Question #2

of 77 At the inception of a market-rate plain vanilla swap, the value of the swap to the fixed-rate payer is: A) positive. B) zero. C) either positive or negative. Chantal DuPont is the CFO of Vetements Verdun, a manufacturer of specialty clothing and uniforms, located in northern France. The firm is currently undergoing an expansion which will require DuPont to draw down 25 million on Vetements Verdun's credit line as a 90-day bridge loan before the mortgage closes. The money will not be needed for 60 days, at which point the interest rate will be determined. The interest rate on the loan will be based off 90- day LIBOR. DuPont is becoming concerned because of signs that interest rates may begin to rise. The firm cannot afford to have its borrowing costs increase significantly over current rates. In response to DuPont's concerns, the company's CEO, Viviane Lamarre, has asked DuPont to hedge the firm's borrowing costs, even if that entails some near-term outlays. DuPont and Lamarre discuss entering into a forward rate agreement (FRA) to hedge Vetements Verdun's interest rate exposure on the credit line. Current LIBOR rates are: LIBOR rate 30-day 2.6% 60-day 2.8% 90-day 3.0% 120-day 3.2% 150-day 3.3% 180-day 3.4% They decide to go forward with the hedge and DuPont enters into the appropriate FRA for the full amount of 25 million. In the first 30 days of the FRA, the fixed income markets rally sharply. The new set of LIBOR rates, on the thirtieth day of the FRA, is: LIBOR rate 30-day 2.2% 60-day 2.4% 90-day 3.6% 120-day 3.8% 150-day 3.8% 180-day 3.8% At the settlement date, the interest savings on the loan term is 23,750. DuPont tells Lamarre, "I am looking forward to cashing our settlement check for 23,750." Lamarre adds, "Yes, and on top of that we get to borrow for 90 days at a below-market rate." Both DuPont and Lamarre are pleased with their decision to hedge.