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FRM Handbook Example 23.9: FRM Exam 2008 Q 3-31

RM1

New Member
Thread starter #1
the question is:

Helman Bank has made a loan of USD 300m @6.5% per annum. Helman enters into a Total Return Swap under which it will pay the interest on the loan plus the change in the MtM value of the loan, and in exchange Helman will receive LIBOR + 50 bp. Settlement payments are made semi-annually. What is the cash flow for Helman on the first settlement date if the MtM value of the loan falls by 2% and LIBOR is 4%.

a) Net inflow of USD 9.0m
b) Net inflow of USD 12m
c) Net outflow of USD 9.0m
d) Net outflow of 12m

The answer gives "C: Net outflow of 9.0m". However is there a typo in the question? Should it read that the MtM value of the loan increases by 2% in order to arrive at this figure?
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
#2
Hi morrin,

I totally agree, this question looks incorrect to me, as Helman should receive the depreciation, not pay for it. Should be:
Helman's inflow = (L+0.5%)/2*300 = 4.5%/2 * 300
Helman's outflow = 6.5%/2*300 + value delta*300 = 6.5%/2*300 + [-2%*300]
Helman's cash flow = inflow - outflow = (L+0.5%)/2*300 - (6.5%/2*300 + [-2%*300])

if L = 4%,
= 4.5%/2*300 - (3.25%*300 - 2%*300)
= [2.25% - (3.25% - 2.0%)] * 300
= (2.25% - 1.25%)*300 = 1.0%*300 = +3.0 million INFLOW
(matches my overall sense: a loss of 1% on the 1/2 spread between 6.5% and 4.5% is overcome by 2% gain on the reference depreciation, which is compensation per the point of the TROR hedge)

The answer incorrectly assumes that reference depreciation of 2% is paid by Helman. If the loan appreciated, it would be:
cash flow = inflow of 2.25% - (outflow of 3.25% + appreciation of 2.0%) = 2.25% - 5.25% = -3% = $9 million OUTFLOW

I am copying this thread to GARP ... GREAT CATCH, congrats

thanks, David
 
#7
the question as it's worded should yield +3. Am I correct?
i.e +6.75 from LIBOR payments, +6 from depreciation in the underlying's value, -9.75 from interest pymts. If someone can confirm that'd be great. Many thanks
 
#8
Hi, Im not sure if this still applies for the FRM Part 2 November 2017 exam? This is still incorrect in the focus review video. Please correct it. Credit Risk Focus Review Video (1 of 2)
 

Nicole Seaman

Chief Admin Officer
Staff member
Subscriber
#9
Hi, Im not sure if this still applies for the FRM Part 2 November 2017 exam? This is still incorrect in the focus review video. Please correct it. Credit Risk Focus Review Video (1 of 2)
Hello @dbansal,

We have not updated the focus review videos recently (they are on our update list for 2018), but this post is already tagged for revision so we will make sure that the new video is correct. Videos take a great deal of time, especially when there is so much material to cover with study notes, writing in-depth PQs, creating new instructional videos, preparing detailed XLS and customer support. So, unfortunately, it is not easy to just "correct it", but we will definitely make sure it is corrected when we create a new video. ;)

Thanks,

Nicole
 
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