prashantsahni

Determine the transactions involved with a plain vanilla interest rate swap and whether or not notional principal is generally swapped:

Plain vanilla interest rate swap

Notional principal

A) pay fixed rate, pay fixed rate swapped

B) pay floating rate, pay fixed rate not swapped

C) pay fixed rate, pay floating rate swapped

---

The most common type of interest rate swap is called a plain vanilla interest rate swap. It involves trading fixed interest rate payments for floating-rate payments. Notional principal is generally not swapped in single currency swaps.

prashantsahni

Which of the following statements regarding plain-vanilla interest rate swaps is least accurate?

A) The settlement dates are when the interest payments are to be made.

B) The time frame covered by the swap is called the tenor of the swap.

C) In a swap contract, the counterparties usually swap the notional principal.

---

The notional principal is generally not swapped, as it is usually the same for both parties in the swap deal.

prashantsahni

All of the following are ways to exit a swap contract EXCEPT:

A) selling a swaption.

B) entering an offsetting swap with the original counterparty.

C) making a cash payment to the original counterparty.

---

Selling a swaption gives the seller an obligation to enter into a swap if the swaption is exercised. To exit a swap, the entity would want to buy the swaption.

kim226

An offsetting swap is a swap that:

A) reduces the credit risk of an earlier swap.

B) is opposite to an existing swap in cash flows.

C) reduces the principal amount of a swap.

---

An offsetting swap is a swap with opposite cash flows to an existing swap. It is one way to exit a swap position, just as an offsetting trade is used to close out a futures position.

kim226

The least likely way to terminate a swap agreement prior to expiration is to:

A) sell the swap.

B) make/receive a payment to/from the original counterparty.

C) exercise a swaption.

---

There is no functioning secondary market in swaps; selling a swap would be unusual and would require the permission of the counterparty.

kim226

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

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

---

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.

kim226

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 decreases in value against the U.S. dollar.

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

C) interest rates in Australia decline.

---

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.

kim226

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.

---

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.

kim226

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

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

B) One party makes certain payments in Euros.

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

---

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.

kim226

Which of the following statements about a currency swap is CORRECT?

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

B) Payments are netted at each settlement date.

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

---

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.