Question 1

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

Accepted Answer

Sovereign risk is the risk of default by a government on its financial obligations, while credit risk is the risk of default by a borrower on its financial obligations. Sovereign risk is dependent on the financial status of the government, while credit risk is dependent on the financial status of the counterparty.

Question 2

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

Accepted Answer

A forward swap, also known as a deferred swap, involves an exchange of interest payments over a swap period that does not begin until a specified future point in time. The parties agree on the swap rate at the outset, but the exchange of cash flows occurs at a future date.

Question 3

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

Accepted Answer

Financial institutions with more interest rate-sensitive liabilities than assets are adversely affected by rising interest rates. This is because as interest rates rise, the cost of borrowing for these institutions increases, while the interest they can earn on their assets may not increase proportionately. Therefore, their net interest margin (the difference between interest earned on assets and interest paid on liabilities) decreases, leading to a decrease in profitability.

Question 4

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

Accepted Answer

Basis risk refers to the risk that the underlying reference rates for the interest rate swap may not move in the same direction, causing the swap to not completely eliminate the institution's exposure to interest rate risk. Credit risk and sovereign risk are not related to the effectiveness of an interest rate swap in managing interest rate risk.

Question 5

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

Accepted Answer

A rate-capped swap involves the exchange of fixed-rate payments for floating-rate payments that are capped. This means that the floating-rate payments received by one party are limited or capped at a certain level, providing protection against rising interest rates.

Question 6

Which of the following statements is incorrect?

Accepted Answer

This statement is incorrect because most financial institutions do hedge their positions in anticipation of unfavorable interest rate movements to mitigate potential losses.

Question 7

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

Accepted Answer

A callable swap allows the party making fixed-rate payments to terminate the swap prior to maturity. This means that the party can call (terminate) the swap if they believe the market conditions have changed in their favor.

Question 8

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

Accepted Answer

The option on a putable swap gives the holder the right to terminate the swap and enter into a fixed-rate contract with the initial counterparty. If interest rates rise, the floating rate payments on the swap will also increase, making the fixed-rate contract more attractive. Therefore, the put option is likely to be exercised in this scenario.

Question 9

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

Accepted Answer

The option on a callable swap would most likely be exercised if interest rates fall. This is because the entity that has the option to call the swap would benefit from refinancing at the lower interest rates.

Question 10

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 perfecttandem with its cost of deposits, this reflects

Accepted Answer

This reflects basis risk, which is the risk that the index on the swap does not move in perfect tandem with the institution's cost of funds. Basis risk arises from differences in the financial instruments used to hedge against interest rate risk, which may not perfectly match the underlying assets or liabilities being hedged. Sovereign risk and credit risk are unrelated to this specific situation.

Question 11

____ swap allows the party making fixed payments to extend the swap period.

Accepted Answer

An extendable swap allows the party making fixed payments to extend the swap period. This means that the party can continue to pay fixed rates beyond the original maturity date of the swap. A forward swap is a type of swap that is agreed upon today but will not be effective until a future date, it does not allow for extensions. A callable swap allows the party making variable payments to terminate the swap early, while a putable swap allows the party making fixed payments to terminate the swap early.

Question 12

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.

Accepted Answer

In a period when interest rates are expected to rise, many institutions will want to lock in current rates to avoid paying more later, hence they prefer a fixed-for-floating swap. The fixed rate specified on interest rate swaps will be higher under these conditions because the expectation of rising rates is priced into the swap rate by the market.

Question 13

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

Accepted Answer

The London Interbank Offer Rate (LIBOR) is the most commonly used index for floating-rate payments in a swap arrangement. It is a widely accepted benchmark for short-term interest rates, based on the rates at which banks lend unsecured funds to one another in the London wholesale money market. The other options, such as the coupon rate on existing bonds, stock dividend rate based on a U.S. stock index, and Treasury bond yield, are not typically used as the index for floating-rate payments in a swap arrangement.

Question 14

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

Accepted Answer

Credit risk is the risk of default by the counterparty in a swap agreement. In this case, the affected party can discontinue its payments to the other party if they default, making the credit risk manageable. Basis risk relates to an imperfect correlation between the two legs of the swap, and sovereign risk is the risk of default by a government. Neither of these is relevant to the given scenario.

Question 15

Savings institutions participate in the swap market primarily to

Accepted Answer

Savings institutions participate in the swap market primarily to reduce interest rate risk. By swapping fixed-rate payments for floating-rate payments or vice versa, savings institutions can manage their exposure to interest rate fluctuations. They may also use swaps to match the cash flow characteristics of their assets and liabilities, or to enhance their return on investment by investing in securities with a higher yield than their funding costs. However, they typically do not serve as an intermediary or dealer in the swap market.

Question 16

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

Accepted Answer

In a plain vanilla swap, one party agrees to pay a fixed-rate payment in exchange for receiving a floating-rate payment from the other party. Therefore, the correct choice is A, fixed-rate payments in exchange for floating-rate payments. Choice C and D are not relevant to a swap, and choice B describes a currency swap, not a plain vanilla swap.

Question 17

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 ____anup-front premium in exchange for the cap.

Accepted Answer

The answer of Assume a financial institution has rate-sensitive liabilities...

Question 18

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

Accepted Answer

An equity swap typically involves the exchange of future cash flows between two parties, where one set of cash flows is generally based on a fixed interest rate, while the other is based on the return of an equity index, not a bond index.

Question 19

Swap transactions are only used to

Accepted Answer

Swap transactions can be used for both hedging against interest rate movements (upward or downward) and for speculative purposes, so none of the options A, B, or C alone fully captures their use.

Question 20

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

Accepted Answer

The notional value is the principal amount used to calculate the interest payments in an interest rate swap agreement. The other choices are not relevant to this aspect of the agreement.

Quiz 15: Swap Markets