6.) Assuming Silva's advice is followed and Libor rates are 5% and 6% on 15 October 2013
and 15 December 2013, respectively, the effective annual interest rate on Short Hills
Corporation's loan is closest to:
A. 3.50%.
B. 5.42%.
C. 4.64%.
Watanbe
Kamiko Watanabe, CFA, is a portfolio adviser at Wakasa Bay Securities. She specializes in the use
of derivatives to alter and manage the exposures of Japanese equity and fixed-income
portfolios. She has meetings today with two clients, Isao Sato and Reiko Kondo.
Sato is the manager of the Tsushima Manufacturing pension fund, which has a target asset
allocation of 60% equity and 40% bonds. The fund has separate equity and fixed-income
portfolios, whose characteristics are provided in Exhibits 1 and 2. Sato expects equity values to
increase in the coming two years and, in order to avoid substantial transaction costs now and in
two years, would like to use derivatives to temporarily rebalance the portfolio. He wants to
maintain the current beta of the equity portfolio and the current duration of the bond portfolio.
Exhibit 1: Tsushima Pension Fund
Equity Portfolio Characteristics
Current market value ¥27.5 billion
Benchmark Nikkei 225 Index
Current beta 1.15
Exhibit 2: Tsushima Pension Fund
Bond Portfolio Characteristics
Benchmark Nikko Bond Performance
Index composite
Current duration 4.75
In order to rebalance the pension fund to its target allocations to equity and bonds, Watanabe
recommends using Nikkei 225 Index futures contracts, which have a beta of 1.05 and a current
contract price of ¥1,525,000, and Nikko Bond Performance Index futures, which have a duration
of 6.90 and a current contract price of ¥4,830,000. She assumes the cash position has a duration
of 0.25.
Sato wants to know if other derivatives could be used to rebalance the portfolio. In response,
Watanabe describes the characteristics of a pair of swaps that, together, would accomplish the
same rebalancing as the proposed futures contracts strategy.
Kondo manages a fixed-income portfolio for the Akito Trust. The portfolio’s market value is ¥640
million, and its duration is 6.40. Kondo believes interest rates will rise and asks Watanabe to
explain how to use a swap to decrease the portfolio’s duration to 3.50. Watanabe proposes a
strategy that uses a pay-fixed position in a three-year interest rate swap with semi-annual
payments. Kondo decides he wants to use a four-year swap to manage the portfolio’s duration.
After some calculations, Watanabe tells him a pay-fixed position in a four-year interest rate
swap with a duration of –2.875 would require a notional principal of ¥683 million (rounded to
the nearest million yen) to achieve his goals.
Kondo asks Watanabe whether it would be possible to cancel the swap prior to its maturity.
Watanabe responds with three statements:
Statement 1: If you purchase a swaption from the same counterparty as the original
swap, it is common to require the payments of the two swaps be netted
or cash settled if the swaption is exercised.
Statement 2: You could purchase a payer swaption with the same terms as the original
swap. This approach would protect you from falling fixed swap rates but
at the cost of the premium you would pay to the swaption
counterparty.
Statement 3: During the life of the swap, you could enter into a new pay-floating swap
with the same terms as the original swap, except it would have a
maturity equal to the remaining maturity of the original swap. However,
the fixed rate you receive might be lower than the fixed rate you are
paying on the original swap.
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