Question 1

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.

Accepted Answer

This statement is true. Swap spreads for short-term maturities are more closely correlated with the rates in the Eurodollar CD futures market, while long-term swap spreads are more closely tied to the credit risk in the corporate bond market.

Question 2

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.

Accepted Answer

The statement is true. There are various types of swaps beyond the generic fixed-for-floating structure, such as those mentioned in the statement.

Question 3

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.

Accepted Answer

An interest rate floor provides a minimum interest rate level below which the interest rate on a floating-rate instrument cannot fall. This can help a depository institution to protect against a decline in interest rates but still maintain the potential to benefit if rates increase. An interest rate floor can be used to lock in an interest rate spread over the institution's cost of funds.

Question 4

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

Accepted Answer

If the settlement rate equals the contract rate, it means that the predicted interest rate has not changed and there is no difference between the estimated and actual interest rate. Therefore, there is no gain or loss for either party, and they both receive the same amount agreed upon in the FRA contract.

Question 5

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: ________.

Accepted Answer

For a call option on a fixed-income instrument, the value of the option decreases as interest rates increase and the price of the underlying fixed-income instrument decreases. This is because the option holder has the right to buy the underlying fixed-income instrument at a specified price, but as interest rates increase and the price of the fixed-income instrument decreases, it becomes less valuable to exercise the option. Therefore, the value of the call option decreases.

Question 6

What is forward start swap?

Accepted Answer

The answer of What is forward start swap?...

Question 7

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

Accepted Answer

The answer of What is a forward rate agreement (FRA)?...

Question 8

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.

Accepted Answer

An interest rate floor is a derivative contract used to hedge against falling interest rates, not to establish a lower bound on investment returns for fixed-rate assets. It is more relevant for variable-rate assets.

Question 9

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

Accepted Answer

The answer of An future rate swap is an agreement...

Question 10

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.

Accepted Answer

A position in an interest rate swap can indeed be interpreted as both a position in a package of forward contracts and as a series of cash flows equivalent to buying and selling cash market instruments, as swaps essentially involve exchanging one set of cash flows for another.

Question 11

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

Accepted Answer

The answer of A ceiling is created by buying an...

Question 12

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.

Accepted Answer

This statement accurately describes the definitions of a cap and an interest rate floor.

Question 13

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.

Accepted Answer

In an FRA, the buyer benefits from a rising reference rate, while in a futures contract, the buyer benefits from a falling rate.

Question 14

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

Accepted Answer

Currency swaps involve exchanging a series of cash flows in different currencies, while interest rate/equity swaps involve exchanging interest rate or equity exposures. Both types of swaps exist in addition to interest rate swaps.

Question 15

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.

Accepted Answer

This statement is true. The swap market was initially created to allow borrowers to exploit perceived credit arbitrage opportunities, but such opportunities are limited and depend on market imperfections.

Question 16

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

Accepted Answer

The interest differential formula given is incorrect for the scenario where the contract rate is greater than the settlement rate. The correct formula would involve subtracting the contract rate from the settlement rate, which is the opposite of what is stated.

Question 17

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.

Accepted Answer

An interest rate agreement typically involves one party agreeing to compensate the other if the reference rate deviates from the strike rate, not if it is the same. This is used to hedge against interest rate fluctuations.

Question 18

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).

Accepted Answer

This statement is true, as the swap market allows for the exchange of cash flows between parties, which can be used to alter the cash flow characteristics of assets or liabilities. This allows for greater flexibility in managing financial risk and achieving investment objectives.

Question 19

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

Accepted Answer

Both commercial banks and investment banking firms can take positions in swaps as part of their business activities. Swap dealers, which can be commercial banks or investment banking firms, actively engage in taking and managing swap positions. However, they also act as intermediaries between their clients who wish to enter into swap transactions.

Question 20

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

Accepted Answer

Swaps can be used by investment bankers to create a security by combining two or more swaps with different underlying assets or payment terms. The new security can then be sold to investors.

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