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CFA Institute Exam CFA-Level-II Topic 3 Question 14 Discussion

Actual exam question for CFA Institute's CFA Level II Chartered Financial Analyst exam
Question #: 14
Topic #: 3
[All CFA Level II Chartered Financial Analyst Questions]

Rock Torrey, an analyst for International Retailers Incorporated (IRI), has been asked to evaluate the firm's swap transactions in general, as well as a 2-year fixed for fixed currency swap involving the U .S . dollar and the Mexican peso in particular. The dollar is Torrey's domestic currency, and the exchange rate as of June 1,2009, was $0.0893 per peso. The swap calls for annual payments and exchange of notional principal at the beginning and end of the swap term and has a notional principal of $100 million. The counterparty to the swap is GHS Bank, a large full-service bank in Mexico.

The current term structure of interest rates for both countries is given in the following table:

Torrey believes the swap will help his firm effectively mitigate its foreign currency exposure in Mexico, which sterns mainly from shopping centers in high-end resorts located along the eastern coastline. Having made this conclusion, Torrey begins writing his report for the management of IRI. In addition to the terms of the swap, Torrey includes the following information in the report:

* Implicit in the currency swap under consideration is a swap spread of 75 basis points over 2-year U .S . Treasury securities. This represents a 10 basis point narrowing of the spread as compared to this time last year. Thus, we can assume that the credit risk of the global credit market has decreased. Unfortunately, the decline provides no insight into the credit risk of the individual currency swap with GHS Bank, which could have increased.

* In order to decrease the counterparty default risk on the currency swap, we will need to utilize credit derivatives between the beginning and midpoint of the swap's life when this particular risk is at its highest. This is a significantly different strategy than we normally use with interest rate swaps. For interest rate swaps, counterparty default risk peaks at the middle of the swap's life, at which point we utilize credit derivative CQuntermeasures to offset the risk.

* Because currency swaps almost always include netting agreements and interest rate swaps can be structured to include mark-to-market agreements, we can significantly reduce the credit risk of these swap instruments by negotiating swap contracts that include these respective features. When negotiating these features is not possible, credit risk can be reduced by using off-market swaps that do not require an initial payment from IRI.

Six months have passed (180 days) since Torrey issued his report to IRI's management team, and the current exchange rate is now $0,085 per peso. The new term structure of interest rates is as follows:

Calculate the value of the 2-year currency swap from the perspective of the counterparty paying dollars six months after Torrey's initial analysis.

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Suggested Answer: C

Use the new Mexican term structure to derive the present value factors:

Zl80 (360) - 1 / [1 4 0.050(180 / 360)] = 0.9756

Z180 (720) = 1 / [1 t 0.052(540 / 360)] = 0.9276

The present value of the fixed payments plus the principal is:

0.0507 x (0.9756 + 0.9276) + 0.9276 = 1.0241 per peso

Apply this to notional principal and convert at current exchange rate:

1.0241 x ($100M / 0.0893) m 0.085= $97.48 million

The value of the swap is the difference between this value and the pay dollar fixed present value derived in the previous question:

$97

.48 - $101.69M = - $4.21 million (Study Session 17, LOS 61 A)


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