Hull Chapter 7 - Options, Futures, and Other Derivatives

Question 1

2003 Q9.a Define an interest rate swap

Answer 1

An interest rate swap is a deal whereby one exchanges a series of fixed interest rate payments for a series of floating interest rate payments or vise versa.

Question 2

2003 Q9.b Assume that an intermediary is involved in an interest rate swap. Briefly describe the obligations of each of the three parties involved.

Answer 2

One party borrows at a fixed rate, and pays the intermediary at a floating rate. The other party borrows money at a floating rate, and pays the intermediary at a fixed rate. The intermediary receives the payments then pays fixed/floating rates to the appropriate party, and keeps a commission. The only risk to the intermediary is the default risk of one party.

Question 3

2003 Q9.c Cite and explain one example of how an interest rate swap could be used by a fixed income portfolio manager to control risk or improve returns.

Answer 3

A fixed income portfolio manager receives fixed schedule interest rate payments. This leaves the value of the portfolio vulnerable to rise interest rates. A fixed for floating swap will lower the risk of a decline in portfolio value.

Question 4

Driefly describe what a swap rate means

Answer 4

A swap rate for a particular maturity is the average of bid and offer fixed rates that a market maker is prepared to exchange for LIBOR in a standard plain vanilla swap with that maturity.

Question 5

Foreign exchange swap: Principal is exchanged at the maturity!!

Answer 5

Principal is exchanged at the maturity!!

Question 6

Criticism of the Comparative-Advantage Argument

Answer 6

The spread differentials exist due to the nature of the contracts involved:

1. fixed-rates are usually issued for long term (e.g. 5-years)
2. floating-rates are usually for 6-month
3. If the creditworthiness of the company declines, the lender has the option of increasing the spread over LIBOR that is charged. The providers of fixed-rate financing do not have the option to change the terms of to loan in this way.
4. The spreads between the rates offered to AAACorp and BBBCorp are a reflection of the extent to which BBBCorp is more likely to default than AAACorp.
5. BBBCorp’s spread over 6-month is likely to rise than fall

Question 7

Two types of varied interest rate swaps

Answer 7

a. A constant maturity swap (CMS swap) is an agreement to exchange a LIBOR rate for a swap rate.
An example: exchange 6-month LIBOR applied to a certain principal for the 10-year swap rate applied to the same principal every 6 months for the next 5 years

b. A constant maturity Treasury swap (CMT swap): exchange a LIBOR rate for a particular Treasury rate (e.g., the 10-year Treasury rate).