The next six questions relate to the following case:

The Westfield Machine Tool and Die Company (WMTC) is a US-based manufacturer of cutting tools that operates production plants in the United States and Spain. WMTCs CEO has received an economic report forecasting that interest rates in the future will likely increase worldwide. He has asked WMTCs CFO, Yolanda Lopez, to examine ways by which different kinds of swaps could be used as a means of reducing the companys interest rate and currency risks.

Lopez has identified the following areas where swaps might be an attractive tool for managing risk:

• WMTCs employee pension plan portfolio
• WMTCs existing five-year bank loan
• Foreign exchange risk associated with cash flows repatriated from the operations in Spain
• New debt issue associated with upcoming expansion projects

Information regarding WMTCs pension plan portfolio is shown in Exhibit 1. Within the WMTC pension plan portfolio, the allocation within equities is heavily weighted towards the companys own stock. WMTC would like to retain these shares for corporate control purposes.

Exhibit 1. Pension Plan Portfolio of Westfield Machine Tool Company (in millions of US dollars)
Equities
Diversified Equities	$200
WMTC Common Stock	$400
Total Equities	$600
Fixed Income (Bonds)*
Treasuries	$200
Corporates	$300
Total Fixed Income	$500
Bond Portfolio Duration	6 Years
Total Portfolio Value	$1,100
*All bonds are fixed rate, and pay interest semiannually and on the same sate

Lopez recommends the allocation to WMTC equity be reduced to 20% of the overall equity portfolio. Lopez determines that WTMC can achieve this reallocation objective by executing an equity swap that would enable it to alter the allocation more easily and less expensively than by executing transactions in the underlying securities. Furthermore, using the equity swap would allow WMTC to retain the company shares held in the WMTC pension portfolio.

Lopez also recommends that WMTC reduce the duration of the bond portfolio by 50%. She states that, in order to achieve this duration target, WMTC should use a 6-year interest rate swap with semiannual payments. Lopez estimates the duration of the swaps fixed payments to be 75% of the swap maturity.

Lopez is also concerned about WMTCs five-year variable rate loan given the forecast of rising interest rates. Additionally, Lopez would like to use a currency swap to lock in the exchange rate when WMTC repatriates Euro cash flows from Spain into US dollars over the next two years. Additional pertinent facts regarding WMTCs existing debt obligation and cash flows from Spain are provided in Exhibit 2.

Exhibit 2. Relevant Debt and Cash Flow Information
Debt: Five-year rate loan principal amount: $10,000,000. Rate: Libor +200 basis points, paid semiannually, reset every six months. Loan rate was reset today at a Libor of 5%
Cash Flows: Estimated 12million annually to be repatriated to US from operations in Spain, in equal semiannual installments. Current spot exchange rate: 1.4 USD/EUR

To hedge the interest rate risk on the five-year variable rate loan, Lopez recommends that WMTC enter into a contract with Swap Traders International (STI), who offers an interest rate swap with a notional principal of $10 million that provides a fixed rate of 6% in exchange for Libor, with semiannual payments.

To hedge the currency risk associated with the cash flows to be repatriated from its operations in Spain. Lopez recommends that WMTC enter into a currency swap with semiannual payments, where the fixed swap rate in Euros is 4.5%, and the fixed swap rate in US dollars is 5.00%.

WMTC also has some major expansion plans for its Spanish operations. In two years, Lopez expects that WMTC will need to raise 50 million. Lopez expects that WMTC will raise the funds using a floating interest rate loan at the prevailing Libor rate in 2 years with annual interest payments. Lopez is considering hedging the interest rate risk relating to the future borrowing, so she contacts STI, who offers a swaption expiring in 2 years with Libor as the underlying floating rate and an exercise rate of 6%

1. Lopez will most likely achieve the pension plans equity reallocation objective by entering into an equity swap whereby WMTC receives a return on:

1. $320 million of the S&P 500 index and pays a return on $320 million of WMTC common stock.
2. $280 million of the S&P 500 index and pays a return on $280 million of WMTC common stock.
3. $280 million of WMTC common stock and pays a return on $280 million of the S&P 500 index.

2.To achieve the target duration for the pension plans bond portfolio, WMTC should enter into an interest rate swap with a modified duration that is:

1. negative, requiring WTMC to make fixed rate payments and receive floating rate payments.
2. negative, requiring WTMC to make floating rate payments and receive fixed rate payments.
3. positive, requiring WTMC to make fixed rate payments and receive floating rate payments.

3. WMTC can achieve the bond portfolio duration target by using an interest rate swap with a notional principal closest to:

1. $343 million.
2. $353 million.
3. $375 million.

4. If WMTC hedges the interest rate risk on the five-year variable rate loan by using the interest rate swap recommended by Lopez, the net interest payment at the first settlement date in six months would be closest to:

1. $300,000.
2. $400,000.
3. $800,000.

5. If WMTC hedges the currency risk relating to the cash flows from its Spanish operations using the currency swap recommended by Lopez, WMTC would generate semiannual cash inflows from the swap closest to:

1. $4.8 million.
2. $8.4 million.

6. If Lopez decides to use a swaption with STI to hedge the interest rate risk relating to the expansion loan, then Lopez should:

1. sell a payer swaption.
2. buy a payer swaption.
3. buy a receiver swaption.