Which of the following statements about a currency swap is CORRECT?
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Swap payments are based on the notional amounts of each currency and either a fixed or floating rate for either or both parties. While changes in exchange rates might be reflected in interest rates, they have no direct effect on any of the payment amounts over the term of the swap.
Which of the following statements regarding a fixed-for-fixed currency swap of euros for British pounds is least accurate?
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The original notional principal amounts are exchanged at contract termination; there is no adjustment to the amounts for the change in exchange rates over the life of the swap.
An investor enters into a swap that requires the notional principal amounts be exchanged at the beginning and at the end of the swap contract. This is most likely a:
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A currency swap requires that the notional amount of one currency be exchanged for the notional amount of the other currency at both the beginning and the end of the swap.
Consider a U.S. commercial bank that wishes to make a two-year, fixed-rate loan in Australia denominated in Australian dollars. The U.S. bank will fund the loan by issuing two-year CDs in the U.S. Why would the U.S. bank wish to enter into a currency swap? The bank faces the risk that:
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There is no interest rate risk for the bank because the bank has fixed rates for two years on both the asset and the liability. However, the bank faces a problem in that if the Australian dollar decreases in value, the loan (and the interest payments from the loan) will not translate back into as many U.S. dollars. Indeed, if the Australian dollar decreases significantly, the loan (and the interest payments from the loan) may not translate back into enough U.S. dollars to repay the CDs.
Consider a U.S. commercial bank that takes in one-year certificates of deposit (CDs) in its Hong Kong branch, denominated in Hong Kong dollars, to fund three-year, fixed-rate loans the bank is making in the U.S. denominated in U.S. dollars. Why would this bank wish to enter into a currency swap? The bank faces the risk that the Hong Kong dollar:
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The bank faces two problems. First, if the Hong Kong dollar increases in value, it will take more U.S. dollars to repay the Hong Kong depositors. Indeed, if the Hong Kong dollar increases significantly, it may take more U.S. dollars to repay the Hong Kong depositors than the bank makes on the U.S. loan. Secondly, if the interest rate in Hong Kong rises, the bank pays more in interest on its CDs while the rate on the bank’s U.S. loans does not change. In this case, interest expense would rise and interest income would remain the same, which narrows the bank’s profits
A U.S. bank enters into a plain vanilla currency swap with a notional principal of US$100m (￡67m). At each settlement date, the U.S. bank pays a fixed rate of 8% on the pounds received, and an English bank pays a variable rate equal to London Interbank Offered Rate (LIBOR) on the U.S. dollars received. Given the following information, what payment is made to whom at the end of year 2?
The U.S. bank pays:
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The U.S. bank pays 8% fixed on ￡67m, which makes for an annual payment of ￡5.36m. The variable rate to be used at time period 2 is set at time period 1 (the arrears method). Therefore, the English bank pays 5.5% times US$100m for a payment of US$5.5m.
The term exchange of borrowings refers to:
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In effect, in a currency swap, the two parties make independent borrowings and then exchange the proceeds. This is known as an exchange of borrowings. A swaption is an option on a swap that can be either American or European in form. (Swaptions are a Level II Topic).
Why are payments NOT usually netted out in a currency swap?
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Payments are not usually netted out because the payments are denominated in two different currencies, which does not easily allow for netting.
Consider a quarterly-pay currency swap where Party A pays London Interbank Offered Rate (LIBOR) on $1,000,000 and Party B pays 4% on 900,000 euros. Current LIBOR is 3% and at the end of 90 days it is 4%. Which of the following statements regarding the first settlement date is most accurate?
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Floating rate payments in a swap are based on the reference rate for the prior period. The payment is: 0.03 × 90/360 × 1,000,000 = $7,500
Consider a currency swap in which Party A pays 180-day London Interbank Offered Rate on $1,000,000 and Party B pays the Japanese yen riskless rate on 130,000,000 yen. Which of the following statements regarding the terms required at the initiation of the swap is CORRECT?
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Since Party A is paying in dollars, Party A must receive dollars in exchange for yen at the beginning of the swap.
A U.S. bank enters into a plain vanilla currency swap with a German bank. The swap has a notional principal of US$15m (Euro 15.170m). At each settlement date, the U.S. bank pays a fixed rate of 6.5 percent on the Euros received, and a German bank pays a variable rate equal to LIBOR+2 percent on the U.S. dollars received. Given the following information, what payment is made to whom at the end of year 2?
| U.S. bank pays | German bank pays |
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The U.S. bank pays 6.5% fixed on Euro 15,170,000, which makes for an annual payment of Euro 986,050. The variable rate to be used at time period 2 is set at time period 1 (the arrears method). Therefore, the German bank pays 6.5% + 2% = 8.5% times US$15,000,000 for a payment of US$1,275,000.
XYZ company has entered into a "plain-vanilla" interest rate swap on $1,000,000 notional principal. XYZ company pays a fixed rate of 8% on payments that occur at 90-day intervals. Six payments remain with the next one due in exactly 90 days. On the other side of the swap, XYZ company receives payments based on the LIBOR rate. Describe the transaction that occurs between XYZ company and the dealer at the end of the first period if the appropriate LIBOR rate is 8.8%.
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XYZ company owes the dealer ($1,000,000)(0.08)(90/360) = $20,000. The dealer owes XYZ company ($1,000,000)(0.088)(90/360) = $22,000. Net: The dealer pays XYZ company $22,000 - $20,000 = $2,000
Consider a swap with a notional principal of $100 million.
Given the above diagrams, which of the following statements is CORRECT? At time period 2:
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The variable rate to be used at time period 2 is set at time period 1 (the arrears method). Therefore, the appropriate variable rate is 7%, the fixed rate is 8%, and the interest payments are netted. The fixed-rate payer, counterparty B, pays according to:
(Swap Fixed Rate – LIBORt-1)(# of days/360)(Notional Principal).
In this case, we have (0.08 - 0.07)(360/360)($100 million) = $1 million
Consider a $10,000,000 1-year quarterly-pay swap with a fixed rate of 4.5% and a floating rate of 90-day London Interbank Offered Rate (LIBOR) plus 150 basis points. 90-day LIBOR is currently 3% and the current forward rates for the next four quarters are 3.2%, 3.6%, 3.8%, and 4%. If these rates are actually realized, at the termination of the swap the floating-rate payer will:
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The payment at the fourth (final) settlement date will be based on the realized LIBOR at the third quarter, 3.8%. The net payment by the floating rate payer will be: (0.038 + 0.015 ? 0.045) × 90/360 × 10,000,000 = $20,000
Consider a swap with a notional principal of $120 million.
Given the above diagrams, which of the following statements is CORRECT? At the end of 360 days:
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The variable rate to be used at the end of 360 days is set at the 180-day period (the arrears method). Therefore, the appropriate variable rate is 10%, the fixed rate is 11%, the time period is 180 days, and the interest payments are netted. The fixed-rate payer, counterparty A, pays according to:
(Swap Fixed Rate – LIBORt-1)(# of days/360)(Notional Principal).
In this case, we have (0.11 - 0.10)(180/360)($120 million) = $0.6 million
Currency swap markets consist of transactions in:
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In this explanation, Euro is used to represent foreign currency. In a currency swap, one counterparty (D) holds dollars and wants Euros. The other counterparty (E) holds Euros and wants dollars. They decide to swap their currency positions at the current spot exchange rate. The counterparties exchange the full notional principal at the onset of the swap. Then, on each settlement date, one party pays a fixed rate of interest on the foreign currency received, and the other party pays a floating rate on the dollars received. Interest payments are not netted. Generally, the variable interest rate on the dollar borrowings is determined at the beginning of the settlement period and paid at the end of the settlement period. At the conclusion of the swap, the notional currencies are again exchanged. Thus, currency swaps involved transactions in both the spot and forward (future) markets. A fixed-for-fixed currency swap is equivalent to a portfolio of foreign exchange forward contracts (both parties need to deliver currency in the future).
Consider a swap with a notional principal of $300 million, annual payments, and a 30E/360 daycount convention (every month has 30 days, a year has 360 days).
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LIBOR |
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Counterparty |
??????????? |
Counterparty |
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7% Fixed |
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LIBOR = 5.5% |
LIBOR = 6.5% |
LIBOR = 7% | |||
Given the above diagram, which of the following statements is most accurate? At time period 2:
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The variable rate to be used at time period 2 is set at time period 1 (the arrears method). Therefore, the appropriate variable rate is 6.5%, the fixed rate is 7%, and the interest payments are netted. The fixed-rate payer, counterparty B, pays according to:
[Swap Fixed Rate – LIBORt-1][(# of days)/(360)][Notional Principal].
In this case, we have [0.07 – 0.065][360/360][$300 million] = 1.5 million.
Consider a swap with a notional principal of $100 million.
Given the above diagrams, which of the following statements is CORRECT? At the end of year 3:
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The variable rate to be used at the end of year 3 is set at the end of 2? years (the arrears method). Therefore, the appropriate variable rate is 9%, the fixed rate is 6.5%, and the interest payments are netted. The fixed-rate payer, counterparty B, pays according to:
(Swap Fixed Rate – LIBORt-1)(# of days/360)(Notional Principal).
In this case, we have (0.065 - 0.09)(180/360)($100 million) = $-1.25 million.
Consider a $10,000,000 1-year quarterly-pay swap with a fixed rate of 4.5 percent and a floating rate of 90-day London Interbank Offered Rate (LIBOR) plus 150 basis points. 90-day LIBOR is currently 3 percent and the current forward rates for the next four quarters are 3.2 percent, 3.6 percent, 3.8 percent, and 4 percent. If these rates are actually realized, at the first quarterly settlement date:
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The first floating rate payment is based on current LIBOR + 1.5% = 4.5%. This is equal to the fixed rate so no (net) payment will be made on the first settlement date.
No Errors Printing has entered into a "plain-vanilla" interest rate swap on $1,000,000 notional principal. No Errors receives a fixed rate of 5.5% on payments that occur at quarterly intervals. Platteville Investments, a swap broker, negotiates with another firm, Perfect Bid, to take the pay-fixed side of the swap. The floating rate payment is based on LIBOR (currently at 6.0%). Because of the current interest rate environment, No Errors expects to pay a net amount at the next settlement date and has created a reserve to cover the cash outlay. At the time of the next payment (due in exactly one quarter), the reserve balance is $1,000. To fulfill its obligations under the swap, No Errors will need approximately how much additional cash?
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The net payment formula for the floating rate payer is: Floating Rate Paymentt = (LIBORt-1 ? Swap Fixed Rate) × (# days in term / 360) × Notional Principal If the result is positive, the floating-rate payer owes a net payment and if the result is negative, then the floating-rate payer receives a net inflow. Note: We are assuming a 360 day year. Here, Floating Rate Payment = (0.06 ? 0.055) × (90 / 360) × 1,000,000 = $1,250. Since the result is positive, No Errors will pay this amount. Since the reserve balance is $1,000, No Errors needs an additional $250.
In a plain vanilla interest rate swap:
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A plain vanilla swap is a fixed-for-floating swap.
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