1215

Consider a quarterly-pay currency swap where Party A pays London Interbank Offered Rate (LIBOR) on $1,000,000 and Party B pays 4% on 900,000 euros. Current LIBOR is 3% and at the end of 90 days it is 4%. Which of the following statements regarding the first settlement date is most accurate?

A) Party A must make a payment of $10,000.

B) Party A must make a payment of $7,500.

C) The payments made depend on the exchange rate.

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Floating rate payments in a swap are based on the reference rate for the prior period. The payment is:

0.03 × 90/360 × 1,000,000 = $7,500

1215

Consider a currency swap in which Party A pays 180-day London Interbank Offered Rate on $1,000,000 and Party B pays the Japanese yen riskless rate on 130,000,000 yen. Which of the following statements regarding the terms required at the initiation of the swap is CORRECT?

A) Party A must pay 130,000,000 yen and receive $1,000,000.

B) An exchange of principal amounts is not required at the initiation of the swap.

C) Party A must pay $1,000,000 and receive 130,000,000 yen.

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Since Party A is paying in dollars, Party A must receive dollars in exchange for yen at the beginning of the swap.

1215

A U.S. bank enters into a plain vanilla currency swap with a German bank. The swap has a notional principal of US$15m (Euro 15.170m). At each settlement date, the U.S. bank pays a fixed rate of 6.5 percent on the Euros received, and a German bank pays a variable rate equal to LIBOR+2 percent on the U.S. dollars received. Given the following information, what payment is made to whom at the end of year 2?

U.S. bank pays

German bank pays

A) Euro 986,050 US$975,000

B) US$975,000 Euro 986,050

C) Euro 986,050 US$1,275,000

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The U.S. bank pays 6.5% fixed on Euro 15,170,000, which makes for an annual payment of Euro 986,050. The variable rate to be used at time period 2 is set at time period 1 (the arrears method). Therefore, the German bank pays 6.5% + 2% = 8.5% times US$15,000,000 for a payment of US$1,275,000.

1215

XYZ company has entered into a "plain-vanilla" interest rate swap on $1,000,000 notional principal. XYZ company pays a fixed rate of 8% on payments that occur at 90-day intervals. Six payments remain with the next one due in exactly 90 days. On the other side of the swap, XYZ company receives payments based on the LIBOR rate. Describe the transaction that occurs between XYZ company and the dealer at the end of the first period if the appropriate LIBOR rate is 8.8%.

A) Dealer receives $2,000.

B) Dealer pays XYZ company $20,000.

C) XYZ company receives $2,000.

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XYZ company owes the dealer ($1,000,000)(0.08)(90/360) = $20,000. The dealer owes XYZ company ($1,000,000)(0.088)(90/360) = $22,000. Net: The dealer pays XYZ company $22,000 - $20,000 = $2,000

1215

Consider a swap with a notional principal of $100 million.

Given the above diagrams, which of the following statements is CORRECT? At time period 2:

A) A pays B $2 million.

B) B pays A $1 million.

C) A pays B $7 million and B pays A $8 million.

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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 7%, the fixed rate is 8%, and the interest payments are netted. The fixed-rate payer, counterparty B, pays according to:

(Swap Fixed Rate – LIBOR_t-1)(# of days/360)(Notional Principal).

In this case, we have (0.08 - 0.07)(360/360)($100 million) = $1 million

1215

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.

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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

1215

A U.S. bank enters into a plain vanilla currency swap with a notional principal of US$100m (￡67m). At each settlement date, the U.S. bank pays a fixed rate of 8% on the pounds received, and an English bank pays a variable rate equal to London Interbank Offered Rate (LIBOR) on the U.S. dollars received. Given the following information, what payment is made to whom at the end of year 2?

The U.S. bank pays:

A) ￡5.36m and the English bank pays US$6m.

B) US$5.5m and the English bank pays ￡5.36m.

C) ￡5.36m and the English bank pays US$5.5m.

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The U.S. bank pays 8% fixed on ￡67m, which makes for an annual payment of ￡5.36m. The variable rate to be used at time period 2 is set at time period 1 (the arrears method). Therefore, the English bank pays 5.5% times US$100m for a payment of US$5.5m.

1215

The term exchange of borrowings refers to:

A) swaptions.

B) currency swaps.

C) interest rate swaps.

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In effect, in a currency swap, the two parties make independent borrowings and then exchange the proceeds. This is known as an exchange of borrowings. A swaption is an option on a swap that can be either American or European in form. (Swaptions are a Level II Topic).

1215

Why are payments NOT usually netted out in a currency swap?

A) There are no payments in a currency swap except at initiation and maturity.

B) The payments are denominated in two different currencies.

C) There is no credit risk in a currency swap.

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Payments are not usually netted out because the payments are denominated in two different currencies, which does not easily allow for netting.

1215

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.

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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.