Derivatives【Reading 64】Sample market, reason, following, 2012

hinsafdar

Which of the following is NOT considered a reason for using the swaps market? To:

A) reduce transactions costs.

B) exploit market inefficiencies.

C) maintain privacy.

---

Historically, the two basic motivations for swaps were to exploit market inefficiencies and attempt to achieve cheaper financing. Today, the swaps market has matured and now offers few arbitrage opportunities to exploit market inefficiencies. In addition to seeking cheaper financing, current reasons for using swaps include reducing transactions costs, avoiding costly regulations, and maintaining privacy.

hinsafdar

Which of the following statements about notional principal in plain vanilla interest rate swaps is least accurate? Notional principal:

A) is not exchanged by the counterparties.

B) is used to calculate the fixed rate interest payment; the swap's market value is used to calculate the floating rate payment.

C) does not vary during the swap tenor.

---

The notional amount is used to calculate both the fixed and the floating rate payment streams. Both of the other choices are true.

hinsafdar

Which of the following statements about a currency swap is least accurate?

A) The periodic interest payments are exchanged in full each period.

B) Most currency swaps are done to exploit market inefficiencies.

C) Notional principal is exchanged at the termination of the swap.

---

Unlike interest rate swaps, notional principal is swapped at both the initiation and the termination of the swap. Full interest payments are exchanged at each settlement date. Exploiting market inefficiencies was once a motivation for currency swaps, but it is not today (because the market is efficient). Today motivations range from reducing transactions costs to maintaining privacy to avoiding regulation.

hinsafdar

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

A) Receive AUD fixed, pay NZD floating.

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

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

---

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

hinsafdar

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 generally agree to swap the notional principal.

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

---

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.

hinsafdar

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.

---

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.

hinsafdar

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 Australian:

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

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

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

---

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.

hinsafdar

Parties agreeing to swap cash flows are:

A) swap facilitators.

B) counterparties.

C) agents.

---

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

hinsafdar

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

C) create arbitrage profits by exploiting market inefficiencies.

---

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.

hinsafdar

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 increases, the value of the bonds decreases.

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

---

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.