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CFA Institute Exam CFA-Level-II Topic 3 Question 68 Discussion

Actual exam question for CFA Institute's CFA Level II Chartered Financial Analyst exam
Question #: 68
Topic #: 3
[All CFA Level II Chartered Financial Analyst Questions]

William Bow, CFA, is a risk manager for GlobeCorp, an international conglomerate with operations in the technology, consumer products, and medical devices industries. Exactly one year ago, GlobeCorp, under Bow's advice, entered into a 3-year payer interest rate swap with semiannual floating rate payments based on the London interbank offered rate (LIBOR) and semiannual fixed rate payments based on an annual rate of 2.75%. At the time of initiation, the swap had a value of zero and the notional principal was set equal to $150 million. The counterparty to GlobeCorp's swap is NVS Bank, a commercial bank that also serves as a swap dealer. Exhibit 1 below summarizes the current LIBOR term structure.

Upper management at GlobeCorp feels that the original swap has served its intended purpose but that circumstances have changed and it is now time to offset the firm's exposure to the swap. Because they cannot find a counterparty to an offsetting swap transaction, management has asked Bow to come up with alternative measures to offset the swap exposure. Bow created a report for the management team which outlines several strategies to neutralize the swap exposure. Two of his strategies are included in Exhibit 2.

After examining its long-term liabilities, NVS Bank has decided that it currently needs to borrow $100 million over the next two years to finance its operations. For this type of funding need, NVS generally issues quarterly coupon short-term floating rate notes based on 90-day LIBOR. NVS is concerned, however, that interest rates may shift upward and the LIBOR curve may become upward sloping. To manage this risk, NVS is considering utilizing interest rate derivatives. Managers at the bank have collected quotes on over-the-counter interest rate caps and floors from a well known securities dealer. The quotes, which are based on a notional principal of $100 million, are provided in Exhibit 3.

One of the managers at NVS Bank, Lois Green, has expressed her distrust of the securities dealer quoting prices on the caps and floors. In a memo to the CFO, Green suggested that NVS use an alternative but equivalent approach to manage the interest rate risk associated with its two-year funding plan. Following is an excerpt from Green's memo:

"Rather than using a cap or floor, NVS Bank can effectively manage its exposure to interest rates resulting from the 2-year funding requirement by taking long positions in a series of put options on fixed-income instruments with expiration dates that coincide with the payment dates on the floating rate note."

"As a cheaper alternative, NVS can effectively manage its exposure to interest rates resulting from the 2-ycar funding requirement by creating a collar using long positions in a series of call options on interest rates and long positions in a series of call options on fixed income instruments all of which would have expiration dates that coincide with the payment dates on the floating rate note."

Which of the following statements regarding the GlobeCorp swap initiated one year ago is most likely correct?

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Suggested Answer: A

At the initiation of GlobeCorp's fixed rate payer swap, the value was zero and the fixed rate was set at 2.75%. To determine the change in the value of the swap, we must determine the fixed rate on comparable swaps available today using the LIBOR curve. Since a year has passed since the initiation of the swap, a comparable swap as of today would be a 2-year swap with semiannual payments. First calculate the discount factors for the 180-, 360-, 540-, and 720-day LIBOR interest rates as follows:

GlobcCorp could enter into an equivalent swap today at an annualized fixed rate of 2.38% versus the fixed rate of 2.75% that it is currently paying on the existing swap. Therefore, the existing swap has negative value to GlobeCorp and has thus decreased from an initial value of zero. Current credit risk is greater for NVS Bank since the negative value of the swap to GlobcCorp increases the chance that the company will default on the obligation and fail to make the required payments to NVS. (Study Session 17, LOS 6l.c,i)


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