FINANCIAL ENGINEERING 2020-21 Assignment One1

This is an individual piece of work
Briefing
This assignment provides you with the opportunity to learn how to apply swaps to financial
problems. It is an example of the application of swaps in financial engineering and is
representative of the kinds of uses market practitioners make of swaps (both interest rate
swaps [as in this case] and cross-currency swaps).
It is also an opportunity to practice good “business-style” reporting. The length of the
assignment solution you provide is limited to two pages with a minimum font size of 10 point
and some margin around the pages! The intention here is for you to practice the kind of report
writing skills that are useful in your future career. No manager wants to get a long,
overcomplicated, often rambling report when the same information can be provided with
brevity, clarity, and the essentials explained in a much shorter document. This is your
opportunity to practice such succinctness.
Note that you must provide the “logic” and show the “calculations” to support your
conclusions. You MUST show how the value and cash flows work to deliver the solution.
Otherwise, it is largely a fail. In doing so, remember to follow the cash.
You can assume the reader (your audience) is knowledgeable about swaps, their uses, and so
forth, so definitions and explanations of basic details are not required. The basics (e.g. what is
covered in, say, Hull) can be taken as understood. That said, you do need to show how you
worked out the numbers from the data provided in the case. That is, you do have to have a
workable solution that can be followed by a fellow expert and explain (briefly) how it was
arrived at. Namely, based on the conditions in the market as described in the case, how a
market practitioner could deliver the outcome you describe

The Case: Repackaging Debt
Part A   
Scot Bank has been given the opportunity to buy a large number of US dollar-denominated
bonds issued by Scottish Energy Enterprises (SEE), a triple-B rated British utility company.
This would amount to a principal amount of $100 million—but the bonds are currently trading
in the market at a discount.
The bonds carry a fixed annual-pay coupon of 6 per cent and have exactly five years to
maturity—so the first coupon you will receive from buying the bonds is one year away. There
is no accrued interest.
The bonds are being offered to Scot Bank at 84.837 per cent of par. At this price, the yieldto-maturity on the bonds is 10 per cent.
Unfortunately, Scot Bank, although interested in the opportunity, would want to hold a
floating rate asset, not a fixed-coupon bond.
However, the Lightning Investment Bank (LIB) has offered to repackage the bonds for Scot
Bank as synthetic floating rate notes via a special purpose vehicle (SPV).
The deal is as follows: Scot Bank will provide $100 for each bond purchased and will receive
LIBOR, as the floating rate, plus a 20 basis points spread (0.20 per cent) over the reference
rate for the five years, plus a repayment of the $100 principal at maturity. These floating rate
payments will take place at the end of each year (i.e. annually) to match the payments on
the bond and up to and including the final maturity at the end of year 5.
The terms and conditions in the US dollar interest-rate swaps market are given below:
Par Swaps Curve
Maturity 1 Year 2 years 3 Years 4 Years 5 Years
Par swaps rate
against LIBOR
9.50% 9.59% 9.62% 9.69% 9.70%
LIBOR: London Interbank Offered Rate (the reference rate for the floating side of the swap)
Swap interest rates are annual pay
Questions for Part A
1. Briefly explain why Scot Bank would wish to hold a floating rate asset issued by SEE
rather than the fixed rate bonds.
2. Analyse the synthetic floating rate note offer for value. Explain and show how the cash
flows of the transaction add or do not add up. In doing this, you might like to briefly
comment on the following issues/questions:
a. Is the transaction a reasonable one from Scot Bank’s perspective or is the Lightning
Investment Bank using its superior knowledge of financial engineering and
derivatives to exploit the bank?
b. Take into account in your thinking that Scot Bank is not a sophisticated user of
derivatives.
c. Is any mispricing (i.e. deviation from fair value) significant and what are the
advantages/disadvantages of Scot Bank entering into the synthetic being offered by
Lighting Investment Bank?
d. Explain and show how LIB has structured the deal. (Remember: follow the cash!)
[Part A: 70%]

Part B
Assume two years have now passed. Interest rates have dropped and the new interest rate
swaps curve is as given below:
New Par Swaps Curve
Maturity 1 Year 2 years 3 Years
Par swaps rate against LIBOR 8.25% 8.38% 8.45%
Between the initial transaction in Part A and Part B, Scot Bank has reviewed its investments
and would now like to unwind the synthetic floating rate note created from holding SEE dollar
bonds and sell-off the bonds. At this point, the bonds, with exactly 3-years to maturity, are
trading at 93.18 in the market.
Questions for Part B
a. What will be the new value of the synthetic floating rate note package and will
Scot Bank be able to unwind the transaction without incurring a loss?
b. At what price must the SPV sell the bonds to break even, so that ScotBank does
not incur a loss of principal?
c. Explain what has to happen at this point for all the cash flows to net off correctly
and ensure that ScotBank does not incur a loss of principal. (Remember: follow
the cash!)
[Part A: 30%]
[Total A and B: 100%]

 

Some Thoughts on Writing the Assignment   

As detailed in the brief above, I am not expecting a long report on this assignment. So, keep it
short and to the point: It is not a large part of the course’s assessment.
The maximum word count (excluding tables and references) is 800 words.
You will need to plan what to say, given the length/word count limitation. Use the exhibits to
provide the technical detail and write to explain/justify the results you obtain.
As you realise, this is an exercise in financial engineering using swaps, so what I am looking
for is your ability to understand and calculate the transactions involved and explain the
results/ processes involved. Therefore, in a sense, what I am seeking is a diagnostic analysis,
with all the cash flows accounted for—but that said, there is no single pre-set way of
addressing the topic.
Make sure you show how you arrived at the result (i.e. how the solution to the problem was
arrived at) as this is definitely a core part of the assignment.
Working with a spreadsheet and using this to present your results is fine. Just don’t give me
the decimal dust. Work in millions to two decimal places (Excel will do the necessary
rounding) and seek to report your findings in the way the market speaks. It should be basis
points for fractions of a percent and not decimals (0.15% = 15 basis points).
There is no set report format, but it is good practice to plan the written document in the form
of a report. After all, this is how you might have to report your findings if you were writing
this in a business setting.
Consider the layout and the presentation of the tables. Think how the whole report will look
to the reader, so consider the impression it gives to the recipient. You should be aiming for a
professional look to your report.
Happy learning!

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