Question #71

of 77 A swap is equivalent to a series of: 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 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. 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%