Assignment No - 4

Mini Case No - 1
Derrick honny, CFA, has operated his own portfolio management business for many years. Several of his
clients have fixed income positions, and one of honnys analysts has advised him that the firm can
improve the performance of these portfolios through swaps. honny has begun investigating the
properties of swaps. his plan is first to establish some minor positions to gain some experience before
actively using swaps on behalf of his clients.
honny knows that the most basic type of swap is the plain vanilla swap where one counterparty pays
LiBor as the floating rate, and the other counterparty pays a fixed rate determined by the swap market.
he feels this would be a good place to begin and plans to engage in a 2-year, annual-pay plain vanilla
swap where he pays LiBor and receives the fixed swap rate from the other counterparty. to get an idea
regarding the swap rate he can expect on the 2-year swap, he collects market data on LiBor. Details
are shown in Figure 1.

He finds that when taking a swap position that there are other types of risks to consider. Honny thinks
he should try to hedge some of these other types of risk the contract might have. He first focuses on
credit risk. He finds it interesting that the credit risk of a swap typically varies over the time between
inception and maturity. Also, there is something called potential credit risk, which also varies over the
life of the swap. Sometimes current credit risk is more of a concern than potential credit risk, sometimes
potential credit risk is more of a concern than current credit risk, and sometimes they are of equal
concern.
As he learns more, Honny considers other possible swap positions that he might take. He is considering
entering into a 4-year swap instead of a 2-year swap, but he knows this can be more risky. Instead of a
4-year swap, he investigates taking the 2-year swap position, which he first considered, and then taking
a position in a derivative that will allow him to extend the horizon two more years when the 2-year swap
expires. He finds that there are two appropriate varieties of derivatives that can be used to achieve this
goal: (1) swaptions and (2) forward swaps.
One of Honnys clients, George Rosen, is aware of Honnys plans to use swaps and other derivatives in
the management of his clients portfolios. Rosen has a position for which he thinks a swap strategy will
be appropriate. Rosen asks Honny to arrange for him a payer swaption that matures in three years.
Honny is uncertain of the level of Rosens familiarity with swaps and swaptions, so he wants to make
sure that the derivative is appropriate for the client. He asks Rosen exactly what he intends to
accomplish by entering into the swaption.
Honny realizes that more of his clients may approach him about using swaptions. He wants to be able to
advise his clients about how to use them, how to close positions early, and how to settle positions at
maturity. He finds that there are several ways to close a swaption position and to settle a swaption at
maturity.
1. which of the following would be the least appropriate alternative investments to replicate the
exposure Honny will get from the 2-year, plain vanilla swap position that he plans to take?
A. Long a series of interest rate puts and short a series of interest rate calls.
B. Short a series of bond futures.
C. Short a series of forward rate agreements.
2. Given the 1- and 2-year rates, the 2-year swap fixed rate would be closest to:
A. 4.20%.
B. 4.51%.
C. 4.80%.
3. At the inception of a swap, the:
A. potential credit risk is greater than the current credit risk.
B. current credit risk is greater than the potential credit risk.
C. current credit risk is equal to the potential credit risk, and both are equal to zero.
4. to have the right to extend the 2-year swap position when the swap expires, the most appropriate
position for Honny would be to long a:
A. payer swaption.
B. receiver swaption.
C. forward swap.
5. which of the following is least likely a reason that rosen might want to enter into a swaption with a
maturity of three years? to:
A. close an existing swaption position.
B. hedge a floating rate bond that he owns with three years to maturity.
C. have the right to terminate a 5-year swap early.
6. which of the following is the least likely way the market value of a swaption at expiration can be
received?
A. As an annuity settlement.
B. By paying the swap spread.
C. By entering into the underlying swap.

Mini Case No 2