Questions 37 through 42 relate to Risk Management Applications of Derivatives.
Joenia Dantas Case Scenario
Joenia Dantas is a financial risk manager for Alimentos Serra (AS), a Brazilian
manufacturer and exporter of soybean-based food products. AS is a privately held
corporation, wholly owned by Cesar Serra. Recently, AS took out a R25,000,000, four-
year, floating-rate bank loan requiring semi-annual payments of interest based on SELIC
(Banco Central do Brasil’s overnight lending rate) plus a spread of 4.50 percent and
repayment of principal at maturity. Serra believes that interest rates will rise in the near
future and worries that AS will be unable to absorb the higher loan costs associated with
an increase in rates. Dantas tells him that she will convert the loan to a 10.80 percent
fixed rate by entering into the pay-fixed side of a four-year, R25,000,000 notional
principal interest rate swap with semi-annual payments that exchanges SELIC for a fixed
rate of 10.80 percent. She explains that the swap will act as a hedge for the loan,
reducing the company’s net cash flow risk and net market value risk.
Discussions with Dantas about using interest rate swaps to reduce risk cause Serra to
think about the fixed income portion of his personal investment portfolio, which includes
R12.0 million in bonds that have a modified duration of 5.50 years. Serra’s beliefs about
rising interest rates make him want to reduce the bond portfolio’s modified duration to
2.00 years using interest rate swaps. In order to determine the correct swap position, he
needs to learn how to calculate the modified duration of a swap. He asks Dantas how to
do this. She explains it to him, using the example described in Exhibit 1.
Exhibit 1
Data for Swap Example
Maturity of swap 4 years
Payment structure semiannual
Fixed rate on swap 10.8%
Duration of 4-year, 10.8% coupon bond 2.91 years
Serra decides to use a swap that has a modified duration of -2.40 years for the pay-fixed
side to reduce his bond portfolio’s duration to the desired level.
Dantas knows that AS currently needs to borrow an additional R30,000,000 for 5 years to
fund its growth. Brazilian credit markets have tightened and it would cost 17.70 percent
per year to borrow this amount locally, but AS can obtain a yen-denominated loan at a
fixed rate of 9.50 percent. This would expose it to substantial currency risk. A 5-year
currency swap is available in which AS would pay interest in real to the counterparty at
12.20 percent and receive interest in yen from the counterparty at 7.10 percent. The
current exchange rate is ¥40/R.
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In addition to the current needs, in six months AS will enter into a four-year, quarterly
payment, R50,000,000 loan to fund local projects. Dantas expects to borrow these funds
at a floating rate and convert the loan to fixed using an interest rate swap. She explains to
Serra that AS can commit to a fixed rate of 14.3 percent for the future loan by buying a
payer swaption today with an exercise rate of 14.3 percent for a four-year swap with
quarterly payments and a notional principal amount of R50,000,000.
37. Dantas’ explanation of her plan to convert the four-year loan from floating to
fixed is most likely:
A. correct.
B. incorrect, because the fixed loan rate will be 15.30%.
C. incorrect, because the swap should be entered to pay SELIC.
38. Dantas’ characterization of the interest rate swap as a hedge for the bank loan is
most likely:
B. incorrect, because the swap increases the cash flow risk of AS.
C. incorrect, because the swap increases the market value risk of AS.
39. The duration of the interest rate swap described in Exhibit 1 is closest to:
A. -2.41 years.
B. -2.66 years.
C. -2.91 years.
40. In order to reduce the duration of his bond portfolio to the desired level, Serra will
enter into a pay-fixed swap position with a notional principal closest to:
A. R17.5 million.
B. R27.5 million.
C. R42.0 million.
41. If AS enters into the yen-real currency swap with a notional principal of ¥1.2
billion (R40.0 million), net yen interest expense for each year is closest to:
A. ¥28.80 million.
B. ¥85.20 million.
C. ¥114.00 million.
42. Dantas’ description of the use of a swaption in anticipation of future borrowing is:
B. incorrect, because AS should enter into a receiver swaption.
C. incorrect, because the fixed rate paid on the loan may be less than 14.3%.
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