Exam 8: Interest Risk and Swaps

Your firm is faced with paying a variable rate debt obligation with the expectation that interest rates are likely to go up. Identify two strategies using interest rate futures and interest rate swaps that could reduce the risk to the firm.

A firm with variable-rate debt that expects interest rates to rise may engage in a swap agreement to:

The real exposure of an interest or currency swap is not the total notional principal, but the mark-to-market values of differentials in interest or currency interest payments since the inception of the swap agreement.

Instruction 8.1: For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period. • Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%. • Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50% • Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%. -Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer strategy #1? (Assume your firm is borrowing money.)

Instruction 8.1: For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period. • Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%. • Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50% • Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%. -Refer to Instruction 8.1. Choosing strategy #1 will:

Historically, interest rate movements have shown less variability and greater stability than exchange rate movements.

Instruction 8.1: For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period. • Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%. • Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50% • Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%. -Refer to Instruction 8.1. If your firm felt very confident that interest rates would fall or, at worst, remain at current levels, and were very confident about the firm's credit rating for the next 10 years, which strategy would you likely choose? (Assume your firm is borrowing money.)

Instruction 8.1: For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period. • Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%. • Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50% • Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%. -Refer to Instruction 8.1. Choosing strategy #3 will:

One of the reasons companies use interest rate swaps is because they pursue a target debt structure that combines maturity, currency of composition, and fixed/floating pricing.

Instruction 8.1: For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period. • Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%. • Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50% • Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%. -Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer strategy #3? (Assume your firm is borrowing money.)

An agreement to exchange interest payments based on a fixed payment for those based on a variable rate (or vice versa) is known as a/an:

Individual borrowers - whether they be governments or companies - possess their own individual credit rating, the market's assessment of their ability to repay debt in a timely manner. These credit assessments influence all the following EXCEPT:

The potential exposure that any individual firm bears that the second party to any financial contract will be unable to fulfill its obligations under the contract is called:

A firm with fixed-rate debt that expects interest rates to fall may engage in a swap agreement to:

________ is the possibility that the borrower's creditworthiness is reclassified by the lender at the time of renewing credit. ________ is the risk of changes in interest rates charged at the time a financial contract rate is set.

Interest rate calculations differ by the number of days used in the period's calculation and in the definition of how many days there are in a year (for financial purposes). One of the practices is to use 260 business days in a year.

A basis point is one-tenth of one percent.

If a financial manager with an interest liability on a future date were to sell Futures and interest rates end up going up, the position outcome would be:

Instruction 8.1: For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period. • Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%. • Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50% • Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%. -Refer to Instruction 8.1. Choosing strategy #2 will:

A/an ________ is a contract to lock in today interest rates over a given period of time.