Joenia Dantas is a financial risk manager for Alimentos Serra (AS), a Brazilian manufacturer and exporter of soybean-based food products. AS is a privately held corporation, wholly owned by Cesar Serra. Recently, AS took out a R25,000,000, four-year, floating-rate bank loan requiring semi-annual payments of interest based on SELIC (Banco Central do Brasil's overnight lending rate) plus a spread of 4.50 percent and repayment of principal at maturity. Serra believes that interest rates will rise in the near future and worries that AS will be unable to absorb the higher loan costs associated with an increase in rates. Dantas tells him that she will convert the loan to a 10.80 percent fixed rate by entering into the pay-fixed side of a four-year, R25,000,000 notional principal interest rate swap with semi-annual payments that exchanges SELIC for a fixed rate of 10.80 percent. She explains that the swap will act as a hedge for the loan, reducing the company's net cash flow risk and net market value risk.Discussions with Dantas about using interest rate swaps to reduce risk cause Serra to think about the fixed income portion of his personal investment portfolio, which includes R12.0 million in bonds that have a modified duration of 5.50 years. Serra's beliefs about rising interest rates make him want to reduce the bond portfolio's modified duration to 2.00 years using interest rate swaps. In order to determine the correct swap position, he needs to learn how to calculate the modified duration of a swap. He asks Dantas how to do this. She explains it to him, using the example described in Exhibit 1.Exhibit 1Data for Swap ExampleMaturity of swap4 yearsPayment structuresemiannualFixed rate on swap10.8%Duration of 4-year, 10.8% coupon bond2.91 yearsSerra decides to use a swap that has a modified duration of -2.40 years for the pay-fixed side to reduce his bond portfolio's duration to the desired level.Dantas knows that AS currently needs to borrow an additional R30,000,000 for 5 years to fund its growth. Brazilian credit markets have tightened and it would cost 17.70 percent per year to borrow this amount locally, but AS can obtain a yen-denominated loan at a fixed rate of 9.50 percent. This would expose it to substantial currency risk. A 5-year currency swap is availablein which AS would pay interest in real to the counterparty at 12.20 percent and receive interest in yen from the counterparty at 7.10 percent. The current exchange rate is ¥40/R.In addition to the current needs, in six months AS will enter into a four-year, quarterly payment, R50,000,000 loan to fund local projects. Dantas expects to borrow these funds at a floating rate and convert the loan to fixed using an interest rate swap. She explains to Serra that AS can commit to a fixed rate of 14.3 percent for the future loan by buying a payer swaption today with an exercise rate of 14.3 percent for a four-year swap with quarterly payments and a notional principal amount of R50,000,000.
1.Dantas' explanation of her plan to convert the four-year loan from floating to fixed is most likely:A. correct.B. incorrect, because the fixed loan rate will be 15.30%.C. incorrect, because the swap should be entered to pay SELIC
2. Dantas' characterization of the interest rate swap as a hedge for the bank loan is most likely:A. correct.B. incorrect, because the swap increases the cash flow risk of AS.C. incorrect, because the swap increases the market value risk of AS
3. The duration of the interest rate swap described in Exhibit 1 is closest to:A. -2.41 years.B. -2.66 years.C. -2.91 years.
4. In order to reduce the duration of his bond portfolio to the desired level, Serra will enter into a pay-fixed swap position with a notional principal closest to:A. R17.5 million.B. R27.5 million.C. R42.0 million.
5. If AS enters into the yen-real currency swap with a notional principal of ¥1.2 billion (R40.0 million), net yen interest expense for each year is closest to:A. ¥28.80 million.B. ¥85.20 million.C. ¥114.00 million.
6. Dantas' description of the use of a swaption in anticipation of future borrowing is:A. correct.B. incorrect, because AS should enter into a receiver swaption.C. incorrect, because the fixed rate paid on the loan may be less than 14.3%.