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CFA Guideline Answer
a. The Swap Value and its Effect on Ferris’ Portfolio
Because Karla Ferris believes interest rates will rise, she will want to swap her $1,000,000
fixed-rate corporate bond interest to receive six-month U.S. dollar LIBOR. She will continue to
To execute this swap, she would enter into a two-year term, semi-annual settle, $1,000,000
nominal principal, pay fixed-receive floating U.S. dollar LIBOR swap. If rates rise, the swap’s
mark-to-market value will increase because the U.S. dollar LIBOR Ferris receives will be higher
than the LIBOR rates from which the swap was priced. If Ferris were to enter into the same
b. Eurodollar Futures Strategy
The appropriate futures hedge is to short a combination of Eurodollar futures contracts with
different settlement dates to match the coupon payments and principal. This futures hedge
accomplishes the same objective as the pay fixed-receive floating swap described in Part a. By
If rates rise, the mark-to-market values of the Eurodollar contracts decrease; their yields
must increase to equal the new higher forward and spot LIBOR rates. Because Ferris must
short or sell the Eurodollar contracts to duplicate the pay fixed-receive variable swap in Part a,
she gains as the Eurodollar futures contracts decline in value and the futures hedge increases
Why the Derivative Strategies Achieve the Same Result
Arbitrage market forces make these two strategies provide the same result to Ferris. The
two strategies are different mechanisms for different market participants to hedge against
increasing rates. Some money managers prefer swaps; others, Eurodollar futures contracts.
Each institutional market participant has different preferences and choices in hedging interest
rate risk. The key is that market makers moving into and out of these two markets ensure that
As more and more market makers sold Eurodollar futures contracts, the selling pressure
would cause their prices to fall and yields to rise, which would cause the present value cost of
selling the Eurodollar contracts also to increase. Similarly, as more and more market makers
7. Rone Company asks Paula Scott, a treasury analyst, to recommend a flexible way to
manage the company’s financial risks.
Two years ago, Rone issued a $25 million (U.S.$), five-year floating rate note (FRN). The
FRN pays an annual coupon equal to one-year LIBOR plus 75 basis points. The FRN is non-
callable and will be repaid at par at maturity.
Scott expects interest rates to increase and she recognizes that Rone could protect itself
against the increase by using a pay-fixed swap. However, Rone’s Board of Directors prohibits
both short sales of securities and swap transactions. Scott decides to replicate a pay-fixed
swap using a combination of capital market instruments.
a. Identify the instruments needed by Scott to replicate a pay-fixed swap and describe the
required transactions.
b. Explain how the transactions in Part a are equivalent to using a pay-fixed swap.
CFA Guideline Answer
a. The instruments needed by Scott are a fixed-coupon bond and a floating rate note (FRN).
The transactions required are to:
b. At the outset, Rone will issue the bond and buy the FRN, resulting in a zero net cash flow at
initiation. At the end of the third year, Rone will repay the fixed-coupon bond and will be repaid
the FRN, resulting in a zero net cash flow at maturity. The net cash flow associated with each of
8. A company based in the United Kingdom has an Italian subsidiary. The subsidiary generates
€25,000,000 a year, received in equivalent semiannual installments of €12,500,000. The
British company wishes to convert the euro cash flows to pounds twice a year. It plans to
engage in a currency swap in order to lock in the exchange rate at which it can convert the
euros to pounds. The current exchange rate is €1.5/£. The fixed rate on a plain vanilla
currency swap in pounds is 7.5 percent per year, and the fixed rate on a plain vanilla
currency swap in euros is 6.5 percent per year.
a. Determine the notional principals in euros and pounds for a swap with semiannual payments
that will help achieve the objective.
b. Determine the semiannual cash flows from this swap.
CFA Guideline Answer
a. The semiannual cash flow must be converted into pounds is €25,000,000/2 = €12,500,000.
In order to create a swap to convert €12,500,000, the equivalent notional principals are
b. The cash flows from the swap will now be
9. Ashton Bishop is the debt manager for World Telephone, which needs €3.33 billion Euro
financing for its operations. Bishop is considering the choice between issuance of debt
denominated in:
Euros (€), or
U.S. dollars, accompanied by a combined interest rate and currency swap.
a. Explain one risk World would assume by entering into the combined interest rate and
currency swap.
Bishop believes that issuing the U.S.-dollar debt and entering into the swap can lower
World’s cost of debt by 45 basis points. Immediately after selling the debt issue, World would
swap the U.S. dollar payments for Euro payments throughout the maturity of the debt. She
assumes a constant currency exchange rate throughout the tenor of the swap.
Exhibit 1 gives details for the two alternative debt issues. Exhibit 2 provides current
information about spot currency exchange rates and the 3-year tenor Euro/U.S. Dollar currency
and interest rate swap.
Exhibit 1
World Telephone Debt Details
Characteristic Euro Currency Debt U.S. Dollar Currency Debt
Par value €3.33 billion $3 billion
Term to maturity 3 years 3 years
Fixed interest rate 6.25% 7.75%
Interest payment Annual Annual
Exhibit 2
Currency Exchange Rate and Swap Information
Spot currency exchange rate $0.90 per Euro ($0.90/€1.00)
3-year tenor Euro/U.S. Dollar
fixed interest rates 5.80% Euro/7.30% U.S. Dollar
b.Show the notional principal and interest payment cash flows of the combined interest rate
and currency swap.
Note: Your response should show both the correct currency ($ or €) and amount for each cash
flow.
Answer problem b in the template provided below:
Cash Flows
of the Swap
Year 0 Year 1 Year 2 Year 3
World pays
Notional principal
Interest payment
World receives
Notional principal
Interest payment
c. State whether or not World would reduce its borrowing cost by issuing the debt denominated
in U.S. dollars, accompanied by the combined interest rate and currency swap. Justify your
response with one reason.
CFA Guideline Answer
a. World would assume both counterparty risk and currency risk. Counterparty risk is the risk
that Bishop’s counterparty will default on payment of principal or interest cash flows in the swap.
b.
Year 0 Year 1 Year 2 Year 3
World pays
Notional $3 billion €3.33 billion
Principal
c. World would not reduce its borrowing cost, because what Bishop saves in the Euro market,
she loses in the dollar market. The interest rate on the Euro pay side of her swap is 5.80
percent, lower than the 6.25 percent she would pay on her Euro debt issue, an interest savings
of 45 bps. But Bishop is only receiving 7.30 percent in U.S. dollars to pay on her 7.75 percent
MINI CASE: THE CENTRALIA CORPORATION’S CURRENCY SWAP
The Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It
has decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to
manufacture microwave ovens for sale in the European Union. The plant is expected to cost
€5,500,000, and to take about one year to complete. The plant is to be financed over its
economic life of eight years. The borrowing capacity created by this capital expenditure is
$2,900,000; the remainder of the plant will be equity financed. Centralia is not well known in the
Spanish or international bond market; consequently, it would have to pay 7 percent per annum
to borrow euros, whereas the normal borrowing rate in the euro zone for well-known firms of
equivalent risk is 6 percent. Alternatively, Centralia can borrow dollars in the U.S. at a rate of 8
percent.
Study Questions
1. Suppose a Spanish MNC has a mirror-image situation and needs $2,900,000 to finance a
capital expenditure of one of its U.S. subsidiaries. It finds that it must pay a 9 percent fixed rate
in the United States for dollars, whereas it can borrow euros at 6 percent. The exchange rate
has been forecast to be $1.33/€1.00 in one year. Set up a currency swap that will benefit each
counterparty.
*2. Suppose that one year after the inception of the currency swap between Centralia and the
Spanish MNC, the U.S. dollar fixed-rate has fallen from 8 to 6 percent and the euro zone fixed-
rate for euros has fallen from 6 to 5.50 percent. In both dollars and euros, determine the market
value of the swap if the exchange rate is $1.3343/€1.00.
Suggested Solution to The Centralia Corporation’s Currency Swap
1. The Spanish MNC should issue €2,180,500 of 6 percent fixed-rate debt and Centralia
should issue $2,900,000 of fixed-rate 8 percent debt, since each counterparty has a relative
comparative advantage in their home market. They will exchange principal sums in one year.
The contractual exchange rate for the initial exchange is $2,900,000/€2,180,500, or
*2. The market value of the dollar debt is the present value of a seven-year annuity of
$232,000 and a lump sum of $2,900,000 discounted at 6 percent. This present value is
$3,223,778. Similarly, the market value of the euro debt is the present value of a seven-year
