optiix

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) is exposed to an increase in interest rates.

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The firm isn’t concerned with rising rates. If rates fall, however, they face an increase in the value of their liabilities or market value risk (which is a type of interest rate risk).

optiix

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) zero.

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

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The duration of the position will increase with the addition of the pay-floating/receive-fixed position. Both of the remaining answers cannot be correct.

optiix

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

A) close to zero and is unaffected by the addition of a receive-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 but decreases to near zero with the addition of a pay-floating position in a swap.

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A floating-rate note’s 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.

optiix

A firm has outstanding floating rate debt on which they pay LIBOR + 200 basis points, and management expects interest rates to increase in the very near future. In order to create synthetic fixed-rate debt, the best strategy for the firm is to enter into a swap in which they:

A) receive floating and pay floating.

B) pay fixed and receive floating.

C) pay floating and receive fixed.

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To create synthetic fixed-rate debt, the firm should pay fixed and receive floating in a swap. The floating rate payment they receive in the swap will partially offset the floating rate they pay on their debt. Any portion of the floating rate on the debt that remains (assume 100bps) will add to the fixed rate they pay on the swap. Their net position on the debt and the swap will be pay fixed + 100 bps = fixed rate.

optiix

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

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

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

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

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A floating-rate note’s 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.

optiix

A manager of a $2 million dollar fixed-income portfolio with a duration of 3 wants to increase the duration to 4. The manager chooses a swap with a net duration of 2. The manager should become a:

A) pay-floating counterparty in the swap with a notional principal of $1 million.

B) pay-floating counterparty in the swap with a notional principal of $2 million.

C) receive-floating counterparty in the swap with a notional principal of $1 million.

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To increase duration, the manager should be a pay-floating/receive-fixed counterparty in the swap with a notional principal equal to:

NP = $2,000,000 × (4 − 3) / 2
NP = $1,000,000.

optiix

A manager of a $40 million dollar fixed-income portfolio with a duration of 4.2 wants to lower the duration to 3. The manager chooses a swap with a net duration of 2.1. What notional principal (NP) should the manager choose for the swap to achieve the target duration?

A) $22,857,143.

B) $56,000,000.

C) $70,000,000.

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NP = $40,000,000 × (3 − 4.2) / -2.1NP = $22,857,143
Since the manager wants to reduce the duration of his portfolio, he should take a receive-floating/pay-fixed position in the swap with that notional principal. Remember that a receive-floating swap has a negative duration, so we enter –2.1 in the equation.

optiix

If a fixed-income portfolio manager wants to double the duration of a portfolio with a swap that has the same duration as the portfolio, then the notional principal would be:

A) half the value of the portfolio.

B) twice the value of the portfolio.

C) equal to the value of the portfolio.

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The number of contracts to change the DD of a portfolio is the (DTarget – Dcurrent)/DD of instrument used

Since we use only one contract with swaps, we set the number of contracts equal to 1.0:

1 = (DDTarget – DDcurrent)/DDswap

Then convert dollar duration, DD, into value times duration, D:

1 = [DTarget(VP) – Dcurrent(VP)] / DS(NP) → (VP) (DTarget – Dcurrent) / DS(NP)

If we then rearrange the equation by moving NP to the other side we get…

NP = (VP)(DTarget – Dcurrent) / DS

With the target duration = 2 X current portfolio duration with the swap having the same duration as the current portfolio we then have
NP = (VP)(2DTarget – Dcurrent) / DS NP = (VP)(D) / D
NP = VP

optiix

From the borrower’s perspective, a plain-vanilla currency swap can create a synthetic fixed-rate euro loan when entered into as a:

A) fixed-rate receiver and combined with a fixed-rate dollar loan.

B) floating-rate receiver and combined with a floating-rate dollar loan.

C) floating-rate receiver and combined with a fixed-rate dollar loan.

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The borrower has borrowed dollars and pays a floating rate. Becoming the floating-rate receiver in the swap will mean swapping the dollars and getting the floating-rate payments on the dollars to pass through to the original lender. The borrower will then pay fixed on the euros received.

optiix

A European firm can borrow at 8% in the U.S. and at 7% in Europe. A U.S. firm can borrow at 7% in the U.S. and at 8% in Europe. If the U.S. firm needs euros and the European firm needs dollars, then a currency swap could save each counterparty:

A) a minimum of 2% a loan on the foreign currency.

B) up to 1% (maximum) in a loan on the foreign currency.

C) a minimum of 1% in a loan on the foreign currency.

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The European firm can borrow euros at 7% and lend them at that rate to the U.S. firm who then saves 1%. The American firm, in turn, can borrow dollars at 7% and lend them at that rate to the European firm who then also saves 1%. It could also be possible for the American firm to re-lend the dollars at, say 7.5%, and still get the Euros at a lower rate, say 7.1%. Such an arrangement would mean the net rate on the loan is less than 7% for the American firm and more than 7% for the European firm. Such a discrepancy is unlikely, however, and the 1% (maximum) savings each is the only possible answer.