Question 1

Nominal differences in currency swaps

Accepted Answer

The answer of Nominal differences in currency swaps
...

Question 2

In an interest-only currency swap

Accepted Answer

In an interest-only currency swap, the counterparties exchange only the interest payments, not the principal. Therefore, they do not need to raise the actual notational principal in their home markets or hedge with forward contracts on the currency.

Question 3

In an efficient market without barriers to capital flows,the cost-savings argument of the QSD is difficult to accept,because

Accepted Answer

In an efficient market without barriers to capital flows, the prices of debt instruments and exchange rates would be accurately reflecting their respective risks and market conditions. Therefore, the cost-savings argument of the QSD, which suggests that it is possible to profit from differences in premium payments for different types of debt instruments or maturities of forward contracts, would not hold true. Any perceived arbitrage opportunity would be quickly exploited by other market participants, resulting in the elimination of the price discrepancy. Option B is irrelevant as it does not relate to the QSD, while Option C repeats Option A.

Question 4

Consider a plain vanilla interest rate swap.Firm A can borrow at 8 percent fixed or can borrow floating at LIBOR.Firm B is somewhat less creditworthy and can borrow at 10 percent fixed or can borrow floating at LIBOR + 1 percent.Eun wants to borrow floating and Resnick prefers to borrow fixed.Both corporations wish to borrow $10 million for 5 years.Which of the following swaps is mutually beneficial to each party and meets their financing needs?

Accepted Answer

In this scenario, Firm A wants to borrow floating and Firm B prefers fixed. Therefore, Firm A should borrow externally at 8% fixed for 5 years and then swap LIBOR to Firm B at 8.5% fixed on a notational principal of $5 million. This will allow Firm A to benefit from the lower LIBOR rate, while Firm B benefits from the higher fixed rate. Firm B can then borrow externally at LIBOR +1% to meet their financing needs. This swap is mutually beneficial to both parties as it allows them to access financing at their preferred rates while mitigating their respective risks.

Question 5

When a swap bank serves as a broker,

Accepted Answer

When a swap bank serves as a broker, it matches counterparties but does not assume any risk of the swap. The swap bank receives a commission for its role in matching buyers and sellers but does not take on any exposure to the terms of the swap. Therefore, option B is the correct choice. Option A is incorrect because the swap bank would only accept one side of the swap, not both. Option C is partially correct but does not capture the full nature of a swap broker's role. Option D is incorrect as there is a correct option for this question.

Question 6

When a swap bank serves as a dealer,

Accepted Answer

When a swap bank serves as a dealer, it acts as an intermediary between two counterparties (buyers and sellers) of a swap. In this role, the swap bank stands willing to accept either side of a swap, which means that it can buy or sell the swap to the counterparty. As a dealer, the swap bank assumes the risk of the swap, but it also earns a profit from the transaction, either through the bid-ask spread or a commission. Therefore, option A is the best choice.

Question 7

Consider a bank that has entered into a five-year swap on a notational balance of $10,000,000 with a corporate customer who has agreed to pay a fixed payment of 10 percent in exchange for LIBOR.As of the fourth reset date,determine the price of the swap from the bank's point of view assuming that the fixed-rate side of the swap has increased to 11 percent.LIBOR is at 5 percent.

Accepted Answer

The bank has agreed to pay LIBOR and receive a fixed payment of 10 percent from the corporate customer. However, the fixed-rate side of the swap has now increased to 11 percent. This means the bank is paying more than it is receiving in the swap.

On the fourth reset date, the swap has a remaining life of 1 year. To value the swap, we need to determine the present value of the remaining fixed payments and the remaining floating payments.

Present value of remaining fixed payment = 10% * $10,000,000 * (1/1.05^4) = $7,974,448.68

Present value of remaining floating payment = LIBOR * $10,000,000 * (1/1.05^4) = $4,774,668.43

So, the net present value of the swap for the bank is:

-$7,974,448.68 + $4,774,668.43 = -$3,199,780.25

This means that the bank is losing money on the swap, and so the answer is B, a $90,090.09 loss.

Question 8

Which combination of the following represent the risks that a swap dealer confronts. (i)interest rate risk
(ii)basis risk
(iii)exchange rate risk
(iv)political risk
(v)sovereign risk

Accepted Answer

Swap dealers face a variety of risks including interest rate risk, basis risk, exchange rate risk, political risk, and sovereign risk, as they are involved in transactions that can be affected by changes in these factors.

Question 9

A major that can be eliminated through a swap is exchange rate risk.

Accepted Answer

Currency swaps can mitigate exchange rate risk, but their effectiveness is contingent on the foreign counterparty fulfilling their obligations and not defaulting.

Question 10

A major risk faced by a swap dealer is credit risk.This is

Accepted Answer

Credit risk is the risk that a counterparty will not be able to fulfill their obligation to the swap dealer, such as making timely payments. Therefore, option A - the probability that a counterparty will default - best describes credit risk. Option B refers to double default risk, which is a subset of credit risk. Option C refers to market risk. Option D is incorrect as one of the options must be the correct answer.

Question 11

Some of the risks that a swap dealer confronts are "basis risk" and "sovereign risk." Select the definitions that best describe each.

Accepted Answer

Basis risk refers to the situation where the floating rates of the two counterparties are not pegged to the same index, while sovereign risk refers to the risk that a country may impose exchange restrictions on the currency involved in the swap. Option B correctly defines both terms. Option A interchanges the definitions, while option C describes a different risk altogether. Option D partially defines basis risk, but sovereign risk is not about fluctuating exchange rates.

Question 12

Consider fixed-for-fixed currency swap.Firm A is a U.S.-based multinational.Firm B is a U.K.-based multinational.Firm A wants to finance a £2 million expansion in Great Britain.Firm B wants to finance a $4 million expansion in the U.S.The spot exchange rate is £1.00 = $2.00.Firm A can borrow dollars at 10 percent and pounds sterling at 12 percent.Firm B can borrow dollars at 9 percent and pounds sterling at 11 percent.Which of the following swaps is mutually beneficial to each party and meets their financing needs? Neither party should face exchange rate risk.

Accepted Answer

The answer of Consider fixed-for-fixed currency swap.Firm A is a...

Question 13

Consider a fixed for fixed currency swap.The Dow Corporation is a U.S.-based multinational.The Jones Corporation is a U.K.-based multinational.Dow wants to finance a £2 million expansion in Great Britain.Jones wants to finance a $4 million expansion in the U.S.The spot exchange rate is £1.00 = $2.00.Dow can borrow dollars at $10 percent and pounds sterling at 12 percent.Jones can borrow dollars at 9 percent and pounds sterling at 10 percent.Assuming that the swap bank is willing to take on exchange rate risk,but the other counterparties are not,which of the following swaps is mutually beneficial to each party and meets their financing needs?

Accepted Answer

Dow and Jones can both benefit from a swap because they have comparative advantages in different markets. Dow has a comparative advantage in borrowing dollars, and Jones has a comparative advantage in borrowing pounds. By swapping their obligations, they can both potentially reduce their borrowing costs. Option A outlines a swap where both parties can achieve their financing needs at reduced costs compared to their direct borrowing rates in those currencies.

Question 14

A major risk faced by a swap dealer is sovereign risk.This is

Accepted Answer

Sovereign risk in the context of swap dealers refers to the risk that a country will impose exchange restrictions on a currency involved in an existing swap, affecting the ability to fulfill the swap agreement.

Question 15

XYZ Corporation enters into a 6-year interest rate swap with a swap bank in which it agrees to pay the swap bank a fixed-rate of 9 percent annually on a notional amount of SFr10,000,000 and receive LIBOR −½ percent.As of the third reset date (i.e.,midway through the 6-year agreement),calculate the price of the swap,assuming that the fixed-rate at which XYZ can borrow has increased to 10 percent.

Accepted Answer

The price of the swap can be calculated by determining the present value of the difference between the fixed payments XYZ Corporation is committed to making and the floating payments it expects to receive. Since the fixed-rate XYZ can borrow at has increased to 10%, this implies that the fixed rate it agreed to pay (9%) is now more favorable. The calculation involves discounting the future net cash flows of the swap (the difference between the 9% fixed payments and the expected LIBOR - ½% payments) back to the present value using the new borrowing rate. The specific amount (SFr248,685) would be derived from such a calculation, taking into account the remaining term of the swap, the notional amount, and the difference in interest rates.

Question 16

Floating-for-floating currency swaps

Accepted Answer

Floating-for-floating currency swaps can have reference rates that are different for the currencies involved (e.g., dollar LIBOR versus euro LIBOR), but they can also have the same reference rate with different frequencies. For example, one leg of the swap may reference the three-month LIBOR for one currency while the other leg references the six-month LIBOR for the other currency. Therefore, both options A and B are partially true, but C covers all possibilities. Option D is incorrect as there is a correct answer.

Question 17

Find the all-in-cost of a swap to a party that has agreed to borrow $5 million at 5 percent externally and pays LIBOR + ½ percent on a notational principal of $5 million in exchange for fixed rate payments of 6 percent.

Accepted Answer

The all-in-cost of the swap can be calculated by comparing the fixed rate payment of 6 percent to what the party would have paid if they had borrowed at a floating rate. The floating rate is the external borrowing rate of 5 percent plus the LIBOR spread of 0.5 percent, giving a total of 5.5 percent. 
Therefore, the party will save 0.5 percent by entering into the swap. The fixed rate of 6 percent is inclusive of this savings, so the all-in-cost is actually 5.5 percent. Thus, the party will pay LIBOR - 0.5 percent on the notational principal of $5 million. Therefore, the correct answer is C.

Question 18

A major risk faced by a swap dealer is exchange rate risk.This is

Accepted Answer

Exchange rate risk refers to the potential losses a swap dealer may face due to movements in exchange rates. This can affect the swap dealer's profits or losses on currency swaps. Option A refers to credit risk, while Option B refers to default risk, which may also impact a swap dealer but is not specifically related to exchange rate risk. Option D is incorrect as one of the previous options is the correct choice.

Question 19

A major risk faced by a swap dealer is mismatch risk.This is

Accepted Answer

Mismatch risk for a swap dealer primarily involves the challenge of finding a second counterparty to offset the position taken with the first counterparty, ensuring the dealer is not exposed to market movements.

Question 20

Amortizing currency swaps

Accepted Answer

Amortizing currency swaps involve a decrease in debt service exchanges over time as the notational principal is being amortized. In addition, these swaps also have an amortization feature where the amortized portions of the notational principals are periodically re-exchanged. Therefore, choice C is the best answer as it accurately describes both features of amortizing currency swaps.

Quiz 14: Interest Rate and Currency Swaps