Explore Free CFA Institute CFA Level II CFA-Level-II Practice Questions for Exam Mastery

Paul Durham, CFA, is a senior manager in the structured bond department within Newton Capital Partners (NCP), an investment banking firm located in the United States. Durham has just returned from an international marketing campaign for NCP's latest structured note offering, a series of equity linked fixed-income securities or ELFS. The bonds will offer a 4.5% coupon paid annually along with the annual return on the S&P 500 Index and will have a maturity of five years. The total face value of the ELFS series is expected to be $200 million.

Susan Jacobs, a fixed-income portfolio manager and principal with Smith & Associates, has decided to include $10 million worth of ELFS in her fixed-income portfolio. At the end of the first year, however, the S&P 500 Index value is 1,054, significantly lower than the initial value of 1,112 set by NCP at the time of the ELFS offering. Jacobs is concerned that the four remaining years of the ELFS life could have similar results and is considering her alternatives to offset the equity exposure of the ELFS position without selling the bonds, Jacobs decides to offset her portfolio's exposure to the ELFS by entering into an equity swap contract. The LIBOR term structure is shown below in Exhibit 1.

After hearing of her plan, one of the other partners with Smith & Associates, Jonathan Widby, feels it is necessary to meet with Jacobs regarding her proposed strategy. Mr. Widby makes the following comments during the meeting:

"You should also know that I am quite bullish on the stock market for the near future. Therefore, as an alternative strategy, I recommend that you establish a long position in a 1 x 3 payer swaption. This strategy would allow you to wait and see how the market performs next year but will give you the ability to enter into a 2-year swap with terms that can be established today should the market have another down year.

If, however, you choose to proceed with your strategy, know that credit risk for an equity swap is greatest toward the end of the swap's life. Thus, analysts tracking your portfolio will not be happy with the added credit risk (hat your portfolio will be exposed to as the swap nears the end of its tenor. You should think about what credit derivatives you can use to manage this risk when the time comes."

To offset any credit risk associated with the equity swap, Widby recommends using an index trade strategy by entering into a credit default swap (CDS) as a protection buyer. Widby's strategy would involve purchasing credit protection on an index comprising largely the same issuers (companies) included in the equity index underlying the swap. Widby suggests the CDS should have a maturity equal to that of the swap to provide maximum credit protection.

If Jacobs enters into a $10 million 4-year annual-pay floating-rate equity swap based on 1-year LIBOR and the total return on the S&P 500 Index, what is the value of the remaining 3-year swap to the floating rate payer after one year if the Index has increased from 1,054 to 1,103 and the LIBOR term structure is as given below?

LIBOR

1-year: 4.1%

2-ycar: 4.7%

3-year: 5.3%

Paul Durham, CFA, is a senior manager in the structured bond department within Newton Capital Partners (NCP), an investment banking firm located in the United States. Durham has just returned from an international marketing campaign for NCP's latest structured note offering, a series of equity linked fixed-income securities or ELFS. The bonds will offer a 4.5% coupon paid annually along with the annual return on the S&P 500 Index and will have a maturity of five years. The total face value of the ELFS series is expected to be $200 million.

Susan Jacobs, a fixed-income portfolio manager and principal with Smith & Associates, has decided to include $10 million worth of ELFS in her fixed-income portfolio. At the end of the first year, however, the S&P 500 Index value is 1,054, significantly lower than the initial value of 1,112 set by NCP at the time of the ELFS offering. Jacobs is concerned that the four remaining years of the ELFS life could have similar results and is considering her alternatives to offset the equity exposure of the ELFS position without selling the bonds, Jacobs decides to offset her portfolio's exposure to the ELFS by entering into an equity swap contract. The LIBOR term structure is shown below in Exhibit 1.

After hearing of her plan, one of the other partners with Smith & Associates, Jonathan Widby, feels it is necessary to meet with Jacobs regarding her proposed strategy. Mr. Widby makes the following comments during the meeting:

"You should also know that I am quite bullish on the stock market for the near future. Therefore, as an alternative strategy, I recommend that you establish a long position in a 1 x 3 payer swaption. This strategy would allow you to wait and see how the market performs next year but will give you the ability to enter into a 2-year swap with terms that can be established today should the market have another down year.

If, however, you choose to proceed with your strategy, know that credit risk for an equity swap is greatest toward the end of the swap's life. Thus, analysts tracking your portfolio will not be happy with the added credit risk (hat your portfolio will be exposed to as the swap nears the end of its tenor. You should think about what credit derivatives you can use to manage this risk when the time comes."

To offset any credit risk associated with the equity swap, Widby recommends using an index trade strategy by entering into a credit default swap (CDS) as a protection buyer. Widby's strategy would involve purchasing credit protection on an index comprising largely the same issuers (companies) included in the equity index underlying the swap. Widby suggests the CDS should have a maturity equal to that of the swap to provide maximum credit protection.

Based on the strategy appropriate for Jacobs's portfolio, determine the contract rate on the swap strategy.

Paul Durham, CFA, is a senior manager in the structured bond department within Newton Capital Partners (NCP), an investment banking firm located in the United States. Durham has just returned from an international marketing campaign for NCP's latest structured note offering, a series of equity linked fixed-income securities or ELFS. The bonds will offer a 4.5% coupon paid annually along with the annual return on the S&P 500 Index and will have a maturity of five years. The total face value of the ELFS series is expected to be $200 million.

Susan Jacobs, a fixed-income portfolio manager and principal with Smith & Associates, has decided to include $10 million worth of ELFS in her fixed-income portfolio. At the end of the first year, however, the S&P 500 Index value is 1,054, significantly lower than the initial value of 1,112 set by NCP at the time of the ELFS offering. Jacobs is concerned that the four remaining years of the ELFS life could have similar results and is considering her alternatives to offset the equity exposure of the ELFS position without selling the bonds, Jacobs decides to offset her portfolio's exposure to the ELFS by entering into an equity swap contract. The LIBOR term structure is shown below in Exhibit 1.

After hearing of her plan, one of the other partners with Smith & Associates, Jonathan Widby, feels it is necessary to meet with Jacobs regarding her proposed strategy. Mr. Widby makes the following comments during the meeting:

"You should also know that I am quite bullish on the stock market for the near future. Therefore, as an alternative strategy, I recommend that you establish a long position in a 1 x 3 payer swaption. This strategy would allow you to wait and see how the market performs next year but will give you the ability to enter into a 2-year swap with terms that can be established today should the market have another down year.

If, however, you choose to proceed with your strategy, know that credit risk for an equity swap is greatest toward the end of the swap's life. Thus, analysts tracking your portfolio will not be happy with the added credit risk (hat your portfolio will be exposed to as the swap nears the end of its tenor. You should think about what credit derivatives you can use to manage this risk when the time comes."

To offset any credit risk associated with the equity swap, Widby recommends using an index trade strategy by entering into a credit default swap (CDS) as a protection buyer. Widby's strategy would involve purchasing credit protection on an index comprising largely the same issuers (companies) included in the equity index underlying the swap. Widby suggests the CDS should have a maturity equal to that of the swap to provide maximum credit protection.

Which of the following strategies would be most appropriate given Jacobs's situation and desire to offset the equity exposure of the ELFS position in her portfolio? Establish an equity swap as the;

James Walker is the Chief Financial Officer for Lothar Corporation, a U .S . mining company that specializes in worldwide exploration for and excavation of precious metals. Lothar Corporation generally tries to maintain a debt-to-capital ratio of approximately 45% and has successfully done so for the past seven years. Due to the time lag between the discovery of an extractable vein of metal and the eventual sale of the excavated material, the company frequently must issue short-term debt to fund its operations. Issuing these one to six month notes sometimes pushes Lothar's debt to capital ratio above their long-term target, but the cash provided from the short-term financing is necessary to complete the majority of the company's mining projects.

Walker has estimated that extraction of silver deposits in southern Australia has eight months until project completion. However, funding for the project will run out in approximately six months. In order to cover the funding gap. Walker will have to issue short-term notes with a principal value of $1,275,000 at an unknown future interest rate. To mitigate the interest rate uncertainty, Walker has decided to enter into a forward rate agreement (FRA) based on LIBOR which currently has a term structure as shown in Exhibit 1.

Three months after establishing the position in the forward rate agreement, LIBOR interest rates have shifted causing the value of Lothar's FRA . position to change as well. The new LIBOR term structure is shown in Exhibit 2.

While Walker is estimating the change in the value of the original FRA position, he receives a memo from the Chief Operating Officer of Lochar Corporation, Maria Steiner, informing him of a major delay in one of the company's South African mining projects. In the memo, Stciner states the following: "As usual, the project delay will require a short-term loan to cover funding shortage that will accompany the extra time until project completion. I have estimated that in 210 days, we will require a 90-day project loan in the amount of $2,350,000.1 would like you to establish another FRA position, this time with a contract rate of 6.95%."

Which of the following transactions should Walker initiate in order to comply with Steiner's request regarding the funding shortage at the South African gold mine? Establish a:

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:

Evaluate Torrey's statements regarding IRPs ability to mitigate the credit risk inherent in currency swaps and interest rate swaps. Torrey is only correct regarding: