FMP 20 SWAPS

Question 3

What is a plain vanilla interest rate swap?

Answer 3

An over-the-counter derivative where one party pays fixed interest and receives floating interest on a notional principal.

Question 4

How are cash flows computed in a plain vanilla interest rate swap?

Answer 4

Cash flows are calculated based on a fixed rate and a floating rate, typically tied to LIBOR.

Question 5

What is the role of financial intermediaries in the swaps market?

Answer 5

Financial intermediaries facilitate the exchange of cash flows between parties in a swap agreement.

Question 6

What is the importance of confirmation in a swap transaction?

Answer 6

Confirmation is essential for validating the terms of the swap agreement between parties.

Question 7

What is the comparative advantage argument for interest rate swaps?

Answer 7

It posits that companies have varying advantages in different debt markets, allowing them to benefit from swaps.

Question 8

How are discount rates in a plain vanilla interest rate swap computed?

Answer 8

Discount rates are computed using market rates, with OIS replacing LIBOR as the standard post-2008 crisis.

Question 9

How can you calculate the value of a plain vanilla interest rate swap?

Answer 9

By analyzing two simultaneous bond positions or a sequence of forward rate agreements (FRAs).

Question 10

What is a currency swap?

Answer 10

A swap agreement where cash flows in one currency are exchanged for cash flows in another currency.

Question 11

What does a currency swap transform?

Answer 11

It transforms assets or liabilities denominated in one currency into another currency.

Question 12

What is credit risk exposure in a swap position?

Answer 12

The risk that one party will default on its cash flow obligations in a swap agreement.

Question 13

List other types of swaps.

Answer 13

• Commodity swaps
• Volatility swaps
• Exotic swaps

Question 14

When was the over-the-counter swap market born?

Answer 14

The market was initiated with a currency swap between IBM and the World Bank in 1981.

Question 15

What is the notional principal in a swap?

Answer 15

The amount on which cash flows are calculated but is not exchanged between parties.

Question 16

What was used as a proxy for the risk-free discount rate before the 2008 crisis?

Answer 16

LIBOR was used prior to the 2008 crisis.

Question 17

What is the typical payment frequency in a plain vanilla interest rate swap?

Answer 17

Payments are exchanged every six months.

Question 18

Fill in the blank: A swap can transform a floating-rate loan into a _______.

Answer 18

fixed-rate loan.

Question 19

Fill in the blank: After entering a swap, Apple’s effective fixed-rate payment becomes _______.

Answer 19

3.1%.

Question 20

How does a company transform a fixed-rate loan into a floating-rate loan using a swap?

Answer 20

By entering a swap that pays floating and receives fixed.

Question 21

What interest rate does Intel aim to achieve by entering a swap?

Answer 21

A floating rate linked to LIBOR.

Question 22

What does the swap agreement between AAA Corp and BBB Corp illustrate?

Answer 22

The comparative advantage in borrowing fixed versus floating rates.

Question 23

What is the net effect of cash flows for AAA Corp after entering the swap?

Answer 23

It pays less than it would directly in the floating rate market.

Question 24

True or False: The principal amount in a swap is exchanged between parties.

Answer 24

False.

Question 25

What happens to the cash flows in a swap from the perspective of the parties involved?

Answer 25

They are netted against each other, resulting in a single cash flow exchanged.

Question 26

What is the net effect of cash flows for AAA Corp?

Answer 26

AAA Corp pays ___ per annum less than it would pay if it went directly to floating rate markets.

Question 27

What interest rate does BBB Corp pay to outside lenders?

Answer 27

BBB Corp pays LIBOR + 0.6% per annum.

Question 28

What does BBB Corp receive from AAA Corp?

Answer 28

BBB Corp receives LIBOR from AAA Corp.

Question 29

What is the interest rate that BBB Corp pays to AAA Corp?

Answer 29

BBB Corp pays 4.35% per annum to AAA Corp.

Question 30

What is the total apparent gain from an interest rate swap arrangement?

Answer 30

Total gain is always ∆fixed — ∆floating.

Question 31

What are the criticisms of the comparative-advantage argument in swaps?

Answer 31

Criticism includes the expectation that spreads should be arbitraged away and that floating rates will not adjust.

Question 32

What factors contribute to spread differentials between AAA Corp and BBB Corp?

Answer 32

* Credit risk * Fixed and floating market contract nature * Rate adjustments based on creditworthiness

Question 33

What does the Bond Method Valuation for an interest rate swap involve?

Answer 33

The position of one company is equivalent to a long position in floating-rate bond and a short position in a fixed-rate bond.

Question 34

What is the FRA Method Valuation for an interest rate swap?

Answer 34

Valued by assuming forward rates are realized and discounting swap cash flows at the risk-free rate.

Question 35

What is a fixed-for-fixed currency swap?

Answer 35

Exchanging principal and interest payments at a fixed rate in one currency for principal and interest payments at a fixed rate in another currency.

Question 36

In the fixed-for-fixed currency swap example, what fixed rate does British Petroleum pay in dollars?

Answer 36

British Petroleum pays a fixed rate of 3%.

Question 37

What fixed rate does British Petroleum receive in British pounds?

Answer 37

British Petroleum receives a fixed rate of 4%.

Question 38

What is the purpose of a currency swap?

Answer 38

To transform borrowings or assets from one currency to another.

Question 39

What are the two methods to value currency swaps?

Answer 39

* Bond Method * FRA Method

Question 40

What does the Bond Method for currency swaps valuation involve?

Answer 40

The value of a swap is the difference between two bonds defined by domestic and foreign cash flows.

Question 41

What are the two popular types of currency swaps mentioned?

Answer 41

* Fixed-for-floating * Floating-for-floating

Question 42

What is credit risk in the context of swaps?

Answer 42

The possibility of a default by the counterparty when the value of the contract is positive.

Question 43

What is the difference between credit risk and market risk?

Answer 43

Credit risk arises from counterparty default; market risk arises from changes in market variables.

Question 44

What is credit risk in a financial institution?

Answer 44

The possibility of a default by the counterparty when the value of the contract to the financial institution is positive.

Question 45

What is market risk in a financial institution?

Answer 45

The possibility that market variables such as interest rates and exchange rates will move in such a way that the value of a contract becomes negative.

Question 46

How can market risks be hedged?

Answer 46

By entering into offsetting contracts.

Question 47

Is credit risk easy or difficult to hedge?

Answer 47

Less easy to hedge.

Question 48

What is the most common reference floating interest rate in fixed-for-floating interest rate swaps?

Answer 48

LIBOR.

Question 49

What are the standard tenors for LIBOR in interest rate swaps?

Answer 49

One month, three months, and 12 months.

Question 50

In fixed-for-floating interest rate swaps, does the tenor on the floating side have to match the tenor on the fixed side?

Answer 50

No.

Question 51

What is a basis swap?

Answer 51

A floating-for-floating interest rate swap.

Question 52

What is a compounding swap?

Answer 52

A swap where interest on one or both sides is compounded forward to the end of the life of the swap with only one payment date at the end.

Question 53

What defines a LIBOR-in-arrears swap?

Answer 53

The LIBOR rate observed on a payment date is used to calculate the payment on that date.

Question 54

What is an accrual swap?

Answer 54

A swap where interest on one side accrues only when the floating reference rate is in a certain range.

Question 55

What is an amortizing swap?

Answer 55

A swap where the principal reduces in a predetermined way.

Question 56

What is a step-up swap?

Answer 56

A swap where the principal increases in a predetermined way.

Question 57

What is a forward swap?

Answer 57

A swap where the parties do not begin to exchange interest payments until a future date.

Question 58

What is a constant maturity swap (CMS swap)?

Answer 58

An agreement to exchange a LIBOR rate for a swap rate.

Question 59

What is a constant maturity Treasury swap (CMT swap)?

Answer 59

An agreement to exchange a LIBOR rate for a particular Treasury rate.

Question 60

What is a Quanto swap?

Answer 60

A swap where a rate observed in one currency is applied to a principal amount in another currency.

Question 61

What is an equity swap?

Answer 61

An agreement to exchange the total return realized on an equity index for either a fixed or a floating rate of interest.

Question 62

What is an extendable swap?

Answer 62

A swap where one party has the option to extend the life of the swap beyond the specified period.

Question 63

What is a puttable swap?

Answer 63

A swap where one party has the option to terminate the swap early.

Question 64

What are swaptions?

Answer 64

Options on swaps that provide one party with the right to enter into a swap in the future.

Question 65

What are commodity swaps?

Answer 65

A series of forward contracts on a commodity with different maturity dates and the same delivery prices.

Question 66

What is a volatility swap?

Answer 66

A swap where one side pays a pre-agreed volatility while the other side pays the historical volatility realized during the period.

Question 67

What limits the types of swaps that can be created?

Answer 67

The imagination of financial engineers and the desires of corporate treasurers and fund managers.