Deck 23: Swap Contracts, Convertible Securities and Other Embedded Derivatives

Question 1

Consider a pension fund manager that wishes to convert €10 million from notes paying LIBOR to stocks, using an equity swap. The equity swap should be structured so that

A) the pension fund receives LIBOR and pays an equity return based on notional principal of €5 million.
B) the pension fund pays LIBOR and receives an equity return based on notional principal of €5 million.
C) the pension fund receives LIBOR and pays an equity return based on notional principal of €10 million.
D) the pension fund pays LIBOR and receives an equity return based on notional principal of €10 million.
E) none of the above.

Answer 1

D

Question 2

____ have coupons denominated in a currency other than that of their principal.

A) Eurodollar bonds
B) Euromarket bonds
C) Dual currency bonds
D) Bi-currency bonds
E) Forward currency bonds

Answer 2

B

Question 3

Refer to the previous question. Assuming that 3-month LIBOR is 5.00% on the rate determination day, and the contract specified settlement in advance, describe the transaction that occurs between the dealer and Darden.

A) The dealer is obligated to pay Darden €30 864.20.
B) The dealer is obligated to pay Darden €19 359.61.
C) Darden is obligated to pay the dealer €19 359.61.
D) Darden is obligated to pay the dealer €30 864.20.
E) None of the above

Answer 3

A

Question 4

Refer to the following information. A company buys an interest rate cap that pays the difference between LIBOR and 8% if LIBOR exceeds 8%. Current LIBOR is 7%. The amount of the option is €2 500 000 and the settlement is every 6 months. Assume a 360 day year.
Find the payoff if LIBOR closes at 8.2%.

A) €0.00
B) €25 000.00
C) €50 000.00
D) −€25 000.00
E) −€50 000.00

Question 5

____ are debt instruments that have their principal or coupon payments tied to some other underlying variable.

A) Systematic notes
B) Variable rate notes
C) Structured notes
D) Embedded notes
E) PC bonds

Question 6

The intrinsic value of a warrant is calculated as:

A) (Market price of common stock + Warrant exercise price) x Number of shares specified by warrant.
B) (Market price of common stock − Warrant exercise price) x Number of shares specified by warrant.
C) (Market price of common stock + Warrant exercise price)/Number of shares specified by warrant.
D) (Market price of common stock − Warrant exercise price)/Number of shares specified by warrant.
E) None of the above.

Question 7

An advantage of convertible bonds is

A) investors get the upside potential of a bond.
B) investors get the upside potential of a stock.
C) issuing firm can get a lower rate of interest on its debt.
D) a and b.
E) b and c.

Question 8

Which of the following is not true about interest rate swaps?

A) Payments are based on a notional principal.
B) Floating rate payers profit if interest rates fall.
C) Payments can be quarterly as well as semi-annually.
D) Parities exchange debt obligations.
E) Default risk is a possibility in the swaps market.

Question 9

All of the following are normal characteristics of a convertible bond, except

A) conversion at the option of the issuer.
B) conversion into a fixed number of shares of common stock.
C) a conversion price initially above the market price of the common stock.
D) an interest rate lower than that on straight debentures.
E) subordination.

Question 10

The conversion price parity for a convertible bond is defined as

A) market price of convertible bond/conversion ratio.
B) market price of convertible bond x conversion ratio.
C) market price of convertible bond − conversion ratio.
D) market price of convertible bond + conversion ratio.
E) none of the above.

Question 11

Which of the following is not a characteristic of warrants?

A) They are sweeteners added to other security issues.
B) After the initial sale, warrants are detachable.
C) They pay no dividends.
D) They provide no voting rights.
E) No dilution protection is offered in the event of stock dividends or stock splits.

Question 12

Suppose the premium on a three year, four per cent floor is equal to the premium on a three year, eight per cent cap. This combination is referred to as

A) zero-cost warrant
B) zero-premium strap
C) zero-cost collar
D) zero-premium swap
E) zero-cost FRA

Question 13

Refer to the following information. Darden Industries has decided to borrow €25 000 000.00 for six months in two three-month issues. As the Treasurer, you are concerned that interest rates will rise over the next three months and the rate upon which the second payment will be based will be undesirable. (The amount of Darden's first payment will be known at origination.) To reduce the company's interest rate exposure, you decide to purchase a 3 x 6 FRA whereby you pay the dealer's quoted fixed rate of 4.5% in exchange for receiving 3-month LIBOR at the settlement date. In order to hedge her exposure, the dealer buys LIBOR from McIntire Industries at its bid rate of 4%. (Assume a notional principal of €25 000 000.00 and that there are 60 days between month 3 and month 6.)
Assuming that 3-month LIBOR is 5.00% on the rate determination day, and the contract specified settlement in arrears at month 6, describe the transaction that occurs between the dealer and Darden.

A) The dealer is obligated to pay Darden €19 500
B) The dealer is obligated to pay Darden €31 250
C) Darden is obligated to pay the dealer €19 500
D) Darden is obligated to pay the dealer €31 250
E) None of the above

Question 14

The minimum price of a convertible bond is

A) Min (Bond Value, Conversion Value).
B) Max (Bond Value, Conversion Value).
C) Min (Stock Value, Conversion Value).
D) Max (Stock Value, Conversion Value).
E) None of the above.

Question 15

The writer of a ____ agreement makes settlement payments when LIBOR is greater than the striking rate of the agreement.

A) Swap
B) Cap
C) Floor
D) Collar
E) None of the above