Agrawal is considering issuing $10 million 6.75% coupon bonds to finance an expansion. Alternatively, Agrawal could borrow the funds in the Eurodollar market using a series of 6-month LIBOR contracts. A swap contract matching the maturity of the bonds is available. The swap uses 6-month LIBOR as the floating rate component. Identify the interest rate swap that Agrawal should use to evaluate the two alternatives. A. Agrawal would use a pay fixed, receive floating intrest rate swap B. Agrawal would use a pay floating, receive fixed interest rate swap C. Agrawal would use a total return equity payer swaption to evaluate the two borrowing options. D. Given that Agrawal is a US corporation and is considering borrowing in the Eurodollar market, Agrawal would need to use a currency swap to evaluate transaction. I don’t think I understand the question, anyone would like to shed some lights? Thanks.
B is what i’d say.
Could you explain the question?
The question is not very clear, but it appears that they are interested in paying a floating rate, but only have the ability to issue debt with a fixed rate. Therefore, they will pay the fixed rate on the debt, receive that same fixed rate in the swap to cancel that payment out, and pay the floating rate on the swap that is linked to 6-month LIBOR which effectively transforms their fixed debt into floating debt.
it is B, could be D, so it is TRICKY. basically, they want you to know how plain vanilla swaps work, which involve fixed and floating pmts being swapped. In Plain vanillas, at least one party has to pay a floating Floating pmts are done @ LIBOR, which is a lending rate on eurodollar time deposits. people see eurodollar and think currency, buy all a eurodollar is a loan outside the US but denominated in US dollars. keep that in mind
hopetobeat Wrote: ------------------------------------------------------- > Agrawal is considering issuing $10 million 6.75% > coupon bonds to finance an expansion. > Alternatively, Agrawal could borrow the funds in > the Eurodollar market using a series of 6-month > LIBOR contracts. A swap contract matching the > maturity of the bonds is available. The swap uses > 6-month LIBOR as the floating rate component. > Identify the interest rate swap that Agrawal > should use to evaluate the two alternatives. > > A. Agrawal would use a pay fixed, receive floating > intrest rate swap > B. Agrawal would use a pay floating, receive fixed > interest rate swap > C. Agrawal would use a total return equity payer > swaption to evaluate the two borrowing options. > D. Given that Agrawal is a US corporation and is > considering borrowing in the Eurodollar market, > Agrawal would need to use a currency swap to > evaluate transaction. > > I don’t think I understand the question, anyone > would like to shed some lights? Thanks. Check the CFA Errata The final line of the question is - “convert the Eurodollar borrowing to the equivalent of issuing fixed income bonds”
so is B the answer?
Answer is B.
We are all wrong! Answer is A. Explain as follows: Ag would owe floating rate interest on the LIBOR loan. The received floating part of the swap would offset those payments, while the pay fixed side of the swap resembles the fixed coupon payment on the bonds. What a question!