Question 9

Danny McClaren is the CFO of Manchester United Jumpers & Jerseys, Plc, a manufacturer of casual knitwear. Manchester United has recently expanded its production facilities, and as a consequence has taken on 42 million in additional debt. This concerns McClaren because the debt has a 10-year maturity but carries a floating interest rate tied to LIBOR. Holding long-term floating-rate debt makes McClaren uncomfortable.

To stabilize Manchester United’s finances, McClaren considers entering into a plain vanilla pay-fixed swap with Carling Housewares, Ltd., a manufacturer of plates, cups, flatware and other utensils for home entertaining. The swap would cover up to 40 million of Manchester United’s 42 million in debt. The floating rate payer would agree to pay 180-day LIBOR plus 50 basis points, and the fixed-rate payer would pay 4.0%. The swap would be based on a 360-day year and settle twice a year, at the end of each period.

180-day LIBOR is currently 3.0%, but forward market rates suggest that 180-day LIBOR is likely to increase. McClaren expects 180-day LIBOR to rise consistently for the next three years:

Another possibility that McClaren is considering is putting on a collar. His swap broker, Chelsea Howard, assures McClaren that she could get him a zero-cost collar that would run all ten years with a floor at 2.50% and a cap at 4.50%. The collar would also have a notional amount of up to 40 million, use 180-day LIBOR, and settle semi-annually, at the end of each period. Howard tells McClaren, “If you buy a floor and sell a cap, you can keep your borrowing costs within the 2.50% - 4.50% range.” McClaren complains, “Yes, but the cost of the collar is prohibitive. I’d rather take the risk than know I’m losing all that money up front.”

Since each approach has both its advantages and disadvantages, McClaren decides to split the difference. He does 20 million in the swap agreement with Carling Housewares and 20 million in the collar.

Part 1)

Which of the following statements about the following derivative options is most accurate?

A)   The buyer of a floor has a position similar to that of a buyer of a call on the benchmark rate.

B)   A cap is actually a portfolio of put options called caplets.

C)   A swap is a zero-sum game.

D)   An interest rate floor is an agreement in which one party aggress to pay the other when the benchmark rate rises above the rate specified in the contract.

Part 2)

Regarding the statements made by Howard and McClaren about the potential collar:

A)   Howard’s statement is incorrect; McClaren’s statement is incorrect.

B)   Howard’s statement is correct; McClaren’s statement is correct.

C)   Howard’s statement is correct; McClaren’s statement is incorrect.

D)   Howard’s statement is incorrect; McClaren’s statement is correct.

Part 3)

If McClaren’s expectations for LIBOR turn out to be correct, what will be Manchester United’s first payment on the collar?

A)   Pay 200,000 in 720 days.

B)   Receive 100,000 in 900 days.

C)   Receive 100,000 in 720 days.

D)   Pay 400,000 in 720 days.

Part 4)

After entering into the swap and the collar, McClaren wants to make sure his junior analyst, Jennifer Eggenton understands the transactions so that she can monitor Manchester United’s positions. McClaren asks Eggenton about plain vanilla interest rate swaps and she replies with four comments:

Comment 1: At the conclusion of the swap, the notional principal is swapped between the counterparties.

Comment 2: The counterparty with the pay-fixed side of the swap receives floating-rate interest payments.

Comment 3: Interest payments are netted out and net interest is paid by the counterparty that owes interest to the counterparty due interest.

Comment 4: The fixed rate payor can gain identical exposure by issuing a fixed-coupon bond and investing the proceeds in a floating-rate bond with the same maturity and payment dates.

How many correct comments did Eggenton make? Eggenton made:

A)   1 correct comment.

B)   3 correct comments.

C)   2 correct comments.

D)   No correct comments.

Part 5)

If McClaren’s expectations for LIBOR turn out to be correct, what will be Manchester United’s payment on the swap 360 days from now? Manchester United:

A)   receives 50,000.

B)   pays 50,000.

C)   0.

D)   pays 25,000.

Part 6)

What do 180-day LIBOR rates need to do in order to make the swap arrangement more profitable for Manchester
United than the collar?

A)   Decline below 2.50%.

B)   Stay between 3.50% and 4.50%.

C)   Rise above 3.50%.

D)   Remain unchanged.

Part 1)

Which of the following statements about the following derivative options is most accurate?

A)   The buyer of a floor has a position similar to that of a buyer of a call on the benchmark rate.

B)   A cap is actually a portfolio of put options called caplets.

C)   A swap is a zero-sum game.

D)   An interest rate floor is an agreement in which one party aggress to pay the other when the benchmark rate rises above the rate specified in the contract.

The correct answer was C) A swap is a zero-sum game.

The buyer of a floor has a position similar to that of a buyer of a put, not a call, on the benchmark rate. A cap is actually a portfolio of call, not put, options called caplets. An interest rate floor is an agreement in which one party agreess to pay the other when the benchmark rate falls below, not rises above, the rate specified in the contract.

This question tested from Session 17, Reading 66, LOS b

Part 2)

Regarding the statements made by Howard and McClaren about the potential collar:

A)   Howard’s statement is incorrect; McClaren’s statement is incorrect.

B)   Howard’s statement is correct; McClaren’s statement is correct.

C)   Howard’s statement is correct; McClaren’s statement is incorrect.

D)   Howard’s statement is incorrect; McClaren’s statement is correct.

The correct answer was A)

In order for McClaren to fix his borrowing costs between 2.50% and 5.50%, he would buy a cap and sell a floor, not buy a floor and sell a cap. Howard’s statement is incorrect. The cost of a zero-cost collar is, by definition, zero. McClaren’s statement is also incorrect.

This question tested from Session 17, Reading 66, LOS b

Part 3)

If McClaren’s expectations for LIBOR turn out to be correct, what will be Manchester United’s first payment on the collar?

A)   Pay 200,000 in 720 days.

B)   Receive 100,000 in 900 days.

C)   Receive 100,000 in 720 days.

D)   Pay 400,000 in 720 days.

The correct answer was B)

The first payment on the collar will occur when 180-day LIBOR exceeds 4.5%. That happens in 720 days when it hits 5.50%. At that point, the payoff on the cap that Manchester United bought will be:

20 million × ((0.0550 – 0.0450) / 2) = 100,000.

Since Manchester United bought the cap, it receives the payment. Note that the interest rate is divided by 2 to reflect the semi-annual payoff schedule. Also note that the payment will be made at the end of the 180-day period which begins 720 days from now, in other words, in 900 days.

This question tested from Session 17, Reading 66, LOS b

Part 4)

After entering into the swap and the collar, McClaren wants to make sure his junior analyst, Jennifer Eggenton understands the transactions so that she can monitor Manchester United’s positions. McClaren asks Eggenton about plain vanilla interest rate swaps and she replies with four comments:

Comment 1: At the conclusion of the swap, the notional principal is swapped between the counterparties.

Comment 2: The counterparty with the pay-fixed side of the swap receives floating-rate interest payments.

Comment 3: Interest payments are netted out and net interest is paid by the counterparty that owes interest to the counterparty due interest.

Comment 4: The fixed rate payor can gain identical exposure by issuing a fixed-coupon bond and investing the proceeds in a floating-rate bond with the same maturity and payment dates.

How many correct comments did Eggenton make? Eggenton made:

A)   1 correct comment.

B)   3 correct comments.

C)   2 correct comments.

D)   No correct comments.

The correct answer was B)

Eggenton made three correct comments. Eggenton’s statement that the notional principal is swapped is incorrect – the notional principal does not change hands in a plain vanilla interest rate swap. The other comments Eggenton made are correct. The pay-fixed side of the swap pays fixed and receives floating payments; interest payments are netted, and the pay fixed side of the swap is identical to issuing a fixed coupon bond.

This question tested from Session 17, Reading 66, LOS b

Part 5)

If McClaren’s expectations for LIBOR turn out to be correct, what will be Manchester United’s payment on the swap 360 days from now? Manchester United:

A)   receives 50,000.

B)   pays 50,000.

C)   0.

D)   pays 25,000.

The correct answer was D) pays 25,000.

The payment in 360 days depends on LIBOR in 180 days. At that point, 180-day LIBOR will be 3.25%. With LIBOR at 3.25%, the floating-rate payer owes:

((0.0325 + 0.050) / 2) × 20 million = 375,000

The fixed-rate payer always owes:

(0.040 / 2) × 20 million = 400,000

The net payment is (400,000 – 375,000) = 25,000 from the fixed-rate payer to the floating-rate payer. Since Manchester United entered into a pay-fixed swap, it is the fixed-rate payer. Manchester United pays 25,000.

This question tested from Session 17, Reading 66, LOS b

Part 6)

What do 180-day LIBOR rates need to do in order to make the swap arrangement more profitable for Manchester
United than the collar?

A)   Decline below 2.50%.

B)   Stay between 3.50% and 4.50%.

C)   Rise above 3.50%.

D)   Remain unchanged.

The correct answer was C) Rise above 3.50%.

At the current LIBOR of 3.0%, the floating-rate payer owes:

((0.030 + 0.0050) / 2) × 20 million = 350,000

The fixed-rate payer always owes:

(0.040 / 2) × 20 million = 400,000

The net payment is (400,000 – 350,000) = 50,000 from the fixed-rate payer to the floating-rate payer. Since Manchester United is the fixed-rate payer, it pays 50,000. Manchester United does come out even on the swap payments until 180-day LIBOR reaches 3.50%.

At LIBOR of 3.5%, the floating-rate payer owes:

((0.035 + 0.0050) / 2) × 20 million = 400,000, which exactly offsets Manchester United’s fixed payment of 400,000.

At LIBOR of 4.5%:

On the swap:

((0.045 + 0.0050) / 2) × 20 million = 500,000. Since Manchester United always owes 400,000, Manchester United receives 100,000 on the swap.

On the collar:

Manchester United receives zero, since that is the cap on the collar.

At LIBOR of 5.5%:

On the swap:

((0.055 + 0.0050) / 2) × 20 million = 600,000. Since Manchester United always owes 400,000, Manchester United receives 200,000 on the swap.

On the collar:

Manchester United receives 100,000 (calculated in question 3). The swap is more profitable.

The swap will be more profitable than the collar at any level above 3.5% because Manchester United starts profiting above 3.5% on the swap but not until 4.5% on the collar.

This question tested from Session 17, Reading 66, LOS b

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