Reading 40: Risk Management Applications of Swap Strategie market, impact, converts

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CFA Institute Area 8-11, 13: Asset Valuation
Session 13: Risk Management Applications of Derivatives
Reading 40: Risk Management Applications of Swap Strategies
LOS c: Explain the impact to cash flow risk and market value risk when a borrower converts a fixed-rate loan to a floating-rate loan.

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Which of the following positions results in synthetic floating-rate debt?

A) A long position in a fixed-rate bond combined with a pay-fixed interest rate swap.

B) A short position in a fixed-rate bond combined with a pay-fixed interest rate swap.

C) A long position in a fixed-rate bond combined with a receive-fixed interest rate swap.

D) A short position in a fixed-rate bond combined with a receive-fixed interest rate swap.

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Answer and Explanation

The receive-fixed part of the interest rate swap offsets the fixed rate payments the short bond position requires. Therefore, a synthetic floating-rate debt position is created.

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A firm has borrowed from a bank at a cost of LIBOR + 200 basis points and wishes to create synthetic fixed-rate debt to protect against an interest rate increase. The firm should do which of the following? Pay:

A) floating (LIBOR) and receive fixed in a swap.

B) floating (LIBOR) and receive floating (PRIME) in a swap.

C) floating (PRIME) and receive floating (LIBOR) in a swap.

D) fixed and receive floating (LIBOR) in a swap.

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Answer and Explanation

To create synthetic fixed-rate debt to protect against an interest rate increase, the firm should pay fixed and receive variable in a swap.

To create synthetic fixed-rate debt to protect against an interest rate increase, the firm should pay fixed and receive variable in a swap.

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Which of the following statements regarding a firm that currently has fixed-rate, noncallable domestic debt outstanding is least accurate? The firm:

A) can turn the debt into floating rate by entering a receive-fixed swap position.

B) can turn the debt into callable debt by entering into a receiver's swaption position.

C) can turn the debt into dual currency debt by entering into a fixed-for-fixed currency swap where notional principal is not swapped.

D) is exposed to an increase in interest rates.

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Answer and Explanation

Since the debt is currently fixed rate, there is no interest rate exposure for the firm.

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A pay-floating counterparty in a plain-vanilla interest-rate swap also holds a long position in a fixed-rate bond. If the maturity of the bond and swap are both two years, the duration of the position will be:

A) greater than the duration of the bond alone.

B) less than the duration of the bond but greater than zero.

C) zero.

D) one.

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Answer and Explanation

The duration of the position will increase with the addition of the pay-floating/receive-fixed position. None of the other answers can be correct.

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For an issuer of a floating-rate note, the market value of the loan will be:

A) relatively stable but the position will become less stable with the addition of a receive-floating swap position.

B) zero with the addition of a pay-floating swap position.

C) infinite with the addition of a receive-floating swap position.

D) volatile, but the position will become more stable with the addition of a receive-floating swap position.

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Answer and Explanation

A floating-rate notes value will be relatively stable because the payments vary with changes in the interest rates. Adding a receive-floating position will produce a synthetic fixed-payment position whose value will change with changes in interest rates.

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Which of the following statements is most correct? The duration of a long-position in a floating-rate note is:

A) equal to its maturity but decreases to near zero with the addition of a pay-floating position in a swap.

B) close to zero but increases with the addition of a pay-floating position in a swap.

C) equal to its maturity and increases with the addition of a pay-floating position in a swap.

D) close to zero and is unaffected by the addition of a receive-floating position in a swap.

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Answer and Explanation

A floating-rate notes value will be relatively stable because the payments vary with changes in the interest rates. For the long position (the lender), adding a pay-floating position will produce a synthetic fixed-rate position whose value will change with changes in interest rates.