The board of Bontemps International (BI) will substantially increase the company's defined benefit pension fund's allocation to international equities in the future. However, the board wants to retain the ability to reduce temporarily this exposure without making the necessary transactions in the cash markets. You develop a way to meet the board's condition:
BI enters into a swap arrangement with Bank A for a given notional amount and agrees to pay the EAFE (Europe, Australia, and Far East) Index return (in U.S. dollars) in exchange for receiving the LIBOR interest rate plus 0.2 percent (20 basis points).
On the same notional amount, BI arranges another swap with Bank B under which BI receives the return on the S&P 500 Index (in U.S. dollars) in exchange for paying the interest rate on the U.S. Treasury bill plus 0.1 percent (10 basis points).
Both swaps would be for a one-year term.
From BI's perspective, identify and briefly describe:
(a) The major risk that this transaction would eliminate,
(b) The major risk that this transaction would not eliminate (i.e., retain),
(c) Three risks that this transaction would create.

  • CreatedDecember 17, 2014
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