Deck 30: OTC Interest Rate Derivatives: Forward Rate Agreements, Swaps, Caps, and Floors

Question 1

Which of the below represents the "Risk / Return Profile of Counterparties to an Interest Rate Swap"?

A) $\begin{array}{lcc} & \text { Interest Rates Decrease } & \text { Interest Rates Increase } \\\text { Floating-rate payer: } & \text { Gain } & \text { Gain } \\\text { Fixed-rate payer: } & \text { Loss } & \text { Loss }\end{array}$

B) $\begin{array}{lcc} & \text { Interest Rates Decrease } & \text { Interest Rates Increase } \\\text { Floating-rate payer: } & \text { Gain } & \text { Loss } \\\text { Fixed-rate payer: } & \text { Loss } & \text { Gain }\end{array}$

C) $\begin{array}{lcc} & \text { Interest Rates Decrease } & \text { Interest Rates Increase } \\ \text { Floating-rate payer: } & \text { Loss } & \text { Loss } \\\text { Fixed-rate payer: } & \text { Gain } & \text { Gain }\end{array}$

D) $\begin{array}{lcc} & \text { Interest Rates Decrease } & \text { Interest Rates Increase } \\\text { Floating-rate payer: } & \text { Loss } & \text { Gain } \\\text { Fixed-rate payer: } & \text { Gain } & \text { Loss }\end{array}$

Answer 1

$\begin{array}{lcc} & \text { Interest Rates Decrease } & \text { Interest Rates Increase } \\\text { Floating-rate payer: } & \text { Gain } & \text { Loss } \\\text { Fixed-rate payer: } & \text { Loss } & \text { Gain }\end{array}$

Question 2

Suppose that for the next five years party X agrees to pay party Y 10% per year, while party Y agrees to pay party X six-month LIBOR (London Interbank Offered Rate), which is 7.5%. Party X is a fixed-rate payer / floating-rate receiver, while party Y is a floating-rate payer / fixed-rate receiver. Assume that the notional principal amount is $100 million, and that payments are exchanged every six months for the next five years. What will party X pay party Y every six month?

A) $3,750,000
B) $5,000,000
C) $6,250,000
D) $7,000,000

Answer 2

B

Question 3

In an interest rate swap, the dollar amount each counterparty pays to the other is the agreed-upon periodic interest rate times the ________.

A) notional principal amount.
B) par value amount.
C) notional dollar amount.
D) notional market value.

Answer 3

A

Question 4

Suppose that for the next five years party X agrees to pay party Y 10% per year, while party Y agrees to pay party X six-month LIBOR (London Interbank Offered Rate), which is 7.5%.. Party X is a fixed-rate payer / floating-rate receiver, while party Y is a floating-rate payer / fixed-rate receiver. Assume that the notional principal amount is $100 million, and that payments are exchanged every six months for the next five years. What will party Y pay party X every six month?

A) $3,750,000
B) $4,250,000
C) $4,750,000
D) $5,000,000

Question 5

Which of the below statements is FALSE?

A) The buyer of an FRA benefits if the reference rate increases and the seller benefits if the reference rate decreases.
B) In a futures contract, the buyer benefits from a rising rate while the seller benefits from a falling rate.
C) In the case of an FRA, the underlying is a rate with the buyer gaining if the rate increases and losing if the rate decreases.
D) In a futures contract the underlying is a fixed-income instrument.

Question 6

Assume the following terms for an FRA: Reference rate is three-month LIBOR, the contract rate is 4.5%, the notional amount is for $10 million, and the number of days to settlement is 91 days. If the settlement rate is 5.15%, what compensation or payment must make to the buyer by the seller?

A) $16,431
B) $16,219
C) $16,003
D) $15,874

Question 7

The elements of an FRA are the ________.

A) contract rate, reference rate, settlement rate, notional amount, and settlement date.
B) stipulation rate, REPO rate, maturity rate, functional amount, and maturity date.
C) stipulation rate, reference rate, settlement rate, notional amount, and settlement date.
D) contract rate, REPO rate, terminal rate, functional amount, and terminal date.

Question 8

Assume the following terms for an FRA: Reference rate is three-month LIBOR, the contract rate is 5.78%, the notional amount is for $10 million, and the number of days to settlement is 91 days. If the settlement rate is 6.33%, what compensation or payment must make to the buyer by the seller?

A) $13,878
B) $13,903
C) $13,684
D) $13,577

Question 9

The value of an interest rate swap will fluctuate with ________.

A) standard deviations.
B) beta.
C) market interest rates.
D) coupon rates.

Question 10

There are two ways that a swap position can be interpreted. Which of the below is ONE of these?

A) One of these is a package of swap contracts.
B) One of these is a package of cash flows from buying but not selling cash market instruments.
C) One of these is a package of forward/futures contracts.
D) One of these is a package of cash flows from selling but not buying cash market instruments.

Question 11

An ________ an agreement whereby two parties (called counterparties) agree to exchange ________.

A) interest rate swap; periodic interest payments.
B) interest rate swap; regular dividend payments.
C) futures rate swap; periodic interest fees.
D) forward rate swap; periodic dollar compensations.

Question 12

The reference rates that are commonly used for the floating rate in an interest rate swap are those on various money market instruments such as ________.

A) Treasury bills, prime rate, and the London Interbank Offered Rate.
B) LIBOR and commercial paper.
C) bankers acceptances, certificates of deposit, and federal funds rate.
D) All of these

Question 13

Assume the following terms for an FRA: Reference rate is three-month LIBOR, the contract rate is 5.5%, the notional amount is for $10 million, and the number of days to settlement is 91 days. If the settlement rate is 6.25%, what is interest differential?

A) $17,489
B) $18,168
C) $18,531
D) $18,958

Question 14

Suppose that for the next five years party X agrees to pay party Y 10% per year, while party Y agrees to pay party X six-month LIBOR (London Interbank Offered Rate). Party X is a fixed-rate payer / ________, while party Y is a floating-rate payer / ________.

A) fixed-rate receiver; fixed-rate receiver.
B) floating-rate receiver; fixed-rate receiver.
C) floating-rate receiver; floating-rate receiver.
D) floating-rate payer; fixed-rate payer.

Question 15

The FRA's ________ is the rate specified in the FRA at which the buyer of the FRA agrees to pay for funds and the seller of the FRA agrees to receive for investing funds.

A) reference rate
B) contract rate
C) notional rate
D) three-month LIBOR

Question 16

________ the over-the-counter equivalent of the exchange-traded ________ on short-term rates. Typically, the short-term rate is ________.

A) A forward rate agreement; futures contracts; the T-bill rate.
B) A futures contracts; forward rate agreement; LIBOR.
C) A forward rate agreement; futures contracts; LIBOR.
D) A futures contracts; forward rate agreement; the T-bill rate.

Question 17

The ________ is the value of the reference rate at the FRA's settlement date.

A) notional rate
B) going rate
C) contract rate
D) settlement rate

Question 18

A ________ can be viewed as a package of FRAs. In fact, an FRA can be viewed as a special case of a swap in which there ________.

A) swap; is only one settlement date.
B) forward contract; is at least one settlement date.
C) futures contract; is only one settlement date.
D) swap; are two settlement dates.

Question 19

If at the settlement date the settlement rate is ________ the contract rate, the FRA buyer ________ because the buyer can borrow funds at a below-market rate.

A) equal to; suffers
B) greater than; suffers
C) less than; benefits
D) greater than; benefits

Question 20

If the FRA has a ________ of 5% for three-month LIBOR (the ________) and the notional amount is for $10 million, the buyer is agreeing to pay 5% to buy or borrow $10 million at the settlement date and the seller is agreeing to receive 5% to sell or lend $10 million at the settlement date.

A) settlement rate; contract rate
B) reference rate; contract rate
C) settlement rate; reference rate
D) contract rate; reference rate

Question 21

In regards to an interest rate / equity swap, which of the below statements is TRUE?

A) These swaps cannot be used by investment bankers to create a security.
B) Debt instruments created by using swaps are not commonly referred to as structured notes.
C) Debt instruments created by using swaps are commonly referred to as structured notes.
D) None of these

Question 22

________ is an agreement between two parties in which one party, for an upfront premium, agrees to compensate the other if a designated interest rate, called the reference rate, is different from a predetermined level.

A) An interest rate cap and floor
B) An interest rate swap
C) An equity swap
D) A forward rate agreement

Question 23

The agreement is referred to as an ________ when one party agrees to pay the other if the reference rate falls below a predetermined level.

A) interest rate ceiling
B) interest rate cap
C) interest rate floor
D) interest rate bottom

Question 24

Which of the below statements is FALSE?

A) In a payer swaption the buyer of the swaption has the right to enter into an interest rate swap that requires paying a floating rate and receiving a fixed rate.
B) A forward start swap is a swap wherein the swap does not begin until some future date that is specified in the swap agreement.
C) A forward start swap will also specify the swap rate at which the counterparties agree to exchange payments commencing at the start date.
D) None of these

Question 25

Which of the below statements is FALSE?

A) In a basis rate swap, both parties exchange floating-rate payments based on a different reference rate.
B) A nonconstant maturity swap tied to the CMT is called a Constant Maturity Treasury swap.
C) There are options on interest rate swaps: these swap structures are called swaptions and grant the option buyer the right to enter into an interest rate swap at a future date.
D) There are two types of swaptions -a payer swaption and a receiver swaption.

Question 26

Buying a ________ is equivalent to buying a package of puts on a fixed- income instrument and buying a ________ is equivalent to buying a package of calls on a fixed-income instrument.

A) floor (long cap); floor (long floor)
B) cap (long cap); floor (long floor)
C) cap (long cap); cap (long floor)
D) cap (short cap); floor (long floor)

Question 27

While an interest rate swap may be nothing more than a package of forward contracts, several important reasons suggest that it is not a redundant contract. Which of the below is NOT one of these?

A) The longest maturity of forward or futures contracts does not extend out as far as that of an interest rate swap.
B) An interest rate swap is a more transactionally efficient instrument.
C) The liquidity of the interest rate swap market has grown since its beginning in 1981.
D) Forward contract are a more transactionally efficient instrument since their beginning in 1955.

Question 28

A ________ involves the sale of the swap to the original counterparty.

A) buy-back
B) close-out sale
C) cancellation
D) All of these

Question 29

Which of the below statements is TRUE?

A) Vanilla or generic swaps have evolved as a result of the asset / liability needs of borrowers and lenders.
B) A nonamortizing swap is one in which the notional principal amount decreases in a predetermined way over the life of the swap.
C) An amortizing swap is one in which the notional principal amount increases at a predetermined way over time.
D) In a generic or plain vanilla swap, the notional principal amount does not vary over the life of the swap.

Question 30

In a ________, the party that wants out of the transaction will arrange for an additional swap in which (1) the maturity on the new swap is equal to the time remaining of the original swap, (2) the reference rate is the same, and (3) the notional principal amount is the same.

A) swap sale
B) swap buy-back
C) close-out
D) swap reversal

Question 31

The terms of an interest rate agreement include ________.

A) the reference rate and the strike rate that sets the ceiling or floor.
B) the length of the agreement and the frequency of settlement.
C) the notional principal amount.
D) All of these

Question 32

Which of the below statements is TRUE?

A) The convention that has evolved for quoting swaps levels is for a swap dealer to set the floating rate greater than the index and then quote the fixed rate that will apply.
B) The swap spread is determined by different factors than what drive the spread over Treasuries on instruments that replicate a swap's cash flows.
C) Given that a swap is not a package of futures/forward contracts, the shorter-term swap spreads respond directly to fluctuations in Eurodollar CD futures prices.
D) There are three general types of transactions in the secondary market for swaps. These include (1) a swap reversal, (2) a swap sale (or assignment), and (3) a swap buy-back (or close-out or cancellation).

Question 33

In comparing a swap to a futures or forward contract where the underlying is an interest rate instrument such as a Eurodollar CD, which of the below statements is FALSE?

A) The long futures position gains if interest rates decline and loses if interest rates rise - this is similar to the risk/return profile for a floating-rate payer.
B) The risk/return profile for a fixed-rate payer is similar to that of the short futures position: a gain if interest rates increase and a loss if interest rates decrease.
C) Interest rate swaps can be viewed as a package of more basic interest rate control tools, such as forwards.
D) The pricing of an interest rate swap will then depend on the price of a package of forward contracts with the same settlement dates and in which the underlying for the forward contract is the same contract rate.

Question 34

Which of the below statements is FALSE?

A) In an interest rate cap and floor, the buyer pays an upfront fee, which represents the maximum amount the buyer can lose and the maximum amount the writer of the agreement can gain.
B) The seller (writer) of an interest rate cap benefits if the underlying interest rate rises above the strike rate because the buyer must compensate the buyer.
C) In essence, interest rate caps and interest rate floors contracts are equivalent to a package of interest rate options.
D) The buyer of an interest rate floor benefits if the interest rate falls below the strike rate because the seller (writer) must compensate the buyer.

Question 35

Which of the below statements is FALSE?

A) A serious obstacle to accepting the credit arbitrage explanation of the swap market is that opportunities for credit arbitrage should be rare in reasonably efficient international credit markets.
B) An argument suggested for the growth of the interest rate swap market is the increased volatility of interest rates that has led borrowers and lenders to hedge or manage their exposure.
C) To reduce the risk of default, today's swap transactions require that the lower credit-rated entity obtain a guarantee from a highly rated commercial bank.
D) To make money in the swaps market, intermediaries have to do a sufficient volume of business, which is possible only if they have (1) an extensive client base willing to use swaps, and (2) a large inventory of swaps.

Question 36

In regards to an interest rate / equity swap, which of the below statements is TRUE?

A) There are no counterparties to the swap agreement.
B) There is a notional principal amount.
C) There is no notional principal amount.
D) None of these

Question 37

When one party agrees to pay the other if the reference rate exceeds a predetermined level, the agreement is referred to as ________.

A) an interest rate cap.
B) an interest rate option.
C) an interest rate swap.
D) an interest rate floor.

Question 38

The predetermined level of the reference interest rate is called the ________.

A) ceiling rate.
B) reference rate.
C) exercise rate.
D) strike rate.

Question 39

Which of the below statements is TRUE?

A) The position of a fixed-rate payer is equivalent to a long position in a fixed-rate bond and a short position in a floating-rate bond.
B) The interest rate swap can allow each party to accomplish its asset/liability objective of locking in a spread.
C) The interest rate swap does not permit financial institutions to alter the cash flow characteristics of their assets: from fixed to floating or from floating to fixed.
D) By issuing securities in the Eurodollar bond market and using the interest rate swap, an entity cannot reduce its cost of issuing securities.

Question 40

Which of the below statements is FALSE?

A) The initial motivation for the interest rate swap market was borrower exploitation of what were perceived to be credit arbitrage opportunities.
B) A borrower cannot benefit from issuing securities in the market in which it has a comparative advantage and then swapping obligations for the desired type of financing.
C) Several observers have challenged the notion that credit arbitrage opportunities exist by arguing that the comparative advantage argument relies on assumptions of equilibrium in segmented markets.
D) Those who challenge the credit arbitrage notion argue that the differences in quality spreads in the fixed-rate and floating-rate markets represent differences in the risks that lenders face in these two markets.

Question 41

For swaps with maturities of less than five years, the swap spread is driven by rates in the Eurodollar CD futures market, but for swaps with maturities greater than five years, the spread is determined primarily by the credit spreads in the corporate bond market.

Question 42

In addition to the generic swap structure where one party pays fixed and the other floating, there are swaps with varying notional principal amounts, basis swaps (floating payments made by both parties), constant maturity swaps, swaptions, and forward start swaps.

Question 43

An interest rate floor can be used by a depository institution to lock in an interest rate spread over its cost of funds but maintain the opportunity to benefit if rates decline.

Question 44

If at the settlement date the settlement rate equals the contract rate, neither the FRA buyer not the seller benefits.

Question 45

If the underlying is considered a fixed-income instrument, its value changes inversely with interest rates. Therefore, for a call option on a fixed-income instrument: ________.

A) interest rates increase => fixed-income instrument's price decreases => put option's value increases
B) interest rates increase => fixed-income instrument's price decreases => call option's value decreases
C) interest rates decrease => fixed-income instrument's price increases => put option's value decreases
D) All of these

Question 46

What is forward start swap?

Question 47

What is a forward rate agreement (FRA)? Describe the elements associated with an FRA.

Question 48

The buyer of a fixed-rate asset can use an interest rate floor to establish a lower bound on its investment return, yet retain the opportunity to benefit should rates increase.

Question 49

An future rate swap is an agreement whereby two counterparties agree to exchange periodic interest payments based on a notional principal amount.

Question 50

A position in an interest rate swap can be interpreted as a position in a package of forward contracts but not in a package of cash flows from buying and selling cash market instruments.

Question 51

A ceiling is created by buying an interest rate cap and selling an interest rate floor.

Question 52

A cap is an interest rate agreement in which one party agrees to pay the other if the reference rate exceeds the strike rate; an interest rate floor is an interest rate agreement in which one party agrees to pay the other if the reference rate falls below the strike rate.

Question 53

It is important to note the difference of who benefits when interest rates move in an FRA and an interest rate futures contract. The buyer of an FRA benefits if the reference rate increases and the seller benefits if the reference rate decreases. In a futures contract, the buyer benefits from a falling rate while the seller benefits from a rising rate.

Question 54

In addition to interest rate swaps, there exist currency swaps and interest rate / equity swaps.

Question 55

While the initial motivation for the swap market was borrower exploitation of what were perceived to be credit arbitrage opportunities, such opportunities are limited and depend on the presence of market imperfections.

Question 56

If contract rate > settlement rate, then the interest differential equals:
(settlement rate - contract rate) × (days in contract period / 360) × notional amount

Question 57

An interest rate agreement is an agreement between two parties in which one party, for an upfront premium, agrees to compensate the other if the reference rate is the same as the strike rate.

Question 58

The swap market has evolved into a transactionally efficient market for accomplishing asset / liability objectives to alter the cash flow characteristics of assets (an asset swap) or liabilities (a liability swap).

Question 59

Commercial banks and investment banking firms cannot take positions in swaps but rather simply act as intermediaries.

Question 60

Swaps can be used by investment bankers to create a security.

Question 61

There are two types of swaptions - a payer swaption and a receiver swaption. Describe each of these two types of swaptions.

Question 62

Describe an interest rate cap and an interest rate floor.

Question 63

There are three general types of transactions in the secondary market for swaps. These include (1) a swap reversal, (2) a swap sale (or assignment), and (3) a swap buy-back (or close-out or cancellation). Describe a swap reversal.

Question 64

Illustrate an interest rate / equity swap.