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Derivatives【Reading 64】Sample

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.

Currency swap markets consist of transactions in:
A)
the forward market only.
B)
spot markets only.
C)
both spot and forward contracts.



In this explanation, Euro is used to represent foreign currency. In a currency swap, one counterparty (D) holds dollars and wants Euros. The other counterparty (E) holds Euros and wants dollars. They decide to swap their currency positions at the current spot exchange rate.  The counterparties exchange the full notional principal at the onset of the swap.  Then, on each settlement date, one party pays a fixed rate of interest on the foreign currency received, and the other party pays a floating rate on the dollars received.  Interest payments are not netted. Generally, the variable interest rate on the dollar borrowings is determined at the beginning of the settlement period and paid at the end of the settlement period.  At the conclusion of the swap, the notional currencies are again exchanged. Thus, currency swaps involved transactions in both the spot and forward (future) markets. A fixed-for-fixed currency swap is equivalent to a portfolio of foreign exchange forward contracts (both parties need to deliver currency in the future).

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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.



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.

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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)
$250.
C)
$0.



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.

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In a plain vanilla interest rate swap:
A)
payments equal to the notional principal amount are exchanged at the initiation of the swap.
B)
each party pays a fixed rate of interest on a notional amount.
C)
one party pays a floating rate and the other pays a fixed rate, both based on the notional amount.



A plain vanilla swap is a fixed-for-floating swap.

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The term exchange of borrowings refers to:
A)
currency swaps.
B)
swaptions.
C)
interest rate swaps.



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).

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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)
There is no credit risk in a currency swap.
C)
The payments are denominated in two different currencies.



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

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HobbyHorse Syndicate has entered into a "plain-vanilla" interest rate swap on $100,000,000 notional principal. HobbyHorse receives a fixed rate of 7.5% on payments that occur every six months. The floating rate payment is based on LIBOR (currently at 6.75%). Because of the volatile interest rate environment, HobbyHorse has created a reserve to cover any cash outlay required at settlement dates. At the time of the next payment (due in exactly six months), the reserve balance is $250,000. To fulfill its obligations under the swap at the next payment date, HobbyHorse will need approximately how much additional cash?
A)
$0.
B)
$375,000.
C)
$125,000.


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 = (0.0675 - 0.075) × (180 / 360) × 100,000,000 = -$375,000. Since the result is negative, HobbyHorse will receive this amount. Thus, HobbyHorse needs $0 additional cash.


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A swap in which one party pays a fixed rate, one party pays a floating rate, and only a net payment is made on the settlement dates is referred to as a:
A)
plain vanilla swap.
B)
straight swap.
C)
net swap.



A swap in which one party pays a fixed rate, one party pays a floating rate, and only a net payment is made on the settlement dates is referred to as a plain vanilla swap.

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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 $7,500.
B)
Party A must make a payment of $10,000.
C)
The payments made depend on the exchange rate.



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

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