Reading 40: Risk Management Applications of Swap Strategie interest, convert

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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 a: Demonstrate how an interest rate swap can be used to convert a floating-rate (fixed-rate) loan to a fixed-rate (floating-rate) loan.

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

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

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

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

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

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Answer and Explanation

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

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Which of the following statements about debt is least accurate?

A) To create synthetic fixed-rate debt, the portfolio manager can enter a pay-fixed swap.

B) To create synthetic callable debt from existing noncallable debt, the portfolio manager can enter into a receiver's swaption.

C) To create synthetic dual currency debt, the portfolio manager can issue domestic debt and enter into a fixed-for-fixed currency swap where notional principal is swapped at origination.

D) The all-in-cost is another way of saying "the internal rate of return of a financing alternative."

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Answer and Explanation

To create synthetic dual currency debt, the portfolio manager can issue domestic debt and enter into a fixed-for-fixed currency swap where notional principal is NOT swapped at origination.

To create synthetic dual currency debt, the portfolio manager can issue domestic debt and enter into a fixed-for-fixed currency swap where notional principal is NOT swapped at origination.

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To create synthetic fixed-rate debt from a floating-rate obligation, a portfolio manager can do which of the following?

A) Pay fixed and receive variable in a swap.

B) Pay variable and receive fixed in a swap.

C) Sell interest rate caps.

D) Buy interest rate floors.

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Answer and Explanation

To create synthetic fixed-rate debt, a portfolio manager can pay fixed and receive variable in a swap.

To create synthetic fixed-rate debt, a portfolio manager can pay fixed and receive variable in a swap.

To create synthetic fixed-rate debt, a portfolio manager can pay fixed and receive variable in a swap.

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A firm has most of its liabilities in the form of floating-rate notes with a maturity of two years and quarterly reset. The firm 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 firm to hedge the expected change in interest rates?

A) Enter into a 2-year, quarterly pay-fixed, receive-floating swap.

B) Enter into a 2-year, quarterly pay-floating, receive-fixed swap.

C) Buy a swaption that allows the firm to be the fixed-rate payer upon exercise. In other words, go long a payers swaption with a 2-year maturity.

D) Buy a swaption that allows the firm to be the floating-rate payer upon exercise. In other words, go short a payers swaption with a 2-year maturity.

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Answer and Explanation

The firm should receive floating to offset the floating-rate obligation. Given its goals, the firm should enter into the swap to hedge the immediate risk and not the future risk offered by the swaption.

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A bank that has made a $6 million floating rate loan at LIBOR plus 240 basis points wishes to convert it to a fixed-rate loan. The bank uses a swap with a fixed rate equal to 6.4 percent, floating 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 inflows to the bank from the loan and the swap?

A) $132,000.

B) $60,000.

C) $150,000.

D) $88,000.

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Answer and Explanation

The bank will enter into the swap to pay LIBOR and receive 6.4 percent. It passes the LIBOR from the borrower through and keeps the 240 basis points. Thus, the firm earns (0.064+0.024)/4 on $6 million each quarter. This is $132,000.