CFA LEVEL III PRACTICE SOLUTIONS (LOS # 29) Question - #92776 Your answer: B was correct! 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 This question tested from Session 15, Reading 29, LOS c Question - #92265 Your answer: B was incorrect The correct answer was C) subtracting the duration of the floating-rate payments from the duration of the fixed-rate payments The duration of a pay-floating swap is the difference between the duration of the payments Expressed as the formula: DPay-floating = DFixed-rate payments – DFloating-rate payments This question tested from Session 15, Reading 29, LOS b Question - #91859 Your answer: B was incorrect The correct answer was A) A short position in a floating-rate note combined with a pay-fixed interest rate swap 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 This question tested from Session 15, Reading 29, LOS a Question - #91773 Your answer: B was incorrect The correct answer was A) 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 This question tested from Session 15, Reading 29, LOS a Question - #91564 Your answer: B was incorrect The correct answer was A) relatively stable but the position will become less stable with the addition of a receive-floating swap position 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 This question tested from Session 15, Reading 29, LOS c Question - #92698 Your answer: B was correct! 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) / NP = $1,000,000 This question tested from Session 15, Reading 29, LOS d Question - #93028 Your answer: B was correct! Entering into a swap to exchange the returns on the stock for those of the index would be way to create synthetic diversification in a portfolio Note that the added diversification as a result of the swap would reduce unsystematic risk, but systematic risk will still exist This question tested from Session 15, Reading 29, LOS g Question - #91559 Your answer: B was incorrect The correct answer was C) close to zero but increases with the addition of a pay-floating position in a swap 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 This question tested from Session 15, Reading 29, LOS c Question - #92380 Your answer: B was correct! Since the problem asks only about the absolute value, we can ignore the fact that the duration for this position will be opposite in sign to that we usually calculate Although most of the duration is associated with the fixed payments, the next “floating” payment is predetermined Therefore, for example, the duration of a quarterly-reset swap might be duration of fixed payments minus 0.25 Because she receives floating-rate cash flows, taking the pay–fixed/receive–floating position in a swap decreases the dollar duration of a fixed income portfolio This question tested from Session 15, Reading 29, LOS b Question 10 - #92934 Your answer: B was incorrect The correct answer was C) fixed rate and interest rates decline A firm that has contracted to borrow at a fixed rate in the future would want a hedge against interest rates falling and being stuck paying a higher-than-market rate A swaption to become a floating-rate payer benefits the owner when interest rates decline The firm will receive a “high” fixed rate and pay “low” variable rates, and this will offset the higher-than-market rate in the contract This question tested from Session 15, Reading 29, LOS h Question 11 - #91828 Your answer: B was incorrect The correct answer was C) Enter into a 2-year, quarterly pay-fixed, receive-floating swap 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 This question tested from Session 15, Reading 29, LOS a Question 12 - #92835 Your answer: B was incorrect The correct answer was A) up to 1% (maximum) in a loan on the foreign currency 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 This question tested from Session 15, Reading 29, LOS e Question 13 - #92756 Your answer: B was incorrect The correct answer was C) is exposed to an increase in interest rates 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) This question tested from Session 15, Reading 29, LOS c Question 14 - #92693 Your answer: B was correct! At current interest rates, the €7 million per quarter translates to a notional principal in the foreign currency of: NP = 7,000,000 / (0.056 /4) NP = €500,000,000 The notional principal in U.S dollar terms is: €500,000,000 X US$/ €0.8 = $625,000,000 The quarterly cash flows on the swap would then be $625,000,000 X 0.52/4 = $8,125,000 This question tested from Session 15, Reading 29, LOS f Question 15 - #92325 Your answer: B was incorrect The correct answer was A) 20% large stocks and 80% small stocks After the swap, $1 million, or 20% of the portfolio’s exposure will be invested in the Dow Jones Industrial Average index of large stocks $4 million, or 80% of the portfolio will remain invested in small stocks The $1 million notional principal represents 20% of the position That is the amount that has been synthetically transferred from one class of assets to the other This question tested from Session 15, Reading 29, LOS g Question 16 - #92816 Your answer: B was incorrect The correct answer was A) lower borrowing costs Swaps can lower overall borrowing costs by allowing firms to borrow at a lower rate within their own country rather than paying a higher rate by borrowing directly in the foreign currency For example, a U.S borrower needing euros would have to pay a higher rate than a counterparty in Europe The European counterparty can borrow at a lower rate and pass the savings on to the U.S borrower who passes similar savings back via borrowing dollars in the U.S and exchanging them for the euros None of the other answers make sense This question tested from Session 15, Reading 29, LOS e Question 17 - #92735 Your answer: B was incorrect The correct answer was A) $12,000,000 At current interest rates, the €10 million per year translates to a notional principal of: NP = 10,000,000 / 0.05 NP = €200,000,000 The corresponding dollar amount is $222,222,222 = €200,000,000 / (0.9€/$) The annual interest payments on this amount would be $12,000,000 = $222,222,222 × 0.054 This question tested from Session 15, Reading 29, LOS f Question 18 - #91562 Your answer: B was incorrect The correct answer was C) pay fixed and receive floating 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 This question tested from Session 15, Reading 29, LOS c Question 19 - #91909 Your answer: A was correct! The borrower will enter into the swap to receive LIBOR and pay 5.6% The LIBOR payment effectively passes from the counterparty through to the lender while the 200 basis point spread remains an obligation of the borrower Thus, the borrower pays (0.056 + 0.02) / on $4 million each six months = $152,000 This question tested from Session 15, Reading 29, LOS a Question 20 - #91874 Your answer: B was incorrect The correct answer was A) $132,000 The bank will enter into the swap to pay LIBOR and receive 6.4% It passes the LIBOR from the borrower through and keeps the 240 basis points Thus, the firm earns (0.064 + 0.024) / on $6 million each quarter This is $132,000 This question tested from Session 15, Reading 29, LOS a Question 21 - #91952 Part 1) Your answer: B was incorrect The correct answer was A) Buy a six month maturity payer swaption If LIBOR increases as she expects, the cost of Rensselaer’s floating rate loan will increase In this case the firm will want to pay a fixed rate and receive a floating rate in a swap The payer’s swaption will allow them to pay a predetermined fixed rate in a swap The maturity of the swaption should coincide with the initiation of the loan (Study Session 15, LOS 38.h) This question tested from Session 15, Reading 29, LOS a Part 2) Your answer: B was correct! If interest rates increase and the fixed rate on swaps in six months (projected at 7.2%) exceeds the swaption fixed rate, the firm will exercise the swaption and pay 7.0% They receive LIBOR from the swap in the swaption and pay in total 7.0% + 2.0% = 9% in the swap and the loan The firm’s first quarterly payment in net will be 9% × $30,000,000 × 90/360 = $675,000 Note that if swap fixed rates are less than 7.0% in six months, the firm would not exercise the swaption The firm could either a) enter a swap at that time and pay the lower fixed rate or b) not enter a swap and just pay the floating rate in the loan (Study Session 15, LOS 38.h) This question tested from Session 15, Reading 29, LOS a Part 3) Your answer: B was correct! A floating-rate cash flow will have a very low duration which means that its market value is largely resistant to changing interest rates If Rensselaer hedges its floating rate loan so that it becomes a synthetic fixed rate loan, they have increased its duration and increased its sensitivity to changes in interest rates So the loan’s market value risk increases However, they will have decreased the sensitivity of the cash flows in the loan to changes in interest rates, so cash flow risk declines (Study Session 15, LOS 38.c) This question tested from Session 15, Reading 29, LOS a Part 4) Your answer: B was incorrect The correct answer was A) $8,141,762 In order to calculate how much Rensselaer will receive in dollars as a result of the swap, first calculate the implied notional principal (NP) from the quarterly cash flows of EUR 10,000,000, using the quarterly euro interest rate: Next, calculate the dollar implied principal at the current exchange rate: EUR 689,655,172.41/0.72 = $957,854,406.13 Lastly, calculate a dollar cash flow using the quarterly dollar interest rate: $957,854,406.13 × 0.034/4 = $8,141,762 (Study Session 15, LOS 38.f) This question tested from Session 15, Reading 29, LOS a Part 5) Your answer: B was correct! Hiatt is concerned that global interest rates will increase In the currency swap, Rensselaer will pay euros and receive dollars They will therefore want to fix the euro interest rate and receive dollars at a floating interest rate, which is expected to be higher in the future (Study Session 15, LOS 38.a) This question tested from Session 15, Reading 29, LOS a Part 6) Your answer: B was incorrect The correct answer was A) credit risk and economic risk Rensselaer has credit risk because if the swap counterparty defaults on the contract, Rensselaer will not have hedged its dollar cash flows Rensselaer is also exposed to the type of currency risk referred to as economic risk to the extent that local asset and currency movements are correlated Economic risk refers to longer term noncontractual exchange rate risk and the amount to hedge is not readily determined Hoskins states that she does not feel comfortable projecting cash flows from the German factory beyond the next two years She therefore is uncertain how much to hedge in the future and Rensselaer has economic risk (Study Session 15, LOS 38.a) This question tested from Session 15, Reading 29, LOS a Question 22 - #92799 Your answer: B was incorrect The correct answer was A) increase to convert a floating-rate loan to a fixed-rate loan The owner will benefit when interest rates increase because the owner has the right to pay a fixed rate and receive the floating rate, which will be higher with the increase in interest rates Receiving the floating rate and paying the fixed rate can turn a floating-rate loan to a fixed-rate loan This question tested from Session 15, Reading 29, LOS h Question 23 - #92271 Your answer: B was correct! The swap would exchange the return on $100 million in U.S Treasuries for the return on $100 million of the corporate bonds This would create a synthetic mix of $150 million in each position This question tested from Session 15, Reading 29, LOS g Question 24 - #91935 Part 1) Your answer: B was correct! The swap’s fixed payment is based on the fixed rate at the initiation of the swap The pay-fixed side of the swap pays: $200,000,000 × 0.043 × (90/360) = $2,150,000 The swap’s floating payment is based on the previous quarter’s LIBOR The pay-floating side of the swap pays: $200,000,000 × (0.032 + 0.005) × 90/360 = $1,850,000 Therefore, the pay-floating/receive-fixed portion of the swap receives: $2,150,000 - $1,850,000 = $300,000 (Study Session 15, LOS 38.a) This question tested from Session 15, Reading 29, LOS a Part 2) Your answer: B was incorrect The correct answer was C) floating receives $306,667 The swap’s fixed payment is based on the fixed rate at the initiation of the swap The pay-fixed side of the swap pays: $200,000,000 × 0.043 × (92/360) = $2,197,778 The swap’s floating payment is based on the previous quarter LIBOR The pay-floating side of the swap pays: $200,000,000 × (0.044 + 0.005) × 92/360 = $2,504,444 Therefore, the pay-fixed/receive-floating portion of the swap receives: $2,504,444 - $2,197,778 = $306,667 (Study Session 15, LOS 38.a) This question tested from Session 15, Reading 29, LOS a Part 3) Your answer: B was incorrect The correct answer was A) 1.65 This is a straightforward calculation Simply subtract the duration of the floating from the duration of the fixed Duration of the swap = 1.9 – 0.25 = 1.65 (Study Session 15, LOS 38.b) This question tested from Session 15, Reading 29, LOS a Part 4) Your answer: B was incorrect The correct answer was A) Hicks’ statement is incorrect; Larson’s statement is correct The floating rate borrower has a short duration that is very close to but is negative because any outstanding liabilities like a floating rate note or issued bond will have a negative duration from the issuer's point of view The duration of the receive floating/pay fixed swap will be less than because the floating side is less than the fixed side DReceive Floating = DFloating – DFixed (Study Session 15, LOS 38.b) This question tested from Session 15, Reading 29, LOS a Part 5) Your answer: B was incorrect The correct answer was C) $22,413,793 notional principal; receivefloating/pay-fixed swap The notional principal: (V) x [(MDTARGET - MDV)/MDSWAP] = $50,000,000 × [(5 - 6.3)/(-2.9)] = $22,413,793 Since the goal is to reduce the duration of the portfolio, a receive-floating/pay-fixed swap is appropriate A receive-floating swap has a negative duration, therefore MDSWAP is entered in the above equation as a negative number (Study Session 15, LOS 38.d) This question tested from Session 15, Reading 29, LOS a Part 6) Your answer: B was incorrect The correct answer was A) paying floating and receiving fixed in the swap In Situation JMI has issued a leveraged floater which is an outstanding bond liability in which they will have to pay 1.2 x LIBOR x value of the floater To hedge the risk of interest rates increasing they have entered into a swap as the fixed rate payer and floating rate receiver using the LIBOR payments received in the swap to pay on the leveraged floater Since the payment on the leveraged floater is 1.2 x LIBOR, the notional principal of the swap and the bond purchased would have to be 1.2 x value of the leveraged floater issued or 1.2 x 12,000,000 They are earning a positive spread on the swap by purchasing a bond that pays 6% in which they use that payment to pay the 4.4% fixed in the swap The following is not required by the LOS but is for understanding purposes only The net cash flow to JMI is: Net cash flow = multiplier × VFloater × (CBond- Swap Fixed Rate) Net cash flow = 1.2 × 12,000,000 × [(0.06 / 2) - (0.044 / 2)] = $115,200 (Study Session 15, LOS 38.d) This question tested from Session 15, Reading 29, LOS a Question 25 - #92688 Your answer: B was correct! 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: = (DDTarget – DDcurrent)/DDswap Then convert dollar duration, DD, into value times duration, D: = [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 = 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 This question tested from Session 15, Reading 29, LOS d Question 26 - #92829 Your answer: B was incorrect The correct answer was A) floating-rate receiver and combined with a floating-rate dollar loan 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 This question tested from Session 15, Reading 29, LOS e Question 27 - #92678 Your answer: B was correct! NP = $40,000,000 × (3 − 4.2) / -2.1 NP = $22,857,143 Since the manager wants to reduce the duration of his portfolio, he should take a receive-floating/payfixed 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 This question tested from Session 15, Reading 29, LOS d Question 28 - #91763 Your answer: B was incorrect The correct answer was A) 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 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 This question tested from Session 15, Reading 29, LOS a Question 29 - #91566 Your answer: B was correct! 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 This question tested from Session 15, Reading 29, LOS c  ... would have to pay a higher rate than a counterparty in Europe The European counterparty can borrow at a lower rate and pass the savings on to the U.S borrower who passes similar savings back via borrowing... #92829 Your answer: B was incorrect The correct answer was A) floating-rate receiver and combined with a floating-rate dollar loan The borrower has borrowed dollars and pays a floating rate Becoming... payer swaption If LIBOR increases as she expects, the cost of Rensselaer’s floating rate loan will increase In this case the firm will want to pay a fixed rate and receive a floating rate in a