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Week 07-Tutorial-Mishal Manzoor (Fins3616) - T3 2020
Week 07-Tutorial-Mishal Manzoor (Fins3616) - T3 2020
FINANCE
FINS3616
▪ In the swap market, the reference amount against which the interest is
calculated is known as the notional principal.
▪ In a coupon swap, one party pays a fixed rate calculated at the time of trade
as a spread to a particular Treasury bond, and the other side pays a floating
rate.
▪ In a currency swap, the effective interest rate on the money raised is known
as the all-in cost.
▪ A forward rate agreement is a cash-settled, over-the-counter forward
contract that allows a company to fix an interest rate to be applied to a
specified future interest period on a notional principal amount.
ANSWER:
▪ The term notional indicates the basic principal amount on which the cash
flows of the interest rate swap depend.
▪ Usually, only a net interest payment is made depending upon whether the
fixed interest rate stated in the swap is higher or lower than the floating
interest rate.
Additional Notes:
▪ Maturity: ranges from <1 year to 15+ years, but typically 2 – 10 years
▪ Types:
ANSWER:
▪ The term notional refers to the theoretical principal underlying the swap.
▪ In the coupon swap, one party pays a fixed rate calculated at the time of
trade as a spread to a particular Treasury bond, while the other side pays a
floating rate that resets periodically throughout the life of the deal against a
designated index.
▪ In a basis swap, a floating-rate liability tied to one reference rate, say, LIBOR,
is exchanged for a floating rate-liability with another reference rate, say,
90-day Treasury bills.
▪ Thus, coupon swaps convert fixed-rate debt into floating-rate debt (or vice
versa), whereas the basis swap converts one type of floating-rate debt into
another type of floating-rate debt.
Q: Company X, a low rated firm, desires a fixed rate, long term loan. X presently
has access to floating interest rate funds at a margin of 1.25% over LIBOR.
Its direct borrowing cost is 11% in the fixed rate bond market. In contrast,
company Y, which prefers a floating rate loan, has access to fixed rate funds
in the Eurodollar bond market at 9% and floating rate funds at LIBOR + 1/4%.
Suppose they split the cost savings.
A. 9.5%
B. 10.0%
C. 10.5%
D. 10.75%
ANSWER: ‘C’
Borrower Fixed Rate Floating Rate
Company X 11% LIBOR + 1.25%
Company Y 9% LIBOR + 0.25%
Difference 2% 1%
A. LIBOR – 0.25%
B. LIBOR – 0.50%
C. LIBOR
D. LIBOR + 0.50%
ANSWER: ‘A’
Borrower Fixed Rate Floating Rate
Company X 11% LIBOR + 1.25%
Company Y 9% LIBOR + 0.25%
Difference 2% 1%
Suppose the swap bank’s fixed interest rate is 8.625% against 6-month dollar
LIBOR.
Q: What semiannual interest payments will GM receive, and what will GM pay in
return?
ANSWER:
GM SWAP
+LIBOR paid to swap bank BANK
+9% fixed paid to original lender 8.625% (FIXED)
-8.625% received from swap bank
=LIBOR + 0.375% (FLOATING)
9% (FIXED)
FIXED
RATE
LENDER
Q: What is a currency swap? Describe the structure of and rationale for its cash
flows.
ANSWER:
▪ The parties exchange initial principal amounts in the two currencies that are
equivalent in value when evaluated at the spot exchange rate.
▪ One party swaps fixed interest payments for floating payments, the other
swaps floating payments for fixed payments.
▪ Typically, both parties borrow in their home currency and swap their future
cash-flow obligations with the counterparty.
▪ The counterparties also exchange principal amounts at the start and the end
of the swap arrangement.
Q: Comment on the following statement. “In order for one party to a swap to
benefit, the other party must lose.”
ANSWER:
Given that both parties to the swap freely enter into the swap transaction, both
must perceive benefits.
The tax, financial market, and regulatory system arbitrage benefits associated with
swaps are shared by both parties.
Q: XYZ is a U.S. firm, considering to enter into a currency swap with a maturity
of 8 years involving $10 million of its $ debt for an equivalent amount of €
debt. The interest rate on XYZ’s outstanding 8-yr $ debt is 11% p.a. semi-
annually. XYZ’s swap bank is willing to provide a swap that covers XYZ’s
dollar obligations in exchange for payments in € under the swap at a rate of
9% p.a. (also paid semi-annually). The current spot rate is $1.35/€.
ANSWER:
Principal$ = 10,000,000
FIXED
RATE
LENDER
Q1: Dell Computers would like to borrow pounds, and Virgin Airlines wants to
borrow dollars. Because Dell is better known in the United States, it can
borrow on its own dollars at 7 percent and pounds at 9 percent, whereas
Virgin can on its own borrow dollars at 8 percent and pounds at 8.5%.
PART A:
Suppose Dell wants to borrow £10 million for two years, Virgin wants to borrow
$16 million for two years, and the current ($/£) exchange rate is $1.60. What swap
transaction would accomplish this objective? Assume the counterparties would
exchange principal and interest payments with no rate adjustments.
ANSWER:
Virgin would borrow £10 million for two years and Dell would borrow $16 million
for two years.
The two companies would then swap their proceeds and payment streams.
PART B:
What savings are realized by Dell and Virgin?
ANSWER:
Virgin 8% 8.5%
Assuming no interest rate adjustments, Dell would pay 8.5% on the £10 million and
Virgin would pay 7% on its $16 million.
Given that its alternative was to borrow pounds at 9%, Dell would save 0.5% on its
borrowings, or an annual savings of £50,000.
ANSWER:
Ignoring credit risk differences, Virgin would have to provide Dell with a pound
rate of less than 9%.
Given that Virgin has to borrow the pounds at 9.5%, it would have to save at least
0.5% on its dollar borrowing from Dell to make the swap worthwhile.
If Dell borrows pounds from Virgin at 9% - x, then Virgin would have to borrow
dollars from Dell at 8.75% - (0.5% + x) to cover the 0.5% + x difference between the
interest rate at which it was borrowing pounds and the interest rate at which it was
lending those pounds to Dell.
PART D:
Based on the scenario in part (c), suppose Dell borrows dollars at 7 percent and
Virgin borrows pounds at 9.5 percent. If the parties swap their current proceeds,
with Dell paying 8.75 percent to Virgin for pounds and Virgin paying 7.75 percent to
Dell for dollars, what are the cost savings to each party?
ANSWER:
Virgin loses 0.75% on the pounds it swaps with Dell and saves 1% on the dollars it
receives from Dell, for a net savings of 0.25% annually.
▪ A forward forward is a contract in which two parties agree to enter into a
loan agreement at a future time.
▪ Specifies the interest rate, the principal amount, and start and ending dates
of future interest period.
▪ The loan agreement requires the borrower to repay the principal amount
upon maturity of the loan, along with premium (interest).
▪ E.g. locks in an interest rate for a 6-month loan undertaken in 3 months from
now.
Q: Telecom Argentina needs to borrow $5 million in 6 months for a 3-month
period. The company expect the interest rate to rise over the next 6 months,
so it wants to lock in its future interest rate.
Its bank offers a forward forward that fixes the rate at 7.8% per year. In 9 months
from today, how much Telecom Argentina will repay?
ANSWER:
Under this contract, the bank will lend Telecom Argentina $10 million for a 3-
month period at a rate of 1.95% (7.8%/4) in 6 months time.
In return, 9 months from Today, Telecom Argentina will repay the principal plus
interest on the loan, or $5,097,500 ($5 million x 1.0195)
Q: Suppose LIBOR3 is 7.93 percent and LIBOR6 is 8.11 percent. What is the
forward forward rate for a LIBOR3 deposit to be placed in three months?
ANSWER:
Through arbitrage, the future value in six months of $1 invested today must be the
same whether we invest at LIBOR3 today and enter into a forward forward for the
following three months or invest at LIBOR6 today. That is,
where r equals the forward rate for a LIBOR3 deposit to be placed in three months.
▪ Forward Rate Agreements (FRA): an agreement to pay a certain rate of
interest on a specific amount (notional principal) undertaken in the future
period.
▪ The notional amount is not exchanged, but rather a cash amount based on
the rate differentials and the notional value of the contract.
▪ If LIBOR6 increases above 4.5% in 3 months, the bank will pay you the
difference;
▪ If LIBOR6 decreases below 4.5%, you need to pay the bank the difference.
Suppose the actual LIBOR6 at the beginning of the loan period – in 3 months
time, is 5%. What is the FRA payment you receive?
ANSWER:
ANSWER:
▪ To lock in the rate on a one-year $25 million loan to be taken out in six
months, IBM could buy a "6 x 12" FRA on LIBOR for a notional principal of
$25 million.
▪ This means that IBM has entered into a six-month forward contract on 12-
month LIBOR.
▪ Alternatively, IBM can lock in the interest rate on this loan by selling 25
$1 million 6-month futures contracts.
▪ However, this transaction will only protect IBM for the first three months of
its loan.
▪ To hedge the remaining nine months of future loan, IBM would have to sell
25 $1 million 9-month, 12-month, and 15-month futures contracts.
▪ The most important difference between using the FRA and the futures
contract is that is that the latter is marked to market daily, meaning that
gains and losses are settled in cash each day.
▪ In addition, the FRA involves entering into just one contract for the 12-month
loan, whereas using the futures contract to hedge IBM’s interest rate risk
involves entering into four separate three-month futures contracts.
Q6: Suppose that Skandinaviska Ensilden Banken (SEB), the Swedish bank,
funds itself with three-month Eurodollar time deposits at LIBOR. Assume
that Alfa Laval comes to SEB seeking a one-year, fixed rate loan of $10
million, with interest to be paid quarterly. At the time of the loan
disbursement, SEB raises three-month funds at 5.75%, but has to roll over
this funding in three successive quarters. If it does not lock in a funding rate
and interest rates rise, the loan could prove to be unprofitable. The three
quarterly re-funding dates fall shortly before the next three Eurodollar
futures-contract expirations in March, June, and September.
PART A: At the time the loan is made, the price of each contract is 94.12, 93.95,
and 93.80. Show how SEB can use Eurodollar futures contracts to lock in its
cost of funds for the year. What is SEB's hedged cost of funds for the year?
ANSWER:
The formula for the locked-in LIBOR, r, given a price P of a Eurodollar futures
contract is r = 100 - P.
Using this formula, the solution r for each of the contracts is 5.88%, 6.05%, and
6.2%.
So SEB can lock in a cost for its $10 million loan equal to:
Effectively, what this procedure does is to roll over the principal and cumulative
Interest payment each quarter until it is paid off in a lump sum at the end of the
fourth quarter.
PART B: Suppose that the settlement prices of the March, June, and September
contracts are, respectively, 92.98, 92.80, and 92.66. What would have been
SEB's unhedged cost of funding the loan to Alfa Laval?
ANSWER:
We can solve this problem by using the insight that at the time of settlement,
arbitrage will ensure that the settlement price for a Eurodollar futures contract
will be virtually identical to the actual LIBOR on that date.
Given the stated prices at settlement, actual LIBOR on each rollover date was
7.02%, 7.2%, and 7.34%.
This is equivalent to an annual rate of 7.00%, or 90 basis points more than the
hedged cost of the loan.
Q: What are the three types of foreign exchange exposure?
ANSWER:
❑ Translation Exposure
❑ Transaction Exposure
❑ Operating Exposure
A. Changes in financial accounting statements arising from unexpected changes
in currency values is called _______________ to currency risk.
ANSWER:
ANSWER:
▪ The company faces uncertainty as to what its future yen sales revenue will
be. This uncertainty stems from quantity risk, the risk that those future sales
will not materialize, and price risk, the uncertainty as to the yen prices it can
expect to realize in Japan.
▪ If it uses forward contracts to hedge its uncertain future yen sales revenue, it
faces the risk that it will over-hedge, winding up with yen liabilities not offset
by yen assets.
▪ The company can protect itself by using forward contracts to hedge the
certain component of its expected future yen sales then hedging the
remainder of its projected sales revenue with currency options.
Q: Your bank is working with an American client who wishes to hedge its long
exposure in the Malaysian ringgit. Suppose it is possible to invest in ringgit but
not borrow in that currency. However, you can both borrow and lend in U.S.
dollars.
ANSWER:
▪ To hedge its ringgit exposure, your bank's American client should short the
ringgit. This strategy would entail buying a forward contract from your bank.
▪ To create this forward contract, the bank needs to borrow ringgit, sell the
proceeds spot for dollars, and invest the dollars.
▪ Unfortunately, since the bank can't borrow ringgit, it cannot create the
needed forward contract.
Q: Your bank is working with an American client who wishes to hedge its long
exposure in the Malaysian ringgit. Suppose it is possible to invest in ringgit but
not borrow in that currency. However, you can both borrow and lend in U.S.
dollars.
PART B: Several of your Malaysian clients are interested in selling their U.S.
dollar export earnings forward for ringgit. Can you accommodate them by
creating a forward contract?
ANSWER:
In this case, you can create the necessary forward contract by borrowing U.S.
dollars, converting them to ringgit, and investing the ringgit until the forward
contract you sell your Malaysian clients matures.
Q: Many managers prefer to use options to hedge their exposure because it
allows them the possibility of capitalizing on favorable movements in the
exchange rate. In contrast, a company using forward contracts avoids the
downside but also loses the upside potential as well. Comment on this strategy.
ANSWER:
▪ Options are clearly more valuable than forward contracts for the reasons
stated in the question. However, this does not mean that options are
preferable to forward contracts.
▪ The reason has to do with cost. Options are more expensive than forward
contracts at the same forward rate or exercise price.
▪ One must trade off the added benefits of options against their higher costs.
To the extent that these derivative markets are efficient--and the evidence
suggests they are--the expected net present value of entering into either of
these contracts is zero.
▪ The appropriate use of these derivatives is to hedge foreign exchange risk,
not to speculate on future exchange rate movements.
▪ As explained in the chapter, one should match the derivative against the type
of risk being hedged: Known risks should be hedged with forward contracts
and contingent risks with options.
Q: In January 1988, Arco bought a 24.3% stake in the British oil firm Britoil PLC.
It intended to buy a further $1 billion worth of Britoil stock if Britoil was
agreeable. However, Arco was uncertain whether Britoil, which had
expressed a strong desire to remain independent, would accept its bid. To
guard against the possibility of a pound appreciation in the interim, Arco
decided to convert $1 billion into pounds and place them on deposit in
London, pending the outcome of its discussions with Britoil's management.
What exchange risk did Arco face and did it choose the best way to protect
itself from that risk?
ANSWER:
▪ The exchange risk faced by Arco was that it had a contingent pound liability
(the cost of its possible purchase of Britoil) offset by a fixed pound asset
(the deposit).
▪ If the deal went through, Arco would know exactly how many dollars its bid
will cost, namely, $1 billion.
▪ But if the deal fell apart (which it did), Arco would have a large bank account
in London with an uncertain dollar value.
▪ Hedging that deposit would not eliminate exchange risk because if the deal
went through Arco would not know at the time of its offer how many dollars
it would take to buy $1 billion worth of shares at today's exchange rate.
▪ (This analysis leaves aside the issue of fluctuations in the dollar price of
Britoil shares.)
▪ Note that it doesn't make sense to convert dollars into pounds and then
hedge those pounds. Assuming interest parity holds, Arco might as well
have deposited dollars.
▪ The solution for Arco is to buy a call option on $1 billion worth of pounds at
the current spot exchange rate. This limits Arco's downside risk to the call
premium, while enabling it to capitalize on an appreciation in the value of the
pound.
Q: Rolls-Royce, the British jet engine manufacturer, sells engines to U.S.
airlines and buys parts from U.S. companies. Suppose it has accounts
receivable of $1.5 billion and accounts payable of $740 million. It also
borrowed $600 million. The current spot rate is $1.5128/£.
ANSWER:
PART B: Suppose the pound appreciates to $1.7642/£. What is Rolls Royce's gain
or loss, in pound terms, on its dollar transaction exposure?
ANSWER:
▪ Translated at the new exchange rate, the value of its transaction exposure is
now £90.69 million.
▪ Compared to the former value of its transaction exposure, the result is a loss
of £15.07 million (£90.69 million - £105.76 million).
Q: A foreign exchange trader assesses the euro exchange rate three months hence
as follows:
PART A: Will the trader buy or sell euros forward against the dollar if she is
concerned solely with expected values? In what volume?
ANSWER:
▪ ($1.11 x 0.25 + $1.13 x 0.50 + $1.15 x0.25). Because this exceeds the forward
rate of $1.12, the trader will buy euros forward against the dollar. She should
buy an infinite amount of euros. This absurd result is due to the assumption
of a linear utility function.
Q: A foreign exchange trader assesses the euro exchange rate three months hence
as follows:
ANSWER:
Regardless of her utility function, she will be restrained by bank policies designed
to guard against excessive currency speculation.
PART C: Suppose the trader revises her probability assessment as follows:
Assuming the forward rate remains at $1.12, do you think this new assessment will
affect the trader's decision?
ANSWER:
The expected future spot rate remains at $1.13. However, the variance of the
expected spot rate is now greater than it was before.
If the trader is concerned solely with expected values, this will not affect her
speculative activities. But if she is concerned with risk in addition to expected
return, the greater variance and consequent greater risk should lead her to
reduce her speculative activities.
Q: An investment manager hedges a portfolio of Bunds (German government
bonds) with a 6- month forward contract. The current spot rate is €0.84/USD and
the 180-day forward rate is €0.81/USD. At the end of the 6-month period, the Bunds
have risen in value by 3.75 percent (in euro terms), and the spot rate is now
€0.76/USD.
PART A: If the Bunds earn interest at the annual rate of 5 percent, paid semi-
annually, what is the investment manager's total dollar return on the hedged
Bunds?
ANSWER:
Ignoring hedging for the time being, for each $100 invested in
Bunds at a spot rate of €0.84 per dollar, the investment manager would have at the
end of six months an amount of euros equal to €89.25, as follows
▪ Assuming that the investment manager did not anticipate the 3.75% capital
gain and hedged only the expected amount of €86.10, he would now have
$106.30 (86.10/0.81) from the original hedged principal and interest plus an
additional $4.14 (0.84 x 100 x 0.0375/0.76) from the 3.75% capital gain on the
Bund principal of €84 converted into dollars at the spot rate of €0.76:$1.
▪ The total dollar amount received in six months would, therefore, be $110.44
(106.30 + 4.14), which is a 10.44% return on the original $100 investment.
Q: An investment manager hedges a portfolio of Bunds (German government
bonds) with a 6- month forward contract. The current spot rate is €0.84/USD and
the 180-day forward rate is €0.81/USD. At the end of the 6-month period, the Bunds
have risen in value by 3.75 percent (in euro terms), and the spot rate is now
€0.76/USD.
PART B: What would the return on the Bunds have been without hedging?
ANSWER:
▪ As shown in the answer to part a, the euro value of the Bund's principal plus
interest at the end of six months would be €89.25.
▪ Converting this amount into dollars at the spot rate of €0.76:$1 yields an
amount equal to $117.43 (89.25/0.76).
ANSWER:
▪ As shown in the text (see the section titled "The True Cost of Hedging"), the
forward contract reduces the return per dollar invested by an amount equal
to the difference between the forward rate and the actual spot rate at the time
of settlement, or €0.05 (€0.81 - €0.76) per euro hedged.
▪ Relative to the original spot rate, this cost translates into 5.95% ((€0.81 -
€0.76)/€0.84).
Q: A U.S. company needs to borrow $100 million for a period of seven years. It can
issue dollar debt at 7 percent or yen debt at 3 percent.
PART A: Suppose the company is a multinational firm with sales in the United
States and inputs purchased in Japan. How should this affect its financing choice?
ANSWER:
▪ That is, yen are not automatically less expensive to borrow just because the
interest rate on yen is lower than the rate on dollars.
▪ From a risk management standpoint, the key issue is the currency risk being
borne by the MNC and the effect of its borrowing decision on that currency
risk.
▪ From the facts given in the question, it appears that based on its sourcing of
inputs in Japan, the company will short yen (regardless of whether the input
prices are denominated in yen or dollars).
▪ Other things being equal, therefore, it appears that the MNC should borrow
dollars; borrowing yen will just exacerbate its short position in yen.
▪ If this is the case, then the firm's yen exposure is the net of its short and
long exposure, which we cannot ascertain from the facts presented in the
question.
Q: A U.S. company needs to borrow $100 million for a period of seven years. It can
issue dollar debt at 7 percent or yen debt at 3 percent.
PART B: Suppose the company is a multinational firm with sales in Japan and
inputs that are primarily determined in dollars. How should this affect its financing
choice?
ANSWER:
▪ In this case, the firm clearly has a long economic exposure to yen.
ANSWER:
▪ If it raises its foreign currency prices, it risks losing sales, and with them
profits--and worse, permanent market standing.
▪ If it does not raise prices in the foreign currencies, its dollar profit margins
shrink, and with them its profits.
▪ Yet, Chemex may not be affected as much by currency changes as a
commodity chemical maker would be since its products are differentiated (it
makes specialty chemicals).
▪ To the extent that its major competitors are other American companies, who
share a common cost structure, its exchange risk will be lower still.
Q: Chemex, a U.S. maker of specialty chemicals, exports 40 percent of its $600
million in annual sales: 5 percent goes to Canada and 7 percent each to Japan,
Britain, Germany, France, and Italy. It incurs all its costs in U.S. dollars, while most
of its export sales are priced in the local currency.
ANSWER:
▪ Chemex's transaction exposure stems from the fact that most of its export
sales are priced in the local currency of the countries to which it exports.
▪ Its operating exposure arises because the dollar-equivalent prices that it can
charge in foreign markets and its foreign sales volume at a given dollar price
are affected by currency changes.
▪ In other words, currency changes will affect the profits that Chemex can earn
abroad. To the extent that Chemex faces competition in the U.S. from foreign
firms, its domestic profits will also depend on exchange rates.
Q: Chemex, a U.S. maker of specialty chemicals, exports 40 percent of its $600
million in annual sales: 5 percent goes to Canada and 7 percent each to Japan,
Britain, Germany, France, and Italy. It incurs all its costs in U.S. dollars, while most
of its export sales are priced in the local currency.
ANSWER:
▪ Chemex can hedge its transaction exposure by selling its foreign currency
receipts forward for dollars.
Q: The multinational corporation’s economic exposure to currency risk is made
up of transaction exposure and operating exposure.
(TRUE/FALSE)
ANSWER:
❑ TRUE
Q: Transaction exposure is defined as change in the value of monetary
(contractual) cash flows due to an unexpected change in exchange rates.
(TRUE/FALSE)
ANSWER:
❑ TRUE
Q: Transaction exposure to currency risk is defined as change in financial
accounting statements arising from unexpected changes in currency values.
(TRUE/FALSE)
ANSWER:
(TRUE/FALSE)
ANSWER:
❑ TRUE
Q: Transaction exposure to currency risk is easy to hedge with currency
forwards.
(TRUE/FALSE)
ANSWER:
❑ TRUE
Q: The most popular instrument for hedging currency risk is a ________.
a. currency forward
b. currency futures
c. money market hedge
d. currency option
e. currency swap
ANSWER:
❑ A
Q: The preferred way to hedge transaction exposure to currency risk is ____.
ANSWER:
❑ A
Q: Financial market hedges work best for ____ exposures to currency risk.
a. accounting
b. economic
c. operating
d. transaction
e. translation
ANSWER:
❑ D
Q: Internal hedges of currency risk are most likely to be found in ________.
ANSWER:
❑ A
Q: Economic exposure to currency risk is defined as change in the value of
future cash flows due to unexpected changes in currency values.
(TRUE/FALSE)
ANSWER:
❑ TRUE
Q: Operating exposure to currency risk is easy to hedge with currency forwards.
(TRUE/FALSE)
ANSWER:
❑ FALSE
(TRUE/FALSE)
ANSWER:
❑ FALSE
(TRUE/FALSE)
ANSWER:
❑ TRUE