Rone Company asks Paula Scott, a treasury analyst, to recommend a flexible way to manage the company’s financial risks.
Two years ago, Rone issued a $25 million (U.S.$), five-year floating rate note (FRN). The FRN pays an annual coupon equal to one-year LIBOR plus 75 basis points. The FRN is non-callable and will be repaid at par at maturity.
Scott expects interest rates to increase and she recognizes that Rone could protect itself against the increase by using a pay-fixed swap. However, Rone’s Board of Directors prohibits both short sales of securities and swap transactions. Scott decides to replicate a pay-fixed swap using a combination of capital market instruments.
a. Identify the instruments needed by Scott to replicate a pay-fixed swap and describe the required transactions.
b. Explain how the transactions in Part a are equivalent to using a pay-fixed swap.