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LOS b, (Part 3): Define and give examples of plain vanilla interest rate swaps and calculate and interpret the payments on an interest rate swap.
Q1. In a plain vanilla interest rate swap:
A) one party pays a floating rate and the other pays a fixed rate, both based on the notional amount.
B) payments equal to the notional principal amount are exchanged at the initiation of the swap.
C) each party pays a fixed rate of interest on a notional amount.
Q2. 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?
A) No Errors will receive $250.
B) $0.
C) $250.
Q3. 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:
A) the fixed-rate payer will be required to make a payment of $7,500.
B) the floating rate payer will be required to make a payment of $92,500.
C) no payments will be made.
Q4. Consider a swap with a notional principal of $100 million.
Given the above diagrams, which of the following statements is TRUE? At the end of year 3:
A) A pays B $1 million.
B) A pays B $2.5 million.
C) A pays B $1.25 million.
Q5. 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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A |
??????????? |
B |
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7% Fixed |
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0 |
1 |
2 | |||
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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:
A) B pays A $1.5 million.
B) A pays B $1.5 million.
C) B pays A $21.0 million.
LOS b, (Part 3): Define and give examples of plain vanilla interest rate swaps and calculate and interpret the payments on an interest rate swap. fficeffice" />
Q1. In a plain vanilla interest rate swap:
A) one party pays a floating rate and the other pays a fixed rate, both based on the notional amount.
B) payments equal to the notional principal amount are exchanged at the initiation of the swap.
C) each party pays a fixed rate of interest on a notional amount.
Correct answer is A)
A plain vanilla swap is a fixed-for-floating swap.
Q2. 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?
A) No Errors will receive $250.
B) $0.
C) $250.
Correct answer is C)
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.
Q3. 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:
A) the fixed-rate payer will be required to make a payment of $7,500.
B) the floating rate payer will be required to make a payment of $92,500.
C) no payments will be made.
Correct answer is C)
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.
Q4. Consider a swap with a notional principal of $100 million.
Given the above diagrams, which of the following statements is TRUE? At the end of year 3:
A) A pays B $1 million.
B) A pays B $2.5 million.
C) A pays B $1.25 million.
Correct answer is C)
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.
Q5. 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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A |
??????????? |
B |
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7% Fixed |
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0 |
1 |
2 | |||
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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:
A) B pays A $1.5 million.
B) A pays B $1.5 million.
C) B pays A $21.0 million.
Correct answer is A)
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.
ROCKMELON
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