A bank is concerned about excess volatility in its cash flows from some recent business loans it has made.Many of these loans have a fixed rate of interest and the bank's economics department has forecast a sharp increase in interest rates.The bank wants more stable cash flows.Which type of credit derivative contract would you most recommend for this situation?

Question

Quizplus · Accepted Answer

A total-return swap is the most suitable credit derivative contract in this situation because it allows the bank to exchange the fixed interest payments it receives from the business loans for payments that are more closely tied to the current interest rates, thus reducing the volatility in its cash flows caused by the forecasted sharp increase in interest rates.

A Bank Is Concerned About Excess Volatility in Its Cash