Q12. The term notional principal refers to:

A)   the period of time involved.

B)   the amount swapped.

C)   the cash interest payment.

Q13. 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)   U.S. dollar decreases, the value of the bonds decreases.

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

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

Q14. 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)   create arbitrage profits by exploiting market inefficiencies.

B)   avoid costly regulations.

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

Q15. Parties agreeing to swap cash flows are:

A)   counterparties.

B)   swap facilitators.

C)   agents.

Q16. 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 dollar decreases in value, the interest payments from the Australian bonds translate into fewer U.S. dollars.

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

Q17. 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)   The notional principal is swapped at the beginning of an interest rate swap.

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

Q12. The term notional principal refers to: fficeffice" />

A)   the period of time involved.

B)   the amount swapped.

C)   the cash interest payment.

Correct answer is B)

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.

Q13. 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)   U.S. dollar decreases, the value of the bonds decreases.

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

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

Correct answer is C)

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.

Q14. 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)   create arbitrage profits by exploiting market inefficiencies.

B)   avoid costly regulations.

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

Correct answer is A)

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.

Q15. Parties agreeing to swap cash flows are:

A)   counterparties.

B)   swap facilitators.

C)   agents.

Correct answer is A)

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

Q16. Consider a ffice:smarttags" />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 dollar decreases in value, the interest payments from the Australian bonds translate into fewer U.S. dollars.

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

Correct answer is B)

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.

Q17. 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)   The notional principal is swapped at the beginning of an interest rate swap.

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

Correct answer is B)

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.

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