) ASSUMING SILVA'S ADVICE IS FOLLOWED AND LIBOR RATES ARE 5% AND 6%...

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.