Deck 8: Interest Risk and Swaps

Question 1

Instruction 8.1:
For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
• Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
• Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50%
• Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%.
Refer to Instruction 8.1. Choosing strategy #3 will:

A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.

Answer 1

maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.

Question 2

Instruction 8.1:
For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
• Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
• Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50%
• Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%.
Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer strategy #2? (Assume your firm is borrowing money.)

A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.

Answer 2

Your credit rating stayed the same and interest rates went down.

Question 3

Instruction 8.1:
For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
• Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
• Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50%
• Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%.
Refer to Instruction 8.1. Choosing strategy #1 will:

A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.

Answer 3

preclude the possibility of sharing in lower interest rates over the three-year period.

Question 4

The London Interbank Offered Rate (LIBOR) is published under the auspices of the British Bankers Association. A panel of 16 major multinational banks self-report their actual borrowing rate.

Question 5

The basis point spreads between credit ratings dramatically rise for borrowers of credit qualities less than BBB.

Question 6

Instruction 8.1:
For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
• Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
• Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50%
• Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%.
Refer to Instruction 8.1. The risk of strategy #1 is that interest rates might go down or that your credit rating might improve. The risk of strategy #2 is: (Assume your firm is borrowing money.)

A) that interest rates might go down or that your credit rating might improve.
B) that interest rates might go up or that your credit rating might improve.
C) that interest rates might go up or that your credit rating might get worse.
D) none of the above

Question 7

For a corporate borrower, it is especially important to distinguish between credit risk and repricing risk. Explain both types of risks.

Question 8

Instruction 8.1:
For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
• Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
• Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50%
• Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%.
Refer to Instruction 8.1. If your firm felt very confident that interest rates would fall or, at worst, remain at current levels, and were very confident about the firm's credit rating for the next 10 years, which strategy would you likely choose? (Assume your firm is borrowing money.)

A) Strategy #3
B) Strategy #2
C) Strategy #1
D) Strategy #1, #2, or #3; you are indifferent among the choices.

Question 9

Individual borrowers - whether they be governments or companies - possess their own individual credit rating, the market's assessment of their ability to repay debt in a timely manner. These credit assessments influence all the following EXCEPT:

A) cost of capital.
B) access to capital.
C) credit risk premium.
D) risk-free rate.

Question 10

Instruction 8.1:
For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
• Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
• Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50%
• Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%.
Refer to Instruction 8.1. The risk of strategy #1 is that interest rates might go down or that your credit rating might improve. The risk of strategy #3 is: (Assume your firm is borrowing money.)

A) that interest rates might go down or that your credit rating might improve.
B) that interest rates might go up or that your credit rating might improve.
C) that interest rates might go up or that your credit rating might get worse.
D) none of the above

Question 11

Instruction 8.1:
For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
• Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
• Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50%
• Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%.
Refer to Instruction 8.1. Choosing strategy #2 will:

A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.

Question 12

Some of the world's largest and most financially sound firms may borrow at variable rates less than LIBOR.

Question 13

Instruction 8.1:
For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
• Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
• Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50%
• Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%.
Refer to Instruction 8.1. Which strategy (strategies) will eliminate credit risk?

A) Strategy #1
B) Strategy #2
C) Strategy #3
D) Strategies #1 and #2

Question 14

________ is the possibility that the borrower's creditworthiness is reclassified by the lender at the time of renewing credit. ________ is the risk of changes in interest rates charged at the time a financial contract rate is set.

A) Credit risk; Interest rate risk
B) Repricing risk; Credit risk
C) Interest rate risk; Credit risk
D) Credit risk; Repricing risk

Question 15

Instruction 8.1:
For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
• Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
• Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50%
• Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%.
Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer strategy #3? (Assume your firm is borrowing money.)

A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.

Question 16

The single largest interest rate risk of a firm is:

A) interest sensitive securities.
B) debt service.
C) dividend payments.
D) accounts payable.

Question 17

Historically, interest rate movements have shown less variability and greater stability than exchange rate movements.

Question 18

Instruction 8.1:
For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
• Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
• Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50%
• Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%.
Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer strategy #1? (Assume your firm is borrowing money.)

A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.

Question 19

Interest rate calculations differ by the number of days used in the period's calculation and in the definition of how many days there are in a year (for financial purposes). One of the practices is to use 260 business days in a year.

Question 20

Sovereign credit risk is the global financial market's assessment of the ability of a sovereign borrower to repay USD denominated debt.

Question 21

A firm with variable-rate debt that expects interest rates to rise may engage in a swap agreement to:

A) pay fixed-rate interest and receive floating rate interest.
B) pay floating rate and receive fixed rate.
C) pay fixed rate and receive fixed rate.
D) pay floating rate and receive floating rate.

Question 22

A/an ________ is a contract to lock in today interest rates over a given period of time.

A) forward rate agreement
B) interest rate future
C) interest rate swap
D) none of the above

Question 23

An agreement to exchange interest payments based on a fixed payment for those based on a variable rate (or vice versa) is known as a/an:

A) forward rate agreement.
B) interest rate future.
C) interest rate swap.
D) none of the above

Question 24

Your firm is faced with paying a variable rate debt obligation with the expectation that interest rates are likely to go up. Identify two strategies using interest rate futures and interest rate swaps that could reduce the risk to the firm.

Question 25

If a financial manager earning interest on a future date were to buy Futures and interest rates end up going up, the position outcome would be:

A) Futures price falls; short earns a profit.
B) Futures price rises; short earns a loss.
C) Future price falls; long earns a loss.
D) Futures price rises; long earns a profit.

Question 26

If a financial manager with an interest liability on a future date were to sell Futures and interest rates end up going up, the position outcome would be:

A) Futures price falls; short earns a profit.
B) Futures price rises; short earns a loss.
C) Future price falls; long earns a loss.
D) Futures price rises; long earns a profit.

Question 27

Which of the following would be considered an example of a currency swap?

A) exchanging a dollar interest obligation for a British pound obligation
B) exchanging a eurodollar interest obligation for a dollar obligation
C) exchanging a eurodollar interest obligation for a British pound obligation
D) All of the above are examples of a currency swap.

Question 28

The potential exposure that any individual firm bears that the second party to any financial contract will be unable to fulfill its obligations under the contract is called:

A) interest rate risk.
B) credit risk.
C) counterparty risk.
D) clearinghouse risk.

Question 29

A basis point is one-tenth of one percent.

Question 30

An agreement to swap the currencies of a debt service obligation would be termed a/an:

A) currency swap.
B) forward swap.
C) interest rate swap.
D) none of the above

Question 31

The interest rate swap strategy of a firm with fixed rate debt and that expects rates to go up is to:

A) do nothing.
B) pay floating and receive fixed.
C) receive floating and pay fixed.
D) none of the above

Question 32

Unlike the situation with exchange rate risk, there is no uncertainty on the part of management for shareholder preferences regarding interest rate risk. Shareholders prefer that managers hedge interest rate risk rather than having shareholders diversify away such risk through portfolio diversification.

Question 33

An agreement to swap a fixed interest payment for a floating interest payment would be considered a/an:

A) currency swap.
B) forward swap.
C) interest rate swap.
D) none of the above

Question 34

Which of the following is an unlikely reason for firms to participate in the swap market?

A) To replace cash flows scheduled in an undesired currency with cash flows in a desired currency.
B) Firms may raise capital in one currency but desire to repay it in another currency.
C) Firms desire to swap fixed and variable payment or receipt of funds.
D) All of the above are likely reasons for a firm to enter the swap market.

Question 35

The financial manager of a firm has a variable rate loan outstanding. If she wishes to protect the firm against an unfavorable increase in interest rates she could:

A) sell an interest rate futures contract of a similar maturity to the loan.
B) buy an interest rate futures contract of a similar maturity to the loan.
C) swap the adjustable rate loan for another of a different maturity.
D) none of the above

Question 36

A firm with fixed-rate debt that expects interest rates to fall may engage in a swap agreement to:

A) pay fixed-rate interest and receive floating rate interest.
B) pay floating rate and receive fixed rate.
C) pay fixed rate and receive fixed rate.
D) pay floating rate and receive floating rate.

Question 37

If a financial manager with an interest liability on a future date were to sell Futures and interest rates end up going down, the position outcome would be:

A) Futures price falls; short earns a profit.
B) Futures price rises; short earns a loss.
C) Future price falls; long earns a loss.
D) Futures price rises; long earns a profit.

Question 38

Interest rate futures are relatively unpopular among financial managers because of their relative illiquidity and their difficulty of use.

Question 39

An interbank-traded contract to buy or sell interest rate payments on a notional principal is called a/an:

A) forward rate agreement.
B) interest rate future.
C) interest rate swap.
D) none of the above

Question 40

If a financial manager earning interest on a future date were to buy Futures and interest rates end up going down, the position outcome would be:

A) Futures price falls; short earns a profit.
B) Futures price rises; short earns a loss.
C) Future price falls; long earns a loss.
D) Futures price rises; long earns a profit.

Question 41

A swap agreement may involve currencies or interest rates, but never both.

Question 42

Counterparty risk is greater for exchange-traded derivatives than for over-the-counter derivatives.

Question 43

A firm entering into a currency or interest rate swap agreement holds no responsibility for the timely servicing of its own debt obligations since that responsibility now is born by the second party to the contract.

Question 44

How does counterparty risk influence a firm's decision to trade exchange-traded derivatives rather than over-the-counter derivatives?

Question 45

Swap rates are derived from the yield curves in each major currency.

Question 46

Your firm is faced with paying a variable rate debt obligation with the expectation that interest rates are likely to go up. Identify two strategies using interest rate futures and interest rate swaps that could reduce the risk to the firm.

Question 47

One of the reasons companies use interest rate swaps is because they are interested in opportunities to lower the cost of their debt.

Question 48

One of the reasons companies use interest rate swaps is because they pursue a target debt structure that combines maturity, currency of composition, and fixed/floating pricing.

Question 49

The real exposure of an interest or currency swap is not the total notional principal, but the mark-to-market values of differentials in interest or currency interest payments since the inception of the swap agreement.