By Fred Butterfield, CTP
When you sit down to answer questions, whether they are from the sample tests, or for the exam itself, make sure to read the question slowly and completely. All of the questions have been written to provide the minimum amount of information needed to determine the answer. Sometimes there will be additional, unnecessary information, but what is needed will be presented.
As an example: XYZ Company is a U.S. based company that has just issued some euro-denominated bonds in London. The bonds have a duration of 10 years at a rate of 3.5 percent with a par value of €50 million. An FX swap contract was created on the date of the issuance in EUR/USD, with a spot rate of 1.2908 and a forward rate of 1.1102. This bond is subject to what type of risk?
(A) Interest rate
(C) Floating rate
In this question, all of the answers are actual potential risks for the company. To answer it, you have to have some knowledge of the different types of risk and common mitigation techniques for those risks. By reading the question carefully, you see that the duration is fixed at 10 years, so duration risk has been eliminated. The interest is fixed at 3.5 percent, so floating rate risk is also eliminated. The problem states that a swap contract was created, thus eliminating currency risk. The only risk not specifically addressed is interest rate risk, which is a possibility due to the rate quoted on the bonds, but not mentioned in any other way.
By reading the question carefully and completely, and understanding not only the risks associated with the issuance of bonds, but also with the typical mitigation practices for those risks (and the impact and effect of those mitigation practices), the student can determine the correct response to the question. Fred Butterfield, CTP, is a treasury manager based in Denver.