Question #70
Reading: Reading 30 Pricing and Valuation of Forward Commitments
PDF File: Reading 30 Pricing and Valuation of Forward Commitments.pdf
Page: 28
Status: Unattempted
Correct Answer: A
Question
A swap is equivalent to a series of:
Answer Choices:
A. FRAs priced at market rates
B. off-market FRAs
C. interest rate calls. John Williams, CFA, works in the treasury department of Sam Smith Leisure Inc., a U.S. based manufacturer of gym equipment. Recently he has been considering using derivative instruments to lock in returns on excess cash flows that tend to accumulate in the final quarter of each year as demand for equipment peaks during that time. He estimates that this year, in 60-days, the company will have $28.5 million in excess funds to invest for 90 days. Williams is presenting to the board 60 days before the excess funds need to be deposited, which is also 30 days before the year end. He intends to suggest an FRA as a method of
Explanation
Since the fixed rate on the swap is the same at every settlement date, a series of FRAs at
those fixed rates will have values that differ from zero to the extent the fixed rate and the
zero-value rate differ. This makes them off-market FRAs.
(Module 30.6, LOS 30.e)
Typesetting math: 100%
John Williams, CFA, works in the treasury department of Sam Smith Leisure Inc., a U.S. based
manufacturer of gym equipment. Recently he has been considering using derivative
instruments to lock in returns on excess cash flows that tend to accumulate in the final
quarter of each year as demand for equipment peaks during that time.
He estimates that this year, in 60-days, the company will have $28.5 million in excess funds
to invest for 90 days.
Williams is presenting to the board 60 days before the excess funds need to be deposited,
which is also 30 days before the year end. He intends to suggest an FRA as a method of
locking in a return on the deposit. He intends to make the following two statements in favor
of using an FRA.
Statement 1
As we are depositing cash, committing to an FRA will generate a cash inflow on the date we
enter into it.
Statement 2
If rates move in our favor, we will receive a cash payment at the end of the notional
borrowing period.
Williams will present the hypothetical rates and MRR shown in Exhibit 1 to illustrate the
result of using an FRA. Current 2x5 FRA price is 3.8%. All rates are annualized.
Exhibit 1 – FRA Price and Theoretical Future MRR rates
Predicted MRR
rates
In 30 days
In 60 days
In 90 days
In 120 days
In 150 days
30-day MRR
3.9%
4.0%
4.2%
4.4%
4.5%
60-day MRR
4.1%
4.4%
4.5%
4.7%
4.8%
90-day MRR
4.2%
4.7%
4.8%
4.9%
5.2%
120-day MRR
4.5%
5.0%
5.2%
5.3%
5.5%
150-day MRR
4.8%
5.3%
5.4%
5.6%
5.9%
One key question that the CFO is likely to ask is the predicted value of the FRA at the year
end.
Finally Williams is to investigate the potential for Sam Smith Inc. to use a currency swap to
borrow and invest in a manufacturing facility in Europe. A bank has offered the company a
fixed for fixed currency swap involving US dollars and Euros.
Typesetting math: 100%
Some of the swap details are outlined in Exhibit 2.
Exhibit 2– Currency Swap
Initiation:
1st January
Spot rate at
initiation:
USD/EUR 1.19
Settlement:
Quarterly
Principal:
USD 40,000,000
Fixed EUR rate:
1.5%
Fixed USD rate:
1.3%