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Hello i really need some help with this question from SD-2020- AFM Question 3(a)
There is this “SWAP” . i dont understand why Fitzharris Co pays (3·80%) while counterparty 3·80%. How do we get the 3.8% .
Is there any possibility for you to explain the whole question 3 , i had been trying to study the answer for the whole day and still dont really quite get it.
Thank you and please stay safe
.Sorry but I do not have the time at the moment because I have just spent over two hours answering questions.
I will answer later today or else tomorrow morning 🙂
If there was no swap and F borrows fixed they would be paying 4.6% and if the counterparty borrowed floating then they would be paying L + 1.30% So in total they would be paying L + 5.9%
If instead the borrowed the other pay and then swapped, we would have F borrowing at L + 0.50% and the counterparty borrowing at 4.8%. So a total of L + 5.3%
Therefore there is a saving to be made of 0.6% (before bank charges) and since they are sharing the gain equally they will both save 0.3% as against what would have happened if the was no swap.
As in my first sentence, if there was no swap F would be paying a fixed 4.6%. The swapping must therefore end up with him paying 4.3% (before bank fees).
They can settle up in various ways, but the normal one is as follows:
F borrows floating and so pays L + 0.5%
F received L from the counterparty and so is now paying a net 0.5%However, F must end up paying 4.3%, (as above) ands F must pay to the counterparty the missing figure of 4.3 – 0.5 = 3.80%.
F is now paying a total of 4.3% (plus of course 0.5% in bank fees).
Have you watched my free lectures on this.
As far as everything else in Question 3 is concerned, I explain everything in my free lectures on interest rate risk management and you cannot expect me to effectively type them all out her.
Have you watched them all? And have you worked through all of the technical articles on this on the ACCA website?
Hello John
Apologies if this is a silly question, but why do we assume that Fitzharris normally borrow at fixed rate?
And may i just say a massive thank you for your lectures on this area. Have been struggling with understanding these areas and your lectures have made it a lot clearer so thank you 🙂
It is the fact that in the paragraph of the question headed up “Transaction to be hedged” it states that they can borrow at a floating rate and that they are considering hedging the risk by using a swap.
(The fact that the bank has quoted a fixed rate of 4.6% is only mentioned in the paragraph afterwards that gives details of the swap.)
Hello.
I have a slight doubt. In the FITZHARRIS CO questions, why are CALL OPTIONS even being considered when deciding whether we will exercise the option or not? If it is a BORROWING, we will only consider PUT options according to the rule, right? I don’t understand why they have taken CALL options into consideration and then they are exercised them.
Thank you.
You are correct that when borrowing money we will buy put options to limit the maximum interest.
However the question asks about creating a collar, and we create a collar by buying a put option (to limit the maximum interest) and sell a call option (which puts a limit on the minimum interest).
Do read section 8 in Chapter 20 of our free lecture notes to find a full explanation of this.
Thank you very much, sir. Your lectures have helped me to a great extent. I have relied on your lectures since the very start of my ACCA journey and now this is my last paper. Thank you.
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