Question 1

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

Accepted Answer

By entering into a swap agreement to pay fixed-rate interest and receive floating-rate interest, a firm with variable-rate debt can hedge against the risk of rising interest rates. This swap effectively converts their variable-rate debt into fixed-rate debt, stabilizing their interest payments.

Question 2

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

Accepted Answer

The answer of A/an ________ is a contract to lock...

Question 3

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:

Accepted Answer

An agreement to exchange interest payments based on a fixed payment for those based on a variable rate is called an interest rate swap. A forward rate agreement (A) is a type of financial contract that partially functions as a hedging tool or an investment opportunity. An interest rate future (B) is a standardized contract traded on an exchange that obligates the buyer to purchase a specific interest-bearing instrument at a future date for a predetermined price. Therefore, the best choice among the given options is C.

Question 4

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.

Accepted Answer

The answer of Your firm is faced with paying a...

Question 5

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:

Accepted Answer

When interest rates rise, the price of futures contracts typically falls. If the financial manager is long on futures, they would incur a loss as the value of their position decreases.

Question 6

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:

Accepted Answer

When interest rates go up, the price of futures contracts typically falls. Since the financial manager has sold futures (short position), a fall in futures prices means they can buy back the futures at a lower price, thus earning a profit.

Question 7

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

Accepted Answer

Currency swap involves exchanging the principal and interest payments of two different currencies, typically to manage foreign exchange risk or access cheaper funding. Therefore, all of the given options involve exchanging obligations in different currencies, making them examples of currency swaps.

Question 8

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:

Accepted Answer

Counterparty risk refers to the risk of default by the second party to a financial contract. It is also sometimes referred to as credit risk, but this term is more commonly used to describe the risk associated with the borrower of a loan or the issuer of a bond. Counterparty risk is a significant concern in financial markets, and firms will often take steps to mitigate or manage this risk, such as requiring collateral, using credit derivatives, or conducting credit checks on potential counterparties. Interest rate risk refers to the risk of changes in interest rates affecting the value of a financial instrument, while clearinghouse risk refers to the risk of loss resulting from the failure of a clearinghouse to fulfill its obligations.

Question 9

A basis point is one-tenth of one percent.

Accepted Answer

A basis point is one-hundredth of one percent, or 0.01%.

Question 10

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

Accepted Answer

A currency swap is an agreement between two parties to exchange a series of future cash flows in different currencies, usually to manage currency or interest rate risks. In the context of debt service obligations, a currency swap can help borrowers manage their cash flows by swapping the currencies in which they have to make debt payments. This can be useful in cases where the borrower has income streams in a different currency or wants to take advantage of favorable exchange rate movements. The other options, forward swap and interest rate swap, do not accurately describe this scenario.

Question 11

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

Accepted Answer

If a firm expects interest rates to go up and has fixed rate debt, it would benefit from doing nothing because its fixed rate debt will become cheaper relative to the market as rates rise.

Question 12

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.

Accepted Answer

Shareholder preferences regarding interest rate risk management can vary. Some may prefer that the company hedges against such risks to protect earnings, while others might believe they can manage this risk more effectively through their own portfolio diversification strategies. There is no one-size-fits-all preference among shareholders regarding the management of interest rate risk.

Question 13

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

Accepted Answer

An agreement to swap a fixed interest payment for a floating interest payment is a type of interest rate swap. A currency swap involves exchanging one currency for another, and a forward swap is not a commonly used financial term.

Question 14

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

Accepted Answer

All of the reasons listed are common motivations for firms to participate in the swap market. There are other potential reasons such as managing interest rate risk, but the options listed in the question are all valid drivers for swap market activity.

Question 15

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:

Accepted Answer

Selling an interest rate futures contract allows the firm to lock in a future interest rate, thus hedging against the risk of rising interest rates.

Question 16

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

Accepted Answer

If a firm expects interest rates to fall, they would want to pay floating rate (which will decrease) and receive fixed rate (which would be higher than the future floating rate). This would protect them from the decrease in interest rates and allow them to save money on their interest payments. Therefore, the best choice in this situation is to pay floating rate and receive fixed rate, which is option B.

Question 17

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:

Accepted Answer

If interest rates go down, futures prices rise, resulting in a loss for the short position.

Question 18

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

Accepted Answer

Interest rate futures are actually popular among financial managers because they are seen as a useful tool for hedging against interest rate risk. They are also considered relatively liquid and easy to use compared to other financial derivatives.

Question 19

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

Accepted Answer

An interbank-traded contract to buy or sell interest rate payments on a notional principal is known as a forward rate agreement (FRA). In a FRA, the buyer and seller agree to exchange cash flows based on a predetermined notional principal amount, an interest rate, and a settlement date in the future. This agreement helps market participants to mitigate the risk of fluctuations in interest rates.  Interest rate futures and interest rate swaps are other derivative financial instruments that can help manage interest rate risk, but they differ from FRAs in their structure and mechanics.

Question 20

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:

Accepted Answer

When interest rates go down, the price of futures typically rises. A financial manager who buys futures (goes long) would profit from an increase in futures prices.

Quiz 8: Interest Risk and Swaps