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FRM Part I · FRM Exam Part I · How Do Firms Manage Financial Risk?

A firm has issued USD 100 million of floating-rate debt paying 6-month SOFR plus 1%. It enters a swap in which it pays a fixed rate of 4% and receives SOFR on the same notional. Ignoring day-count effects, what is the firm's effective annual borrowing cost, and what risk is eliminated?

The effective cost is 5% fixed. The SOFR received on the swap cancels the SOFR paid on the debt, leaving the 1% spread plus the 4% fixed swap rate. This converts the floating-rate exposure into a fixed rate, removing interest rate risk from changes in SOFR.

  1. ASOFR + 1%; credit risk
  2. B5%; interest rate risk from floating ratesCorrect
  3. C4%; interest rate risk from floating rates
  4. D5%; basis risk between SOFR and the bond

Explanation

The firm pays SOFR + 1% on the debt, receives SOFR on the swap, and pays 4% fixed. Net cost = SOFR + 1% - SOFR + 4% = 5%. This converts floating exposure into fixed, removing floating rate risk. 4% ignores the 1% spread.

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