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CFA Institute Exam CFA-Level-II Topic 2 Question 98 Discussion

Actual exam question for CFA Institute's CFA-Level-II exam
Question #: 98
Topic #: 2
[All CFA-Level-II Questions]

James Walker is the Chief Financial Officer for Lothar Corporation, a U .S . mining company that specializes in worldwide exploration for and excavation of precious metals. Lothar Corporation generally tries to maintain a debt-to-capital ratio of approximately 45% and has successfully done so for the past seven years. Due to the time lag between the discovery of an extractable vein of metal and the eventual sale of the excavated material, the company frequently must issue short-term debt to fund its operations. Issuing these one to six month notes sometimes pushes Lothar's debt to capital ratio above their long-term target, but the cash provided from the short-term financing is necessary to complete the majority of the company's mining projects.

Walker has estimated that extraction of silver deposits in southern Australia has eight months until project completion. However, funding for the project will run out in approximately six months. In order to cover the funding gap. Walker will have to issue short-term notes with a principal value of $1,275,000 at an unknown future interest rate. To mitigate the interest rate uncertainty, Walker has decided to enter into a forward rate agreement (FRA) based on LIBOR which currently has a term structure as shown in Exhibit 1.

Three months after establishing the position in the forward rate agreement, LIBOR interest rates have shifted causing the value of Lothar's FRA . position to change as well. The new LIBOR term structure is shown in Exhibit 2.

While Walker is estimating the change in the value of the original FRA position, he receives a memo from the Chief Operating Officer of Lochar Corporation, Maria Steiner, informing him of a major delay in one of the company's South African mining projects. In the memo, Stciner states the following: "As usual, the project delay will require a short-term loan to cover funding shortage that will accompany the extra time until project completion. I have estimated that in 210 days, we will require a 90-day project loan in the amount of $2,350,000.1 would like you to establish another FRA position, this time with a contract rate of 6.95%."

Which of the following is least likely a reason Walker has chosen to use forward contracts instead of futures contracts?

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Suggested Answer: A

The customizable nature of forward contracts makes them less equipped for offsetting transactions. In order to create an offsetting transaction, a counterparty must be found that is willing to accept the exact terms of the existing forward contract. This is an unlikely occurrence. Futures on the other hand are standardized and creating an offsetting transaction is simple since the clearinghouse is the counterparty to all transactions and is continually making a market for all futures contracts. (Study Session 16, LOS 59.c)


Contribute your Thoughts:

Mona
1 months ago
You know, if I had to choose between spreadsheets and mining projects, I'd pick the spreadsheets every time. At least they don't involve getting dirty underground.
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Leah
1 months ago
Flexibility is key, baby! Walker's probably high-fiving himself for picking forward contracts over those rigid futures contracts.
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Teri
1 months ago
Less scrutiny by regulatory agencies, huh? I wonder if that's why my company switched to forward contracts - they're probably trying to hide something shady.
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Titus
1 months ago
That's true, but maybe Walker prioritized flexibility over liquidity.
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Jennifer
1 months ago
But wouldn't futures contracts be easier to trade and more liquid?
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Alishia
1 months ago
Ah, the joys of mining operations and their pesky short-term financing needs. I bet Walker's desk is just drowning in spreadsheets and FRA calculations.
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Gretchen
1 months ago
Forward contracts offer more flexibility in terms of contract length and notional principal, which is probably why Walker chose them over futures contracts.
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Luis
23 days ago
B) Less scrutiny by regulatory agencies.
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Frank
24 days ago
A) Greater ability to create offsetting positions.
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Cherrie
2 months ago
Yeah, the ability to customize contract length and principal is important.
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Titus
2 months ago
I think Walker chose forward contracts for flexibility.
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