Baran

2、A forward rate agreement (FRA):

A) is risk-free when based on the Treasury bill rate.
 
B) can be used to hedge the interest rate exposure of a floating-rate loan.
 
C) is priced in dollars.
 
D) is settled by making a loan at the contract rate.

Baran

The  correct answer is B
An FRA settles in cash and carries both default risk and interest rate risk, even when based on an essentially risk-free rate. It can be used to hedge the risk/uncertainty about a future payment on a floating rate loan.

Baran

3、A financial institution has entered into a plain vanilla currency swap with one of its customers. The period left on the swap is 3 years, with the institution paying 5 percent on USD20 million and receiving 2.5 percent on JPY1,500 million annually. The current exchange rate is JPY120/USD, and the flat term structure in both countries generates a 3 percent rate in the U.S. and a 0.75 percent rate in Japan. The current value of this swap to the institution is closest to:

A) USD7.95 million.
 
B) USD6.875 million. 
 
C) –USD7.95 million.
 
D) –USD6.875 million.

Baran

The  correct answer is C

The institution is paying USD and receiving JPY, so the value of this swap will equal the current exchange rate times the value of the JPY portion minus the value of the USD portion. The JPY portion of this swap is:

Baran

4、Two banks enter into a 1-year plain vanilla interest-rate swap with the following terms:

Notional principal is $500,000,000.

The fixed component of the swap is 7%, which is the current market rate.

The floating component of the swap is LIBOR + 200bps.

If the current risk-free rate is 4 percent, the value for this swap at inception is closest to:

A) $500,000,000.
 
B) $0.
 
C) $8,750,000.
 
D) $35,000,000.

Baran

The  correct answer is B

The initial value of a swap is always zero. As interest rates move and payments take place, the value of the swap will change for both parties.

Baran

5、A bank entered into a 4-year tenor plain vanilla swap three years ago. The agreements of the swap are to pay 6.5 percent annually, based on annual compounding with a 30/360 day-count convention, fixed rate on a $50 million notional, and receive 1-year London Interbank Offered Rate (LIBOR). The continuously compounded LIBOR for 1-year obligations is currently 5.75 percent. The 1-year LIBOR at the beginning of the period was 6.25 percent. The value of the swap is closest to:

A) $110,000.
 
B) –$110,000.
 
C) $800,522.
 
D) –$257,020.

Baran

The  correct answer is B

The value of the fixed-rate component of the swap is ($50 × 1.065)e(–0.0575) = $50.27M. The value of the floating-rate component of the swap is ($50 × 1.0625)e(–0.0575) = $50.16M. Hence, the value of the swap to this counterparty is $50.16M – $50.27M = –$110,000.

Baran

AIM 11: Discuss the role of credit risk inherent in an existing swap position.

1、The credit risks to the fixed-rate payer in a swap:

A) increase when floating rates are below the swap rate. 
 
B) are greatest at the inception of the swap.
 
C) are greatest just prior to maturity.
 
D) increase when floating rates rise above the swap rate. 

Baran

 The  correct answer is D
When floating rates rise above the swap rate, the fixed rate side of the swap will have positive value, and the credit risk borne by the fixed-rate payer will increase. At the inception of the swap, the value to both sides is zero, and just prior to maturity, when only one net payment remains, credit risk is relatively small.