CFA Level 3 - Derivatives Session 15 - Reading 38

CFA Level 3 - Derivatives Session 15 - Reading 38 (Notes, Practice Questions, Sample Questions) 1. Which of the following positions results in synthetic fixed-rate debt? A)A long position in a floating-rate note combined with a pay-fixed interest rate swap. B)A short position in a floating-rate note combined with a pay-fixed interest rate swap. C)A long position in a floating-rate note combined with a receive-fixed interest rate swap Explanation: 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 2. A borrower with a $4 million floating rate loan pays LIBOR plus 200 basis points on the loan. Payments are semiannual. The borrower wishes to convert this obligation to a fixed-rate loan. The borrower uses a swap with a fixed rate equal to 5.6%, floating rate equal to LIBOR, and notional principal equal to $4 million. Which of the following most closely approximates the semiannual payments made by the borrower on the loan and the swap? A)$76,000. B)$72,000. C)$152,000 Explanation: 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) / 2 on $4 million each six months = $152,000 3. Which of the following statements about debt is least accurate? 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. B)To create synthetic callable debt from existing noncallable debt, the portfolio manager can enter into a receiver's swaption. C)The all-in-cost is another way of saying "the internal rate of return of a financing alternative." Explanation: 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 4. To create synthetic fixed-rate debt from a floating-rate obligation, a portfolio manager can do which of the following? A)Pay variable and receive fixed in a swap. B)Sell interest rate caps. C)Pay fixed and receive variable in a swap. Explanation: To create synthetic fixed-rate debt, a portfolio manager can pay fixed and receive variable in a swap 5. A firm has most of its liabilities in the form of floating-rate notes with a maturity of two years and quarterly reset. The firm is concerned with interest rate movements over the next eight quarters but is not concerned with potential movements after that. Which of the following strategies will allow the firm to hedge the expected change in interest rates? A)Enter into a 2-year, quarterly pay-floating, receive-fixed swap. B)Enter into a 2-year, quarterly pay-fixed, receive-floating swap. C)Buy a swaption that allows the firm to be the fixed-rate payer upon exercise. In other words, go long a payer’s swaption with a 2-year maturity. Explanation: 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 6. For a plain-vanilla interest-rate swap with annual reset and one year to maturity, which of the following is closed to the duration for the floating side of the swap? A)0.50. B)1.00. C)0.75. Explanation: The duration of the floating side is 1/2 the time until the next reset date. Since this is an annual pay swap with 1 year left the duration of the floating side is 1 x 0.5 = 0.5 or 1 divided by 2 = 0.5. The duration of the fixed side of a swap is approximately .75 to the time until maturity. If we take a different example of a 4 year swap with semi-annual payments the duration of the fixed side would be 0.75 x 4 = 3 and the duration of the floating side is 0.5 / 2 = 0.25 7. 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. Explanation: 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 8. 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. Explanation: 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. 9. 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. Explanation: 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 10. 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. Explanation: 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 11. 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 Explanation: 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 12. 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. Explanation: 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 13. An investor has a $5,000,000 investment in small-cap stocks. The investor enters into an equity index swap where the investor pays the return on the Russell 2000 and receives the return on the Dow Jones Industrial Average. The notional principal of the swap is $1 million. The resulting position is a synthetic mix of: A)16.67% large stocks and 83.33% small stocks. B)20% large stocks and 80% small stocks. C)25% large stocks and 75% small stocks. Explanation: 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 14. A borrower who is also the owner of a swaption that gives the holder the right to become a fixed-rate payer and floating-rate receiver would most likely do which of the following? Exercise the swaption when interest rates: A)increase to convert a fixed-rate loan to a floating-rate loan. B)increase to convert a floating-rate loan to a fixed-rate loan. C)decrease to convert a floating-rate loan to a fixed-rate loan Explanation: 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 15. A firm contracts to borrow $5 million in one year. The firm enters into a one-year swaption where the swap maturity and notional principal match that of the planned loan. The swaption gives the firm the right to be a floating-rate payer. This hedging strategy would be most effective if the loan contract specifies a: A)variable rate and interest rates decline. B)variable rate and interest rates increase. C)fixed rate and interest rates decline Explanation: 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 16. A firm has most of its liabilities in the form of floating-rate notes with a maturity of two years and a quarterly reset. The firm is not concerned with interest rate movements over the next four quarters but is concerned with potential movements after that. Which of the following strategies will allow the firm to hedge the expected change in interest rates? A)Go long a payer’s swaption with a 1-year maturity. B)Enter into a 2-year, quarterly pay-fixed, receive-floating swap. C)Go short a payer’s swaption with a 2-year maturity Explanation: The firm will want to receive floating payments to offset the volatility of its floating-rate obligations. A payer’s swaption allows the firm to become a fixed-rate payer/floating-rate receiver in a swap. The one-year maturity corresponds to the start of the period of concern