LOS b, (Part 1): Define and give examples of currency swaps.

Q1. Which of the following statements about a currency swap is TRUE?

A)   Payments are netted at each settlement date.

B)   Changes in exchange rates do not affect the swap payments.

C)   If one party pays a fixed rate of interest, the other party must pay a floating rate.

Q2. Which of the following statements regarding a fixed-for-fixed currency swap of euros for British pounds is least accurate?

A)   One party makes certain payments in Euros.

B)   The notional principal amounts, adjusted for exchange rate changes, are exchanged at the termination of the swap.

C)   The periodic payments are not netted, both payments are always made.

Q3. 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:

A)   plain-vanilla swap.

B)   fixed-for-fixed swap.

C)   currency swap.

Q4. 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:

A)   the Australian dollar increases in value against the U.S. dollar.

B)   interest rates in Australia decline.

C)   the Australian dollar decreases in value against the U.S. dollar.

Q5. 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:

A)   decreases in value against the U.S. dollar and the risk that interest rates increase in Hong Kong.

B)   increases in value against the U.S. dollar and the risk that interest rates increase in Hong Kong.

C)   decreases in value against the U.S. dollar and the risk that interest rates decrease in Hong Kong.

LOS b, (Part 1): Define and give examples of currency swaps. fficeffice" />

Q1. Which of the following statements about a currency swap is TRUE?

A)   Payments are netted at each settlement date.

B)   Changes in exchange rates do not affect the swap payments.

C)   If one party pays a fixed rate of interest, the other party must pay a floating rate.

Correct answer is B)

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.

Q2. Which of the following statements regarding a fixed-for-fixed currency swap of euros for British pounds is least accurate?

A)   One party makes certain payments in Euros.

B)   The notional principal amounts, adjusted for exchange rate changes, are exchanged at the termination of the swap.

C)   The periodic payments are not netted, both payments are always made.

Correct answer is B)

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.

Q3. 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:

A)   plain-vanilla swap.

B)   fixed-for-fixed swap.

C)   currency swap.

Correct answer is C)       

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.

Q4. Consider a ffice:smarttags" />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:

A)   the Australian dollar increases in value against the U.S. dollar.

B)   interest rates in Australia decline.

C)   the Australian dollar decreases in value against the U.S. dollar.

 Correct answer is C)     

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.

Q5. 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:

A)   decreases in value against the U.S. dollar and the risk that interest rates increase in Hong Kong.

B)   increases in value against the U.S. dollar and the risk that interest rates increase in Hong Kong.

C)   decreases in value against the U.S. dollar and the risk that interest rates decrease in Hong Kong.

Correct answer is B)

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.

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