honeycfa

Which of the following characteristics about swaps is least accurate? Swaps:

A) are highly regulated.

B) have no active secondary market.

C) are custom instruments.

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Swap contracts are largely unregulated.

honeycfa

Which of the following regarding a plain vanilla interest rate swap is most accurate?

A) The notional principal is swapped.

B) Only the net interest payments are made.

C) The notional principal is returned at the end of the swap.

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The plain vanilla interest rate swap involves trading fixed interest rate payments for floating rate payments. Swaps are a zero sum game, what one party gains the other party loses. In interest rate swaps, only the net interest rate payments actually take place because the notional principal swapped is the same for both counterparties and in the same currency units, there is no need to actually exchange the cash.

honeycfa

The term notional principal refers to:

A) the amount swapped.

B) the period of time involved.

C) the cash interest payment.

The notional principal is the amount swapped. Note that the notional principal does not actually change hands with plain vanilla interest rate swaps, but is used to calculate the interest payment streams to be exchanged. Notional principal does exchange hands in a foreign currency swap.

honeycfa

Consider a commercial bank with a portfolio of U.S. Treasury bonds. Why would the bank wish to engage in a swap contract? As the:

A) interest rate increases, the value of the bonds decreases.

B) U.S. dollar decreases, the value of the bonds decreases.

C) interest rate decrease, the value of the bonds decreases.

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Interest rates and bond prices are inversely related. Therefore, as interest rates increase, the value of the T-bonds decreases. The bank may wish to engage in a swap contract wherein the bank pays fixed and receives variable. In this case, as interest rates rise, the bank receives higher variable payments for making the same fixed payment in the swap. The cash flows received in the swap offset the reduction in the bond portfolio’s value.

honeycfa

Jan Jurgen, CFA charterholder, recently accepted a position in the Treasury area of a conservatively managed commercial bank. Jurgen intends to suggest the use of plain-vanilla interest rate swaps at today’s Asset & Liability Management Committee meeting. Jurgen is least likely to argue that the use of interest rate swaps will:

A) avoid costly regulations.

B) create arbitrage profits by exploiting market inefficiencies.

C) reduce the exposure from the mismatch between floating rate assets and fixed rate liabilities.

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Exploiting market inefficiencies is no longer considered a motivation for entering into swap agreements. Historically, there were two basic motivations for swaps, to exploit market inefficiencies and to attempt to obtain cheaper financing. Both were based on the belief that financial markets were inefficient. Today, the swap markets have matured and there are few arbitrage opportunities. The swap markets are considered operationally efficient and flexible. Thus, the main reasons to enter into swap agreements today include: to reduce transaction costs, to avoid costly regulations, and to maintain privacy.

honeycfa

Parties agreeing to swap cash flows are:

A) swap facilitators.

B) counterparties.

C) agents.

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The parties agreeing to swap cash flows are called the counterparties.

honeycfa

Consider a U.S. investor who has a portfolio of Australian government bonds that are denominated in Australian dollars. Why would the investor wish to enter into a swap contract? As the:

A) Australian dollar increases in value, the interest payments from the Australian bonds translate into fewer U.S. dollars.

B) Australian interest rate decreases, the value of the Australian bonds decreases.

C) Australian dollar decreases in value, the interest payments from the Australian bonds translate into fewer U.S. dollars.

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As the Australian dollar decreases in value, the interest payments from the bond (and perhaps the bond’s face value if the bond is at maturity), translate into fewer U.S. dollars, which reduces the interest earned on the Australian bonds.

honeycfa

Which of the following statements about swaps is least accurate?

A) The notional principal is swapped at the beginning and end of a currency swap.

B) Motivations to engage in swaps include reducing transaction costs and maintaining privacy.

C) The notional principal is swapped at the beginning of an interest rate swap.

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In interest rate swaps, there is no need to actually exchange the notional amount, since the notional principal swapped is the same for both counterparties and in the same currency units. Net interest is paid by the one who owes it at settlement dates.

Explanations for other responses:

The reasons given now for using the swap markets are to: reduce transactions costs, avoid costly regulations, and maintain privacy. Historically, there were two basic motivations for swaps: to exploit perceived market inefficiencies and to attempt to obtain cheaper financing. Both of these motivations are based on the concept that the financial markets are inefficient. This fact, unfortunately, is no longer true.  Today, the swap markets are mature and offer few arbitrage opportunities. Swap markets are now viewed as being more operationally efficient and a more flexible means of packaging and transforming cash flows than any other method. Currency swaps often occur because of comparative advantage. For example, parties may want to reduce borrowing costs. One firm may have better access to a country’s domestic capital markets than another firm. The U.S. firm (D) may have access to the U.S. capital markets but not the German markets, while the German firm (M) may have access to the German markets but not the U.S. markets. If each firm borrows locally and then exchanges the funds, they will both gain.

In a currency swap, interest payments are made without netting. Full interest payments are exchanged at each settlement date. Currency swap counterparties actually exchange notional principal because the motivation of the parties is to receive foreign currency.

honeycfa

Which of the following statements involving a plain vanilla interest rate swap is least accurate? In a plain interest rate swap, the:

A) counterparty who receives the fixed payment by agreeing to pay variable rate interest is called the receive-fixed side of the swap.

B) parties involved in the swap agreement are called counterparties.

C) parties generally agree to swap the notional principal.

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The notional principal is the dollar amount specified in the swap agreement. The counterparties use the notional principal to determine the amount of the interest payments. They generally do not exchange the notional principal.

honeycfa

Which transaction would least likely be classified as an interest rate swap?

A) Receive U.S. fixed, pay U.S. commercial paper.

B) Pay USD fixed, receive U.S. LIBOR.

C) Receive AUD fixed, pay NZD floating.

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Because it involves two different currencies, this would be a currency swap.