THROUGH 54 RELATE TO RISK APPLICATION OF SWAP STRATEGIES...

Questions 49 through 54 relate to Risk Application of Swap Strategies TSM Derivatives Trading (TSMDT) Case Scenario TSM Derivatives Trading (TSMDT) is a derivatives trading group situated in London, U.K. Amongst the derivative contracts it executes, the group locates interest rate, equity, and commodity swap counterparties by acting as a dealer to parties seeking to hedge their positions. In addition to solely offering dealership services, the group routinely undertakes the dual role of derivatives dealer for and acts as swap counterparty to its customers for an additional fee. Kyote Inc. is one of TSMDT’s customers. Kyote Inc. is a wholesale manufacturer producing cornmeal and other corn-based edible products. For the purposes of producing these products, the manufacturer regularly purchases raw corn. Kyote Inc.’s finished products are distributed to retailers to be further sold to individual retail customers. To secure the purchase price of raw corn, Kyote Inc. plans to enter into a derivative contract. TSMDT’s senior derivatives trader, Josef Silos, recommends the manufacturer enter into a three year commodity swap contract on corn. The 1-year, 2-year, and 3-year corn forward prices are £125, £150, and £165, respectively. The 1-year, 2-year, and 3-year interest rates are 7.5%, 8.0%, and 9.5%, respectively. During an initial meeting with Kyote Inc.’s head of risk management, Silos makes the following statements: Statement 1: “Entering into the commodity swap contract on corn will give your firm (Kyote Inc.) a position equivalent to three forward contracts. Statement 2: “Another way to look at it is, by entering into the commodity swap contract, your firm will effectively be making a 2-year loan to TSMDT.” Statement 3: “The benefit of entering into a commodity swap contract is that your firm’s counterparty credit risk becomes virtually non-existent.” The head of risk management responds to Silos’ statements by asking the following two questions. Question 1: “If forward prices and interest rates change following contract initiation, will it have an impact on the value of our firm’s swap contract?” Question 2: “If, in the future, our demand for corn needs to be increased (decreased) to accommodate an unexpected demand rise (fall) for cornmeal and we are met with seasonally high corn prices, is there a way to accommodate corn price and demand changes when pricing commodity corn swap contracts?” 49. If Kyote Inc. decides to enter into the three-year commodity swap contract on corn, it will most likely: A. make a fixed payment and receive a floating payment on the swap B. make a floating payment and receive a fixed payment on the swap. C. make a fixed payment on the swap only. 50. The effective unit price on the 3-year swap is closest to: A. £119.51/bushel B. £145.56/bushel C. £165.55/bushel 51. TSMDT has entered into a three-year swap contract with Kyote Inc. as a dealer and swap counterparty. Assuming TSMDT hedges corn price risk on the swap contract by entering into three forward contracts, the derivative group’s net cash flow position on the swap and forward contract in the second year is closest to: A. – £4.44 B. + £4.44 C. + £15.55 52. In context of the statements made by Silos to Kyote Inc.’s head of risk management, which of the following statements is most likely incorrect? A. All three statements. B. 1 and 3 only. C. 2 only. 53. The most appropriate response to the risk management head’s first question is: A. there will be no impact on the value of the swap contract. B. the value of the swap contract will change, increase or decrease, only in response to a change in corn forward prices. C. the value of the swap contract will change, increase or decrease, in response to a change in the value of either of the two variables, corn forward prices and forward interest rates. 54. The most appropriate response to the question 2 is: A. Yes. B. No, commodity swap contracts may only accommodate forward price changes. C. No, commodity swap contracts may not be able to accommodate either variable commodity demand or forward prices.