Three years ago, you entered into a five-year interest rate swap agreement by agreeing to pay a fixed rate of 7 percent in exchange for six-month LIBOR. If your counterparty were to default today when the fixed rate on a new two-year swap is 6.5 percent, would you experience an economic loss?
Explain.
6. The Board of Bontemps International (BI) will substantially increase the company's defined-benefit pension fund's allocation to international equities in the future. However, the board wants to retain the ability to reduce temporarily this exposure without making the necessary transactions in the cash markets. You develop a way to meet the board's condition:
BI enters into a swap arrangement with Bank A for a given notional amount and agrees to pay the EAFE (Europe, Australia, and Far East) Index return (in U.S. dollars) in exchange for receiving the LIBOR interest rate plus 0.2 percent (20 basis points). On the same notional amount, BI arranges another swap with Bank B under which BI receives the return on the S&P 500 Index (in U.S. dollars) in exchange for paying the interest rate on the U.S. Treasury bill plus 0.1
percent (10 basis points). Both swaps would be for a one-year term.
From BI's perspective, identify and briefly describe
(a) the major risk that this transaction would eliminate,
(b) the major risk that this transaction would not eliminate (i.e., retain), and
(c) three risks that this transaction would create.
7. A pension plan is currently underfunded by about $400 million. This situation will be resolved soon when the plan sponsor issues a $400 million private placement two-year floater bond that will be placed into the plan under a stipulation that it will be held to maturity. This bond will carry an interest rate of 50 basis points (or 0.5 percent) above the rate of U.S. Treasury bills. The actual, as well as desired, asset allocation is 50 percent bonds and 50 percent domestic equities.
When the bond is added, the portfolio will become significantly overweighted in fixed-incomeinstruments. In addition, the overall duration will be decreased for the next two years. When the bond matures, the proceeds can be used to buy equities and liquid bonds with longer maturities. One Board member has suggested that futures or swaps could be used to keep the portfolio allocation in
line with the desired asset allocation during the two-year period before the floater's maturity.
a. Describe the transactions needed to restore the desired 50 percent/50 percent portfolio allocation using each of the following two derivative instruments: (1) futures, and (2) swaps.
b. Discuss one advantage and one disadvantage of using futures instead of swaps to implement this strategy.