[ 2009 FRM Sample Exam ] Market risk measurement and management Q28

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A is incorrect because the company has a floating outflow of (11.50% ? LIBOR) and a fixed inflow of (6.75%)(USD 50,000,000). The swap suggested has two fixed legs which is not an appropriate structure for an interest rate swap which should have a fixed leg and a variable leg.

B is correct because the company has a floating outflow of (11.50% ? LIBOR) and a fixed inflow of (6.75%)(USD 50,000,000). On the outflow, ?LIBOR is the same as an inflow Pay?floating, Receive?fix. Gamma Industries is exposed to interest rate fluctuations of LIBOR. Therefore, the appropriate swap would be a pay?floating, receive?fixed swap.

C is incorrect because the company has a floating outflow of (11.50% ? LIBOR) and a fixed inflow of (6.75%)(USD 50,000,000). On the outflow, ?LIBOR is the same as an inflow Pay?floating, Receive?fix. Gamma Industries is exposed to interest rate fluctuations of LIBOR. Therefore, the appropriate swap should pay?floating (not fix) and receive fixed (not floating).

D is incorrect because this risk can indeed be hedged by entering into a swap as the company has both fixed and variable rate cash flows arising from the arbitrage transaction described.

Reference: John Hull, Options, Futures, and Other Derivatives, 6th ed. (ffice:smarttags" />New York: Prentice Hall, 2006), Chapter 7.