Deck 15: Swap Markets

Question 1

Swap transactions are only used to

A)hedge against upward interest rate movements.
B)hedge against downward interest rate movements.
C)speculate.
D)none of the above

Answer 1

D

Question 2

The most likely users of plain vanilla swaps would be

A)commercial banks that focus on short-term consumer loans.
B)savings institutions.
C)manufacturing companies.
D)municipal governments.

Answer 2

B

Question 3

The option on a callable swap would most likely be exercised if interest rates

A)rise.
B)fall.
C)remain constant.
D)remain somewhat stable.

Answer 3

B

Question 4

A plain vanilla swap is especially beneficial when interest rates are expected to

A)rise consistently.
B)decline consistently.
C)be stable.
D)rise and then decline.

Question 5

Assume a U.S. savings institution funds its fixed-rate mortgages by attracting short-term deposits. If it engages in an interest rate swap, but the index on the swap does not move in perfect tandem with its cost of deposits, this reflects

A)sovereign risk.
B)basis risk.
C)credit risk.
D)none of the above

Question 6

In a(n) ____ swap, the fixed-rate payer makes a single payment at the maturity date of the swap agreement, while the floating-rate payer makes periodic payments throughout the swap period.

A)rate-capped
B)zero-coupon-for-floating
C)extendable
D)callable

Question 7

Assume a financial institution that has rate-sensitive liabilities and rate-insensitive assets. If interest rates are expected to decline consistently, this institution would benefit by negotiating a(n)

A)forward swap.
B)callable swap.
C)extendable swap.
D)none of the above

Question 8

A ____ swap involves the exchange of fixed-rate payments for floating-rate payments that are capped.

A)rate-capped
B)zero-coupon-for-floating
C)callable
D)putable

Question 9

Assume a financial institution has rate-sensitive liabilities and rate-sensitive assets. If this institution negotiates a rate-capped swap, its ____ payments will be capped, and it will ____ an up-front premium in exchange for the cap.

A)outflow; receive
B)outflow; pay
C)inflow; pay
D)inflow; receive

Question 10

Which of the following statements is incorrect?

A)Interest rate swaps are sometimes used by financial institutions and other firms for speculative purposes.
B)A primary reason for the popularity of interest rate swaps is the existence of market imperfections.
C)Swaps are necessary for some financial institutions to obtain the maturities or rate sensitivities on funds that they desire.
D)Most financial institutions that anticipate that interest rate will move in an unfavorable direction to not hedge their positions.

Question 11

In a swap arrangement, the most common index used for floating-rate payments would be the

A)coupon rate on existing bonds.
B)stock dividend rate based on a U.S. stock index.
C)London Interbank Offer Rate (LIBOR).
D)Treasury bond yield.

Question 12

The option on a putable swap would most likely be exercised if interest rates

A)rise.
B)fall.
C)remain constant.
D)remain somewhat stable.

Question 13

Savings institutions participate in the swap market primarily to

A)serve as an intermediary by matching up two parties in a swap.
B)serve as a dealer by taking the counterparty position in a swap.
C)reduce interest rate risk.
D)none of the above

Question 14

Financial institutions with ____ interest rate-sensitive liabilities than assets are ____ affected by rising interest rates.

A)more; adversely
B)fewer; adversely
C)more; favorably
D)none of the above

Question 15

A(n) ____ swap allows the party making fixed-rate payments to terminate the swap prior to maturity.

A)forward
B)extendable
C)callable
D)putable

Question 16

A ____ swap allows the party making floating-rate payments to terminate the swap prior to maturity.

A)zero coupon-for-floating
B)forward
C)callable
D)putable

Question 17

A(n) ____ swap involves an exchange of interest payments over a swap period that does not begin until a specified future point in time.

A)forward
B)extendable
C)callable
D)putable

Question 18

If a firm negotiates a plain vanilla swap, it will provide ____ payments in exchange for ____ payments.

A)fixed-rate; floating-rate
B)floating-rate; fixed rate
C)stock dividend; fixed-rate
D)stock dividend; floating rate

Question 19

A(n) ____ allows the party making fixed payments to extend the swap period.

A)forward
B)extendable
C)callable
D)putable

Question 20

An equity swap involves the exchange of interest payments for payments linked to the degree of change in a bond index.

Question 21

A firm is involved in an agreement in which it receives payments in periods when a market interest rate falls below an interest rate level specified in the agreement. This means that the firm has

A)purchased an interest rate cap.
B)sold an interest rate cap.
C)purchased an interest rate floor.
D)sold an interest rate floor.

Question 22

According to the text, any political aspects that prevent a counterparty on a swap from meeting its payment obligations represent

A)sovereign risk.
B)basis risk.
C)credit risk.
D)none of the above

Question 23

When a bank participates in a swap of fixed interest rate payments for floating-rate payments, or a swap of currencies, it

A)can match up two parties but cannot take a position in the swap.
B)can match up two parties or can take a position in the swap.
C)cannot match up two parties and cannot take a position in the swap.
D)cannot match up two parties but can take a position in the swap.

Question 24

The typical purchaser of an interest rate cap is a financial institution that is ____ affected by ____ interest rates.

A)favorably; rising
B)favorably; falling
C)adversely; rising
D)adversely; falling

Question 25

Financial institutions primarily use interest rate swaps in a way that will ____ exposure to interest rate risk and ____ potential returns.

A)increase; increase
B)increase; reduce
C)reduce; increase
D)reduce; reduce

Question 26

A firm is involved in an agreement in which it receives payments in periods when a market interest rate rises above an interest rate level specified in the agreement. This means that the firm has

A)purchased an interest rate cap.
B)sold an interest rate cap.
C)purchased an interest rate floor.
D)sold an interest rate floor.

Question 27

The advantage of a rate-capped interest rate swap to a party exchanging fixed payments for floating payments (relative to a plain vanilla swap) is that

A)there is a minimum limit set on interest rate payments received.
B)there is a maximum limit set on the interest payments it will provide.
C)it receives an up-front fee.
D)none of the above

Question 28

Sovereign risk differs from credit risk because it is dependent on the financial status of the government rather than the counterparty itself.

Question 29

____ risk in a swap is typically not overwhelming because the affected party can simply discontinue its payments to the other party.

A)Basis
B)Credit
C)Sovereign
D)None of the above

Question 30

An advantage of a ____ over other interest rate swaps is that the fixed-rate payer has the flexibility to avoid exchanging future interest payments.

A)callable swap
B)putable swap
C)zero-coupon for floating swap
D)forward swap

Question 31

____ risk prevents the interest rate swap from completely eliminating a financial institution's exposure to interest rate risk.

A)Credit
B)Basis
C)Sovereign
D)None of the above

Question 32

In a period when interest rates are expected to rise, ____ institutions will want a fixed-for-floating swap, and the fixed rate specified on interest rate swaps will be ____ under these conditions.

A)many; lower
B)many; higher
C)few; lower
D)few; higher

Question 33

A plain vanilla swap enables firms to exchange ____ for ____.

A)fixed rate payments; variable interest rate payments
B)a high interest rate foreign currency; a low interest rate foreign currency
C)a low interest rate foreign currency; a high interest rate foreign currency
D)bonds; stocks that pay dividends

Question 34

A firm is involved in an agreement in which it makes payments in periods when a market interest rate falls below an interest rate level specified in the agreement. This means that the firm has

A)purchased an interest rate cap.
B)sold an interest rate cap.
C)purchased an interest rate floor.
D)sold an interest rate floor.

Question 35

An arrangement which enables firms to exchange currencies at periodic intervals is called a

A)currency swap.
B)interest rate swap.
C)swap exchange.
D)eurobond swap.

Question 36

The advantage of a rate-capped interest rate swap (relative to a plain vanilla swap) to a party exchanging floating payments for fixed payments is that

A)there is a minimum limit set on interest rate payments received.
B)there is a maximum limit set on the interest payments it will provide.
C)it receives an up-front fee.
D)none of the above

Question 37

A firm is involved in an agreement in which it makes payments in periods when a market interest rate rises above an interest rate level specified in the agreement. This means that the firm has

A)purchased an interest rate cap.
B)sold an interest rate cap.
C)purchased an interest rate floor.
D)sold an interest rate floor.

Question 38

An interest rate swap agreement indicates the ____ value, which represents the principal amount to which interest rates are applied to determine the interest payments involved.

A)vanilla
B)LIBOR
C)programmed
D)notional

Question 39

An interest rate collar represents the ____ of an interest rate cap and a simultaneous ____ of an interest rate floor.

A)sale; sale
B)sale; purchase
C)purchase; purchase
D)purchase; sale

Question 40

An equity swap involves the exchange of

A)preferred stock for common stock.
B)interest payments for an equity position in the counterparty's firm.
C)interest payments for payments linked to the degree of change in a stock index.
D)interest payments for newly issued stock by financial institutions.

Question 41

A rate-capped swap may limit the fixed-rate payer's ability to effectively hedge against interest rate risk.

Question 42

Buyers of credit default swaps are most likely going to receive a payment from the seller of credit default swaps when the economy:

A)is very weak.
B)is stable.
C)experiences high growth.
D)experiences low inflation.

Question 43

A putable swap gives the party making the fixed-rate payments the right to terminate the swap.

Question 44

AIG's financial problems during the credit crisis were attributed to:

A)its weak returns on its investments in junk bonds.
B)its potential losses from its life insurance policies.
C)fraud from avoiding taxes on its gains from credit default swaps.
D)its potential losses from credit default swaps.

Question 45

In a ____, a buyer makes periodic payments to a seller in exchange for protection against the possible default of debt securities specified in the contract.

A)default option contract
B)default futures contract
C)bankruptcy contract
D)credit default swap

Question 46

A common maturity of a credit default swap contract is:

A)one month
B)three months
C)five years
D)25 years

Question 47

An interest rate cap offers payments in periods when a specified interest rate index exceeds a specified floor interest rate.

Question 48

The primary purpose of interest rate swaps is to reduce exchange rate risk.

Question 49

Financial institutions such as U.S. savings institutions and commercial banks traditionally had fewer interest rate-sensitive ____ than ____ and therefore were adversely affected by ____ interest rates.

A)assets; liabilities; increasing
B)liabilities; assets; decreasing
C)liabilities; assets; increasing
D)none of the above

Question 50

The Bank of Moronto has negotiated a plain vanilla swap in which it will exchange fixed payments of 10 percent for floating payments equal to LIBOR plus 0.5 percent at the end of each of the next three years. In the first year, LIBOR is 8 percent; in the second year, 9 percent; in the third year, LIBOR is 7 percent. What is the total net payment the Bank of Moronto makes over the three-year period if the notional principal is $10 million?

A)-600,000
B)600,000
C)450,000
D)-450,000
E)none of the above

Question 51

Interest rate swaps are rarely used by companies that issue bonds.

Question 52

The most common proxy for the benchmark rate from which a floating-rate payment is determined is the prime rate.

Question 53

There is risk that a firm involved in an interest rate swap may not meet its payment obligations; this risk is called systemic risk.

Question 54

Lizard National Bank purchases a three-year interest rate cap for a fee of 2 percent of notional principal valued at $50 million, with an interest rate ceiling of 11 percent and LIBOR as the index representing the market interest rate. Assume that LIBOR is expected to be 9 percent, 12 percent, and 13 percent at the end of each of the next three years, respectively. The total payments received (or paid) by Lizard, including the initial fee, are $____.

A)500,000
B)-500,000
C)-1,500,000
D)1,500,000
E)none of the above

Question 55

Lizard National Bank purchases a three-year interest rate cap for a fee of 2 percent of notional principal valued at $50 million, with an interest rate ceiling of 11 percent and LIBOR as the index representing the market interest rate. Assume that LIBOR is expected to be 9 percent, 12 percent, and 13 percent at the end of each of the next three years, respectively. The dollar amount to be received (or paid) by the seller of the interest rate cap based on the forecast of LIBOR assumed above over the three-year period is $____.

A)-500,000
B)500,000
C)-1,500,000
D)1,500,000
E)none of the above

Question 56

If a large bank that has taken numerous swap positions and guaranteed many other swap positions fails, there could be several defaults on swap payments.

Question 57

Hewitt Inc. has entered into an equity swap arrangement that allows it to swap a fixed interest rate of 8 percent in exchange for the rate of appreciation on the Dow Jones Industrial Average each year over a three-year period. The notional principal is $1 million. If the Dow depreciates by 1 percent, Hewitt will

A)have to make a payment of $70,000.
B)have to make a payment of $90,000.
C)receive a payment of $70,000.
D)receive a payment of $90,000.
E)none of the above

Question 58

Firms A and B have entered into an interest rate swap. On the first payment date, Firm A owes Firm B 12 percent of $10 million, and Firm B owes Firm A 14 percent of $10 million. Most likely, this transaction will be settled in what manner?

A)Firm A will send Firm B $120,000 and Firm B will send Firm A $140,000
B)Firm B will send Firm A $120,000 and Firm A will send Firm B $140,000
C)Firm A will send Firm B $20,000
D)Firm B will send Firm A $20,000
E)none of the above

Question 59

An equity swap involves the exchange of dividend payments for payments linked to the degree of change in a stock index.

Question 60

A forward swap allows an institution to lock in the terms of the arrangement today, and the swap period begins immediately.

Question 61

If a U.S. institution in a forward swap would like to lock in the fixed rate that it will pay when the swap period begins, it is probably concerned that interest rates will ____; the counterparty is likely adversely affected by ____ interest rates.

A)increase; increasing
B)increase; declining
C)decrease; declining
D)decrease; increasing
E)none of the above

Question 62

The same types of risks that apply to interest rate swaps may also apply to currency swaps, except that currency swaps are not subject to basis risk.

Question 63

Interest rate floors are commonly used to hedge against lower interest rates.

Question 64

A financial institution may participate in the swaps markets by:

A)serving as an intermediary by matching up parties that wish to engage in a swap.
B)engaging in swaps to reduce interest rate risk.
C)assuming the credit risk involved in a swap by guaranteeing that the payments will be made.
D)A and B

Question 65

A(n) ____ swap provides the party making the floating-rate payments with a right to terminate the swap.

A)callable
B)extendable
C)plain vanilla
D)putable
E)none of the above

Question 66

An interest rate collar involves the purchase of an interest rate cap and the simultaneously sale of an interest rate floor.

Question 67

Which of the following is not a typical provision of an interest rate swap?

A)the notional principal value to which the interest rates are applied to determine the interest payments involved
B)the fixed interest rate
C)the floating interest rate
D)the underwriter of the bond
E)All of the above are provisions of an interest rate swap.

Question 68

Which of the following is not an advantage of having derivative securities such as swaps traded on an exchange instead of over the counter?

A)more transparent pricing
B)increased trading volume
C)less standardarized contracts, allowing contracts to be tailored to the parties' specific needs
D)more accurate information about the collateral backing a particular contract

Question 69

The London Interbank Offer Rate (LIBOR) varies among currencies.

Question 70

Which of the following is not a reason for financial institutions to engage in interest rate swaps?

A)to reduce interest rate risk
B)to act as an intermediary
C)to act as a dealer in swaps
D)all of the above are reasons for financial institutions to engage in swaps

Question 71

A ____ swap involves an exchange of interest rate payments that does not begin until a specified future point in time.

A)plain vanilla
B)zero-coupon-for-floating
C)forward
D)seasoned vanilla
E)putable

Question 72

Interest rate ____ are interest rate derivative instruments that are normally classified separately from interest rate swaps.

A)caps
B)floors
C)collars
D)all of the above

Question 73

During the credit crisis, many mortgage-backed securities defaulted, generating large profits for sellers of credit default swaps and large losses for buyers of the swaps.