Question 1

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

Comment: Like the situation with exchange rate risk, there is no certainty on the part of management for shareholder preferences regarding interest rate risk.

Question 2

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

Accepted Answer

Interest rate movements tend to change slowly and predictably over time, while exchange rates can be highly volatile and prone to sudden shifts due to economic, political, and other factors.

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. 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.

Accepted Answer

If the borrower's credit rating improves, they would be able to secure a lower fixed rate on the initial $1,000,000 loan. If interest rates go down, the borrower can renew the credit annually at a lower rate, resulting in lower interest expense compared to strategy #1. Therefore, strategy #3 would be preferable under these circumstances.

Question 4

The time value is asymmetric in value as you move away from the strike price (i.e., the time value at two cents above the strike price is not necessarily the same as the time value two cents below the strike price).

Accepted Answer

Comment: The time value is symmetric in value as you move away from the strike price (i.e., the time value at two cents above the strike price is not necessarily the same as the time value two cents below the strike price).

Question 5

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.

Accepted Answer

If a firm expects interest rates to fall, it would benefit from paying a lower, fixed rate and receiving a higher, floating rate. By engaging in a swap agreement, the firm can achieve this by paying the lower fixed rate on a swap contract and receiving the higher floating rate from the counterparty. This would allow the firm to effectively reduce its interest expense and improve its financial position. Choice A would not be beneficial in a decreasing interest rate environment, as the firm would be paying a higher, fixed rate. Choice C would not provide any benefit for the firm, as it would continue to pay a fixed rate regardless of interest rate movements. Choice D would not provide any benefit for the firm, as it would continue to pay a floating rate regardless of interest rate movements.

Question 6

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

Accepted Answer

Comment: A swap agreement may involve both currencies or interest rates.

Question 7

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.

Accepted Answer

All of the given options are likely reasons for a firm to participate in the swap market.

Question 8

A basis point is one-tenth of one percent.

Accepted Answer

Comment: A basis point is one-hundredth of one percent.

Question 9

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

Accepted Answer

The answer of The interest rate swap strategy of a...

Question 10

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

Accepted Answer

A currency swap involves two parties agreeing to exchange or swap their currencies for a specified period of time. This is usually done to manage foreign exchange risk or to take advantage of different interest rates in different currencies. Therefore, an agreement to swap the currencies of a debt service obligation would be termed a currency swap.

Question 11

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

Accepted Answer

An agreement to exchange interest payments based on a fixed payment for those based on a variable rate (or vice versa) is known as an interest rate swap. A forward rate agreement is an agreement between two parties to lock in a future interest rate for a loan or investment, while an interest rate future is a standardized contract traded on exchanges.

Question 12

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

Accepted Answer

The answer of The financial manager of a firm has...

Question 13

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

Accepted Answer

A forward rate agreement (FRA) is a binding contract between two parties that ensures a predetermined interest rate on an underlying notional principal amount for a specified period starting at a future date. It is traded in the interbank market and used for hedging against interest rate risk by financial institutions or investors. Interest rate futures and swaps are also related to managing interest rate risk, but they differ in terms of their contract specifications and terms.

Question 14

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.

Accepted Answer

Strategy #2, with a floating rate based on LIBOR, would be preferred if interest rates went down. If interest rates went up or credit rating changed, strategy #1 or #3 may be preferred depending on the specific circumstances. However, without knowing more about the borrower's credit rating, it is not possible to determine the best choice with certainty.

Question 15

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.

Accepted Answer

Counterparty risk refers to 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. This risk is commonly associated with credit risk as it pertains to the creditworthiness of the counterparty. Clearinghouse risk pertains to the risk of loss posed by a clearinghouse in the event of a default by one or more of its participants. Interest rate risk pertains to the fluctuation of interest rates and their effect on the value of an investment. Thus, the best choice is C.

Question 16

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

Accepted Answer

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

Question 17

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.

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 18

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.

Accepted Answer

A currency swap involves the exchange of both principal and interest payments in one currency for the same in another currency. Option A involves exchanging one currency for another but only involves interest payments, not principal. Option B involves exchanging one currency for another but both are dollar obligations, so it is not a currency swap. Option C involves a currency swap by exchanging both principal and interest payments in eurodollars for the same in British pounds. Therefore, D is the correct answer as all three options involve currency swaps for different currency pairs.

Question 19

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

Accepted Answer

Comment: Interest rate futures are relatively popular among financial managers because of their relative liquidity and their ease of use.

Question 20

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

Accepted Answer

An agreement to swap a fixed interest payment for a floating interest payment is known as an interest rate swap. Option A, currency swap, involves exchanging one currency for another. Option B, forward swap, is not a valid financial term. Option D, none of the above, is incorrect as the correct answer is C.

Quiz 8: Foreign Currency Derivatives and Swaps

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

The time value is asymmetric in value as you move away from the strike price (i.e., the time value at two cents above the strike price is not necessarily the same as the time value two cents below the strike price).

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

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

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

A basis point is one-tenth of one percent.

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

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

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:

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:

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

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

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

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

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

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