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CFA Institute Exam CFA-Level-II Topic 1 Question 92 Discussion

Actual exam question for CFA Institute's CFA Level II Chartered Financial Analyst exam
Question #: 92
Topic #: 1
[All CFA Level II Chartered Financial Analyst Questions]

Rock Torrey, an analyst for International Retailers Incorporated (IRI), has been asked to evaluate the firm's swap transactions in general, as well as a 2-year fixed for fixed currency swap involving the U .S . dollar and the Mexican peso in particular. The dollar is Torrey's domestic currency, and the exchange rate as of June 1,2009, was $0.0893 per peso. The swap calls for annua! payments and exchange of notional principal at the beginning and end of the swap term and has a notional principal of $100 million. The counterparty to the swap is GHS Bank, a large full-service bank in Mexico.

The current term structure of interest rates for both countries is given in the following table:

Torrey believes the swap will help his firm effectively mitigate its foreign currency exposure in Mexico, which sterns mainly from shopping centers in high-end resorts located along the eastern coastline. Having made this conclusion, Torrey begins writing his report for the management of IRI. In addition to the terms of the swap, Torrey includes the following information in the report:

* Implicit in the currency swap under consideration is a swap spread of 75 basis points over 2-year U .S . Treasury securities. This represents a 10 basis point narrowing of the spread as compared to this time last year. Thus, we can assume that the credit risk of the global credit market has decreased. Unfortunately, the decline provides no insight into the credit risk of the individual currency swap with GHS Bank, which could have increased.

* In order to decrease the counterparty default risk on the currency swap, we will need to utilize credit derivatives between the beginning and midpoint of the swap's life when this particular risk is at its highest. This is a significantly different strategy than we normally use with interest rate swaps. For interest rate swaps, counterparty default risk peaks at the middle of the swap's life, at which point we utilize credit derivative CQuntermeasures to offset the risk.

* Because currency swaps almost always include netting agreements and interest rate swaps can be structured to include mark-to-market agreements, we can significantly reduce the credit risk of these swap instruments by negotiating swap contracts that include these respective features. When negotiating these features is not possible, credit risk can be reduced by using off-market swaps that do not require an initial payment from IRI.

Six months have passed (180 days) since Torrey issued his report to IRI's management team, and the current exchange rate is now $0,085 per peso. The new term structure of interest rates is as follows:

Determine whether the excerpt from Torrey's report regarding the timing of peak credit risk is correct with regard to currency swaps and interest rate swaps.

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Suggested Answer: B

The assumption is that the credit risk is low at the beginning of the swap because each counterparty accepted the creditworthiness of the other in order to initiate the transaction. By the middle of the swap's life, payments are coming due and credit risk increases. In interest rate swaps, the credit risk would then decline as the remaining payments were made towards the end of the swap's life. For currency swaps, however, with the exchange of notional principal, the final payment keeps credit risk high through the end of the swap life, causing it to peak between the middle and the end of the swap's life. (Study Session 17, LOS 6l.i)


Contribute your Thoughts:

Mireya
23 days ago
I believe Torrey is correct about both currency and interest rate swaps.
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Kaycee
23 days ago
Nice to see a question that delves into the nuances of swap contracts. I bet this one has the exam-takers scratching their heads, but it's an important concept to understand.
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Keneth
3 hours ago
B) Torrey is only correct regarding interest rate swaps.
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Herminia
5 days ago
A) Torrey is only correct regarding currency swaps.
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Ruth
26 days ago
I agree, it's important to consider credit risk in swaps.
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Rosio
29 days ago
This is a pretty technical question, but the information provided is comprehensive. I'm curious to see the correct answer and how it compares to Torrey's assessment.
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Noel
22 days ago
A) Torrey is only correct regarding currency swaps.
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Lashaun
1 months ago
Hmm, the part about counterparty default risk being highest at the midpoint of interest rate swaps doesn't sound quite right to me. I'd double-check that detail.
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Margart
1 months ago
I think Torrey's report makes sense.
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Ruth
1 months ago
The report seems to have a good grasp of the differences between currency and interest rate swaps. I think Torrey is on the right track with his analysis.
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Beatriz
17 days ago
It's important to consider the timing of peak credit risk in both currency and interest rate swaps.
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Daren
22 days ago
The use of netting agreements in currency swaps can really help reduce credit risk.
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Freeman
23 days ago
I think Torrey's approach to mitigating credit risk with credit derivatives is smart.
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Stephanie
26 days ago
I agree, Torrey's analysis on the differences between currency and interest rate swaps is spot on.
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