CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 finquiz item set answers, study session 15, reading 30

Reading 30: Risk Management Applications of Swap Strategies Correct Answer: B By borrowing pounds indirectly through the swap contract, S-Tech assumes the credit risk that the swap deal

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CFA Level III Item-set - Solution

Study Session 15

June 2018

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Reading 30: Risk Management Applications of Swap Strategies

Correct Answer: B

By borrowing pounds indirectly through the swap contract, S-Tech assumes the credit risk that the swap dealer will default on his/her swap payments Had it borrowed directly in the U.K market by issuing debt in pounds, it would face no credit risk

Correct Answer: A

S-Tech will have to pay the swap dealer 0.05(₤32,190,000) = ₤1,609,500 and will receive 0.08($37,000,000) = $2,960,000 from the swap dealer It will also have to pay

$37,000,000(0.095) = $3,515,000 on the loan it took in the U.S market This means, that in addition to the pound interest it pays, it will have to pay additional interest of:

$3,515,000 – $2,690,000 = $555,000

The credit risk premium (the additional $555,000 paid by S-Tech) is present because S-Tech cannot borrow dollars at the same rate as the fixed rate on the swap S-Tech will have to pay this premium regardless of whether it borrowed directly in the pound market or indirectly through the swap

If after sometime, the fixed pound obligation needs to be changed to a floating rate one, S-Tech should enter into a plain vanilla interest rate swap in pounds as the floating rate payer

It would pay the counterparty interest in pounds at a floating rate and receive interest in pounds at a fixed rate This transaction would shift the pound interest obligation to floating

Correct Answer: C

S-Tech will have to pay the swap dealer 0.05(₤32,190,000) = ₤1,609,500 and will receive 0.08($37,000,000) = $2,960,000 from the swap dealer It will also have to pay

$37,000,000(0.095) = $3,515,000 on the loan it took in the U.S market The net cash flow paid by S-Tech will equal:

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6 Question ID: 9286

Currency swaps are designed for the purpose of managing exchange rate risk They also play

a role in managing interest rate risk, but only in cases in which exchange rate risk is present Also, currency swaps deal with payments in two different currencies However, not all

currency swaps involve the payment of notional principal (like in cases where currency swaps are used to lock in the exchange rate at which foreign cash flows are converted to the domestic currency)

To convert the dollar denominated loan to a euro denominated one, IMM should enter into the swap contract as the euro interest payer and dollar interest receiver This will result in IMM making a net payment in euros

At initiation of the swap, IMM will pay $50 million and receive 50,000,000/(0.75) =

€66,666,667 At the maturity of the swap, IMM will receive $50,000,000 and pay

€66,666,667 to the swap dealer

At the end of each year, IMM will owe 0.055(50,000,000) = $2,750,000 on the dollar

denominated bond The interest due on the swap will equal (0.065)(66,666,667) =

€4,333,333 The interest received by IMM on the swap will equal (0.04)(50,000,000) =

$2,000,000 The net interest due equals:

$2,750,000-$2,000,000 + €4,333,333 = $750,000 + €4,333,333

As can be seen in question 3, IMM has to pay an additional $750,000 in addition to euro interest payments because it cannot borrow at the same rate as the fixed rate on the swap This is because its credit rating is not as good as the rating implied in the LIBOR market term structure Hence, this additional interest of $750,000 can be viewed as a credit risk premium

One of the most common reasons for engaging in a currency swap is to gain the advantage of borrowing indirectly in another currency IMM may have borrowed euros in this way

because it is well known as a creditor in the U.S and hence finds it easier to issue a dollar

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The credit risk premium inherent in the position is paid by IMM and equals the additional

$750,000 that it pays on the position This is a ‘credit risk premium’ because IMM cannot borrow in the U.S market at the same rate as the fixed rate on the swap This is because IMM is more credit risky than high-quality London banks (the swap fixed rate is the rate that

a London bank would pay if it issued a par bond); hence it pays a rate greater than the swap fixed rate

HML’s loan payment on July 1 will equal:

30,000,000[(0.044+0.0320)(91/360)] = $576,333.34

HML’s swap payment will equal:

30,000,000[(0.045)(91/360)]= $341,250

HML’s swap receipt will equal:

30,000,000[(0.044)(91/360) = $333,666.67

The total interest cost equals:

576,333.34+341,250 – 333,666.67 = $583,916.67

HML’s loan payment on October 1 will equal:

30,000,000[(0.046+0.0320)(92/360)] = $598,000

30,000,000[(0.045)(92/360)]= $345,000

30,000,000[(0.046)(92/360) = $352,666.67

598,000+345,000 – 352,666.67 = $590,333.34

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HML has effectively converted its floating rate loan into a fixed rate loan The total rate will equal:

Total payment = loan payment + swap payment – swap receipt

Loan payment = LIBOR + 0.0320 (D/360)

Swap payment = (0.045) (D/360)

Swap receipt = LIBOR (D/360)

Therefore, the net payment equals:

Net rate = 0.045 + 0.0320 (D/360)

Or the annual rate equals = 7.7%

LML’s loan payment on January 1 next year will equal:

30,000,000[(0.07)(92/360)] = $536,666.67

30,000,000[(0.05)(92/360)]= $383,333.34

30,000,000[(0.045)(92/360) = $345,000

536,666.67+383,333.34 – 345,000 = $575,000

LML has converted its fixed rate loan into a floating rate using the swap The net cost to LML at each settlement date equals:

NP (loan rate-swap rate + LIBOR)(D/360)

This equals:

NP (7%-4.5% +LIBOR)(D/360)

Hence, LML will have to make quarterly payments at a rate of LIBOR + 2.5%

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No calculations are necessary for this question By entering into the swap HML has

converted its floating rate loan into a fixed rate loan with quarterly fixed payments at a rate

of 4.5%+3.2%=7.7% There will only be a slight variation in payments due to the difference

in days per quarter However, since the last two periods have the same number of days (92), the last two net payments (October 1 and January 1 next year) will be equal

To convert the fixed rate loan into a floating rate one, BSBank should enter into the swap as the fixed rate payer (receive floating) It will receive 8% on the loan it extended and pay 9.5% on the swap Hence, the net rate it will receive will be:

LIBOR +8%- 9.5% = LIBOR – 1.5%

Hence, the bank will receive an effective floating rate that is 1.5% less than LIBOR

The bank will receive an effective rate of:

LIBOR – 1.5%

Given a notional principal of $50 million and 90 days in each settlement period, the overall interest the bank will receive will equal:

50,000,000 (6% – 1.5%)(90/360) = $562,500

The swap indeed does convert the floating rate loan into a fixed rate loan However, even though LCL does not appear to be exposed to the uncertainty of changing LIBOR, it is still exposed This is because converting a floating rate loan into a fixed rate loan will protect LCL against rising interest rates but if rates fall, LCL will not be able to take the advantage since it has locked a fixed rate on its loan Hence, there is an opportunity cost to taking this position, and LCL is exposed to this cost (in other words, LCL has stabilized its cash

outflows but increased the risk of the company’s market value)

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By entering into the swap as the fixed rate payer, LCL is effectively paying a fixed rate on its loan The net payment by LCL will equal:

NP(swap fixed rate + loan spread) (D/360)

Given a notional principal of $20 million, a swap fixed rate of 5%, a loan spread of 200 basis points and 90 days in each settlement period, the net payment will equal:

20,000,000[(5%+2%)(90/360)] = $350,000

The average duration of a quarterly settlement, floating rate loan from the holder’s

perspective (lender) is 0.125 Since LCL is the issuer of the loan (borrower) the duration of the position is – 0.125 The duration of the swap for LCL will equal:

Duration for pay fixed swap = Duration of floating leg – duration of fixed leg

= 0.125-0.75 = -0.625

Hence, the overall duration of the position (loan + swap) will equal:

– 0.125 – 0.625 = – 0.75

LCL has increased the duration from 0.125 to 0.75 (about six times) The negative sign means that LCL will benefit if interest rates rise

The duration of the swap for LCL will equal:

Duration for pay fixed leg = Duration of floating leg-duration of fixed leg

= 0.125 – 0.75

= – 0.625

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