the swap with a notional principal of $1 million Explanation o m To increase duration, the manager should be a pay- oating/receive- xed counterparty in the swap with a notional principal equal to: w w NP = $2,000,000 × (4 − 3) / NP = $1,000,000 w (Study Session 17, Module 34.1, LOS 34.d) Related Material SchweserNotes - Book Question #35 of 44 A manager of a $40 million dollar xed-income portfolio with a duration of 4.2 wants to lower the duration to The manager chooses a swap with a net duration of 2.1 What notional principal (NP) should the manager choose for the swap to achieve the target duration? https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 21/28 10/12/2018 Learning Management System A) $22,857,143.00 B) $70,000,000.00 C) $56,000,000.00 Explanation NP = $40,000,000 × (3 − 4.2) / -2.1 NP = $22,857,143 Since the manager wants to reduce the duration of his portfolio, he should take a receiveoating/pay- xed position in the swap with that notional principal Remember that a receiveoating swap has a negative duration, so we enter –2.1 in the equation .in (Study Session 17, Module 34.1, LOS 34.d) Related Material en tre SchweserNotes - Book Jane Hiatt and Penny Hoskins have responsibility for interest rate and currency risk Midwestern United States bo ok c management for the Rensselaer Corporation, a large multinational rm based in the Due to an increase in global economic growth, Rensselaer has seen its sales increase and is planning to expand its U.S factory at a cost of $30,000,000 The factory expansion will be m nanced at a oating interest rate of LIBOR plus 200 basis points, with payments made o quarterly over seven years Hiatt expects that Rensselaer will begin the expansion in six months and will receive the $30,000,000 in nancing at that point in time She is concerned, however, w w that global interest rates will increase in the interim and would like to have the option to convert the loan's interest rate to a xed rate in six months Hiatt evaluates the forecasts for w future swap xed rates as well as the current terms of various swaptions, provided in the following table The swaptions are for a 7-year swap where the oating interest rate is LIBOR at Fixed rate for payer's swaption that matures in six months 7.00% Fixed rate for receiver's swaption that matures in six months 7.10% Projected Swap Fixed Rate in six months 7.20% Fixed rate for payer's swaption that matures in seven years 8.40% Fixed rate for receiver's swaption that matures in seven years 8.50% https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 22/28 10/12/2018 Learning Management System Projected Swap Fixed Rate in seven years 9.20% Rensselaer has just opened a factory in Germany that will sell products locally, earning projected cash ows of €10,000,000 on a quarterly basis In order to convert these cash ows into dollars, Hoskins suggests that Rensselaer enter into a currency swap without an exchange of notional principal where euros will be exchanged for dollars Hoskins contacts a currency swap dealer and reports the following exchange rate and annual swap xed interest rates These rates are for an exchange of cash ows starting in three months, which is approximately when Rensselaer will receive its next euro cash ow from its German operation The maturity of the swap will be two years, because Hoskins does not feel comfortable projecting cash ows Exchange rate (EUR per dollar) Question #36 of 44 5.80% bo ok c Swap interest rate in euros 3.40% en tre Swap interest rate in U.S dollars 0.72 in from the German factory beyond the next two years Given her interest rate forecasts, which of the following is the most likely position Hiatt should recommend Rensselaer take to hedge the nancing of the factory expansion? m A) Buy a six month maturity payer swaption .o B) Buy a six month maturity receiver swaption w w C) Buy a seven year maturity payer swaption Explanation w If LIBOR increases as she expects, the cost of Rensselaer's oating rate loan will increase In this case the rm will want to pay a xed rate and receive a oating rate in a swap The payer's swaption will allow them to pay a predetermined xed rate in a swap The maturity of the swaption should coincide with the initiation of the loan (Study Session 17, Module 34.1, LOS 34.a) Related Material SchweserNotes - Book Question #37 of 44 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 23/28 10/12/2018 Learning Management System Assume the rm buys the appropriate swaption and Hiatt's interest rate forecasts prove correct Determine which of the following is closest to the net interest payment Rensselaer will make on the factory expansion loan three months after borrowing the money A) $690,000.00 B) $675,000.00 C) $682,500.00 Explanation en tre in If interest rates increase and the xed rate on swaps in six months (projected at 7.2%) exceeds the swaption xed rate, the rm will exercise the swaption and pay 7.0% They receive LIBOR from the swap in the swaption and pay in total 7.0% + 2.0% = 9% in the swap and the loan The rm's rst quarterly payment in net will be 9% × $30,000,000 × 90/360 = $675,000 Note that if swap xed rates are less than 7.0% in six months, the rm would not exercise the swaption The rm could either a) enter a swap at that time and pay the lower xed rate or b) not enter a swap and just pay the oating rate in the loan bo ok c (Study Session 17, Module 34.1, LOS 34.a) Related Material m SchweserNotes - Book o Question #38 of 44 w w If Hiatt's interest rate forecasts prove correct, and the appropriate hedge is enacted, which of the following best represents the changes in Rensselaer's risk exposure? The rm's cash ow w risk: A) decreases and its market value risk increases B) increases and its market value risk decreases C) decreases and its market value risk decreases Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 24/28 10/12/2018 Learning Management System A oating-rate cash ow will have a very low duration which means that its market value is largely resistant to changing interest rates If Rensselaer hedges its oating rate loan so that it becomes a synthetic xed rate loan, they have increased its duration and increased its sensitivity to changes in interest rates So the loan's market value risk increases However, they will have decreased the sensitivity of the cash ows in the loan to changes in interest rates, so cash ow risk declines (Study Session 17, Module 34.1, LOS 34.a) Related Material in SchweserNotes - Book en tre Question #39 of 44 What are the periodic cash ows resulting from Rensselaer's hedge of the German factory sales? bo ok c A) $4,264,706.00 B) $8,141,762.00 C) $13,888,889.00 Explanation o m In order to calculate how much Rensselaer will receive in dollars as a result of the swap, rst calculate the implied notional principal (NP) from the quarterly cash ows of EUR 10,000,000, using the quarterly euro interest rate: 0.058 w w NP ( ) = 10, 000, 000 w NP = 689, 655, 172.41 Next, calculate the dollar implied principal at the current exchange rate: EUR 689,655,172.41/0.72 = $957,854,406.13 Lastly, calculate a dollar cash ow using the quarterly dollar interest rate: $957,854,406.13 × 0.034/4 = $8,141,762 (Study Session 17, Module 34.1, LOS 34.a) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 25/28 10/12/2018 Learning Management System Question #40 of 44 Suppose that Rensselaer's currency swap can be structured with xed or oating payments If Hiatt's interest rate concerns are correct, which of the following would be the ideal position for Rensselaer to take in the currency swap? From Rensselaer's perspective, the swap should be structured with a: A) oating dollar interest rate and a oating euro interest rate B) oating dollar interest rate and a xed euro interest rate C) xed dollar interest rate and a oating euro interest rate .in Explanation (Study Session 17, Module 34.1, LOS 34.a) SchweserNotes - Book m Question #41 of 44 bo ok c Related Material en tre Hiatt is concerned that global interest rates will increase In the currency swap, Rensselaer will pay euros and receive dollars They will therefore want to x the euro interest rate and receive dollars at a oating interest rate, which is expected to be higher in the future .o In the currency swap, Rensselaer is exposed to: w w A) credit risk and economic risk B) neither credit risk nor economic risk w C) credit risk Explanation Rensselaer has credit risk because if the swap counterparty defaults on the contract, Rensselaer will not have hedged its dollar cash ows Rensselaer is also exposed to the type of currency risk referred to as economic risk to the extent that local asset and currency movements are correlated Economic risk refers to longer term noncontractual exchange rate risk and the amount to hedge is not readily determined Hoskins states that she does not feel comfortable projecting cash ows from the German factory beyond the next two years She therefore is uncertain how much to hedge in the future and Rensselaer has economic risk (Study Session 17, Module 34.1, LOS 34.a) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 26/28 10/12/2018 Learning Management System Question #42 of 44 A U.S rm that wishes to convert its quarterly cash ows of €7 million each to dollars upon receipt The exchange rate is currently €0.8/US$, and the swap rates in the U.S and Europe are 5.2 percent and 5.6 percent respectively What should be the notional principal in dollars of a currency swap, where the principal is not exchanged and the rates are xed, that will accomplish the goal? A) $8,125,000.00 in B) $500,000,000 Explanation en tre C) $625,000,000 At current interest rates, the €7 million per quarter translates to a notional principal in the foreign currency of: NP = €500,000,000 bo ok c NP = 7,000,000 / (0.056 /4) The notional principal in U.S dollar terms is: €500,000,000 x US$/ €0.8 = $625,000,000 The quarterly cash ows on the swap would then be $625,000,000 x 0.52/4 = $8,125,000 o Related Material m (Study Session 17, Module 34.2, LOS 34.f) w w w SchweserNotes - Book Question #43 of 44 A bank that has made a $6 million oating rate loan at LIBOR plus 240 basis points wishes to convert it to a xed-rate loan The bank uses a swap with a xed rate equal to 6.4%, oating rate equal to LIBOR, and notional principal equal to $6 million If the payments are quarterly, which of the following most closely approximates the quarterly in ows to the bank from the loan and the swap? A) $60,000.00 B) $132,000.00 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 27/28 10/12/2018 Learning Management System C) $88,000.00 Explanation The bank will enter into the swap to pay LIBOR and receive 6.4% It passes the LIBOR from the borrower through and keeps the 240 basis points Thus, the rm earns (0.064 + 0.024) / on $6 million each quarter This is $132,000 (Study Session 17, Module 34.1, LOS 34.a) Related Material in SchweserNotes - Book en tre Question #44 of 44 A manager of a $300 million bond portfolio consisting of $50 million in investment-grade corporate bonds and $250 million in U.S Treasuries wants to re-weight to a 50/50 mix This can bo ok c be done with a bond-index swap with a notional principal of: A) $100 million B) $250 million C) $275 million m Explanation w w o The swap would exchange the return on $100 million in U.S Treasuries for the return on $100 million of the corporate bonds This would create a synthetic mix of $150 million in each position (Study Session 17, Module 34.3, LOS 34.g) w Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448229/print 28/28 ... https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice /qbank/ 24 038 518/quiz/ 834 48229/print 5/28 10/12/2018 Learning Management System The swap' s xed payment is based on the xed rate at the initiation of the swap The pay- xed side of. .. 17, Module 34 .2, LOS 34 .e) https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice /qbank/ 24 038 518/quiz/ 834 48229/print 14/28 10/12/2018 Learning Management. .. the swap to hedge the immediate risk and not the future risk o ered by the swaption (Study Session 17, Module 34 .1, LOS 34 .a) w Related Material SchweserNotes - Book Question #26 of 44 Which of