Exam 23: Swap Contracts, Convertible Securities, and Other Embedded Derivatives

Suppose a corporation desires to borrow financial capital for six months, with two three-month installments. The firm is concerned that interest rates may rise over this period of time. To eliminate interest rate exposure the firm could acquire a

An equity call option issued directly by the company whose stock serves as the underlying asset is known as a

Which of the following is not a typical characteristic of a convertible preferred stock?

Which of the following is not true about interest rate swaps?

Exhibit 23.7 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) The WallMal Company has entered into a 4-year interest rate swap, with semiannual settlement, to pay a fixed rate of 8% per year and receive 6-month LIBOR. The notional principal is $50,000,000. -Refer to Exhibit 23.7. Assume that one year later the fixed rate on a new 3-year receive fixed pay floating LIBOR swap has risen to 9% per year. Settlement is on a semiannual basis. Calculate the market value of the FRN based on $100 face value.

Exhibit 23.8 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) An international investment firm buys an interest rate cap that pays the difference between LIBOR and 6% if LIBOR exceeds 6%. Current LIBOR is 5%. The amount of the option is $1,500,000, and the settlement is every 3 months. Assume a 360 day year. -Refer to Exhibit 23.8. Find the payoff if LIBOR closes at 4.7%.

Exhibit 23.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Darden Industries has decided to borrow $25,000,000.00 for six months in two three-month issues. As the Treasurer, you are concerned that interest rates will rise over the next three months and the rate upon which the second payment will be based will be undesirable. (The amount of Darden's first payment will be known at origination.) To reduce the company's interest rate exposure, you decide to purchase a 3 * 6 FRA whereby you pay the dealer's quoted fixed rate of 4.5% in exchange for receiving 3-month LIBOR at the settlement date. In order to hedge her exposure, the dealer buys LIBOR from McIntire Industries at its bid rate of 4%. (Assume a notional principal of $25,000,000.00 and that there are 60 days between month 3 and month 6.) -Refer to Exhibit 23.2. Assuming that 3-month LIBOR is 5.00% on the rate determination day, and the contract specified settlement in arrears at month 6, describe the transaction that occurs between the dealer and McIntire.

An interest rate ____ is a combination of a cap and a floor.

Exhibit 23.4 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Black Gold Industries (BGI) is an independent oil producer with production capacity of 500,000 barrels per month. Due to the cost structure of the business, BGI needs to receive $56.50 per barrel in order to remain solvent. On the other side of this situation is Petrochemicals Unlimited (PU) which uses an average of 500,000 barrels of West Texas crude oil in its normal production operations. The nature of PU's business is such that they will financially suffer if they have to pay more than an average of $57.80 per barrel for oil over the next six years. To hedge against their exposure to volatile oil prices, BI and PU contact a swap dealer to arrange the six-year oil swap described below: -Refer to Exhibit 23.4. Describe the transaction that occurs between BGI and the swap dealer if the monthly average oil futures settlement price is $55.50.

Exhibit 23.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Chimichango Industries has decided to borrow $50,000,000.00 for six months in two three-month issues. As the Treasurer, you are concerned that interest rates will rise over the next three months and the rate upon which the second payment will be based will be undesirable. (The amount of Chimichango's first payment will be known at origination.) To reduce the company's interest rate exposure, you decide to purchase a 3 * 6 FRA whereby you pay the dealer's quoted fixed rate of 5.91% in exchange for receiving 3-month LIBOR at the settlement date. In order to hedge her exposure, the dealer buys LIBOR from Megabuks Industries at its bid rate of 5.85%. (Assume a notional principal of $50,000,000.00 and that there are 60 days between month 3 and month 6.) -Refer to Exhibit 23.3. Assuming that 3-month LIBOR is 5.6% on the rate determination day, and the contract specified settlement in arrears at month 6, describe the transaction that occurs between the dealer and Megabuks.

On the settlement date for a forward rate agreement (FRA) contract, the difference between the two interest rates is multiplied by the FRA's par value and prorated by the length of the holding period.

While LIBOR is usually used with forward rate agreements it is rarely used with other interest rate agreements.

The conversion parity price is equal to the par value of a convertible bond divided by the number of shares into which it can be converted.

Exhibit 23.10 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) TexMex Corporation has decided to borrow $50,000,000 for six months in two three-month issues. The corporation is concerned that interest rates will rise over the next three months. Thus, the corporation purchases a 3 * 6 FRA whereby the corporation pays the dealer's quoted fixed rate of 3.5% in exchange for receiving 3-month LIBOR at the settlement date. In order to hedge her exposure, the dealer buys LIBOR from Newport Inc. at its bid rate of 3%. The notional principal is $50,000,000 and that there are 60 days between month 3 and month 6. -Refer to Exhibit 23.10. Suppose that 3-month LIBOR is 4.00% on the rate determination day, and the contract specified settlement in advance, describe the transaction that occurs between the dealer and Newport.

In a forward rate agreement (FRA) two parties agree today to a future exchange of cash flows based on two different interest rates.

Exhibit 23.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) BioTech Industries has debentures outstanding (par value $1,000) convertible into the company's common stock at $30. The coupon rate is 11 percent payable semiannually and they mature in 10 years. -Refer to Exhibit 23.6. At present, what would be the minimum value of the bond?

Exhibit 23.6 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) BioTech Industries has debentures outstanding (par value $1,000) convertible into the company's common stock at $30. The coupon rate is 11 percent payable semiannually and they mature in 10 years. -The exercise price of The American Dairy Company is $17. You purchase the warrants for $4.00 each when American Dairy's stock price is $20.00 a share. Each warrant entitles you to purchase one share of ADC stock. Calculate your percentage gain assuming the warrant premium drops by 50% and you sell your warrants when the stock reaches $30.00 per share.

Exhibit 23.3 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Chimichango Industries has decided to borrow $50,000,000.00 for six months in two three-month issues. As the Treasurer, you are concerned that interest rates will rise over the next three months and the rate upon which the second payment will be based will be undesirable. (The amount of Chimichango's first payment will be known at origination.) To reduce the company's interest rate exposure, you decide to purchase a 3 * 6 FRA whereby you pay the dealer's quoted fixed rate of 5.91% in exchange for receiving 3-month LIBOR at the settlement date. In order to hedge her exposure, the dealer buys LIBOR from Megabuks Industries at its bid rate of 5.85%. (Assume a notional principal of $50,000,000.00 and that there are 60 days between month 3 and month 6.) -Refer to Exhibit 23.3. Assuming that 3-month LIBOR is 5.6% on the rate determination day, and the contract specified settlement in advance, describe the transaction that occurs between the dealer and Chimichango.

A pay-fixed interest rate swap can be viewed as equivalent to

Exhibit 23.2 USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Darden Industries has decided to borrow $25,000,000.00 for six months in two three-month issues. As the Treasurer, you are concerned that interest rates will rise over the next three months and the rate upon which the second payment will be based will be undesirable. (The amount of Darden's first payment will be known at origination.) To reduce the company's interest rate exposure, you decide to purchase a 3 * 6 FRA whereby you pay the dealer's quoted fixed rate of 4.5% in exchange for receiving 3-month LIBOR at the settlement date. In order to hedge her exposure, the dealer buys LIBOR from McIntire Industries at its bid rate of 4%. (Assume a notional principal of $25,000,000.00 and that there are 60 days between month 3 and month 6.) -Refer to Exhibit 23.2. Assuming that 3-month LIBOR is 5.00% on the rate determination day, and the contract specified settlement in arrears at month 6, describe the transaction that occurs between the dealer and Darden.