[ 2009 FRM Sample Exam ] Market risk measurement and management Q28 management, entering, purchase, receives, selling

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28. Gamma Industries, Inc. issues an inverse floater with a face value of USD 50,000,000 that pays a semiannual coupon of 11.50% minus LIBOR. Gamma Industries intends to execute an arbitrage strategy and earn a profit by selling the notes, using the proceeds to purchase a bond with a fixed semiannual coupon rate of 6.75% a year, and hedging the risk by entering into an appropriate swap. Gamma Industries receives a quote from a swap dealer with a fixed rate of 5.75% and a floating rate of LIBOR. What would be the most appropriate type of swap Gamma Industries, Inc. should enter into to hedge their risk?

A. Pay?fixed, receive?fixed

B. Pay?floating, receive?fixed swap

C. Pay?fix, receive?floating

D. The risk cannot be hedged with a swap

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Babul

 

Correct answer is Bfficeffice" />

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.