48 RELATE TO DIRECTOR SECURITIES. WALTER SKINNER, CFA, MA...

Questions 43-48 relate to Director Securities.

Walter Skinner, CFA, manages a bond portfolio for Director Securities. The bond portfolio is part

of a pension plan trust set up to benefit retirees of Thomas Steel Inc. As part of the investment

policy governing the plan and the bond portfolio, no foreign securities are to be held in the

portfolio at any time and no bonds with a credit rating below investment grade are allowable for

the bond portfolio. In addition, the bond portfolio must remain unleveraged. The bond portfolio is

currently valued at $800 million and has a duration of 6.50. Skinner believes that interest rates

are going to increase, so he wants to lower his portfolio's duration to 4.50. He has decided to

achieve the reduction in duration by using swap contracts. He has two possible swaps to choose

from:

1. Swap A: 4-year swap with quarterly payments.

2. Swap B: 5-year swap with semiannual payments.

Skinner plans to be the fixed-rate payer in the swap, receiving a floating-rate payment in

exchange. For analysis, Skinner assumes the duration of a fixed rate bond is 75% of its term to

maturity.

Several years ago, Skinner decided to circumvent the policy restrictions on foreign securities by

purchasing a dual currency bond issued by an American holding company with significant

operations in Japan. The bond makes semiannual fixed interest payments in Japanese yen but

will make the final principal payment in U.S. dollars five years from now. Skinner originally

purchased the bond to take advantage of the strengthening relative position of the yen. The

result was an above average return for the bond portfolio for several years. Now, however, he is

concerned that the yen is going to begin a weakening trend, as he expects inflation in the

Japanese economy to accelerate over the next few years. Knowing Skinner's situation, one of his

colleagues, Bill Michaels, suggests "You need to offset your exposure to the Japanese yen."

Skinner has also spoken to Orval Mann, the senior economist with Director Securities, about his

expectations for the bond portfolio. Mann has also provided some advice to Skinner in the

following comment:

"I know you expect a general increase in interest rates, but I disagree with your assessment of

the interest rate shift. I believe interest rates are going to decrease. Therefore, you will want to

synthetically remove the call features of any callable bonds in your portfolio by purchasing a

payer interest rate swaption."

...

From Skinner's perspective, the duration of Swap A would be closest to:

A) −2.50.

B) −2.88.

C) −3.00.

Question #44 of 60

Determine the approximate notional principal required for Skinner to achieve a portfolio duration

of 4.5 using Swap B.

A) $320 million.

B) $457 million.

C) $492 million.

Question #45 of 60

To implement Michaels's suggested strategy to offset the dual currency bond's yen exposure

Skinner should enter a:

A) pay JPY versus receive USD currency swap.

B) special receive USD versus pay JPY currency swap with no notional principal exchange.

C) special pay USD versus receive JPY currency swap with no notional principal exchange.

Question #46 of 60

After considering Mann's comments, Skinner reverses his views and believes interest rates will

decline. To hedge the risk of the callable bonds he owns in his portfolio with swaptions, Skinner

should:

A) sell payer swaptions.

B) sell receiver swaptions.

C) buy receiver swaptions.

Question #47 of 60

After his long conversation with Director Securities' senior economist, Orval Mann, Skinner has

completely changed his outlook on interest rates and has decided to extend the duration of his

portfolio. The most appropriate strategy to accomplish this objective using swaps would be to

enter into a swap to pay:

A) fixed and receive floating.

B) floating and receive fixed.

C) floating and receive floating.

Question #48 of 60

Skinner has been consulting with Dwayne Barter, a client of Director Securities and CFO of a

large corporation. Barter is interested in using interest rate swaps to convert his firm's floating

rate debt to fixed rate debt. Barter is planning to enter into a swap to pay a fixed rate and receive

a floating rate in exchange. How would the swap impact the firm's debt?

A) Increase the market value risk.

B) Reduce both the cash flow risk and market value risk.

C) Increase the cash flow risk.

Question #49 of 60