kim226

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

kim226

Which of the following statements about swaps is NOT correct?

A) In an interest rate swap, only the net interest payments are made.

B) In a currency swap, only net interest payments are made.

C) In an interest rate swap, the pay-fixed party makes a sequence of fixed rate interest payments and receives a sequence of floating rate interest payments.

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In a currency swap, the two parties exchange cash at the initiation, make periodic interest payments to each other during the life of the swap agreement, and exchange the principal at the termination of the swap.

kim226

Which term does NOT apply to interest rate swaps?

A) Time to maturity.

B) Notional principal amount.

C) Trading exchange.

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Interest rate swaps are currently not traded on exchanges.

kim226

Which of the following statements regarding a plain vanilla swap is NOT correct?

A) The notional principal amounts are exchanged at contract initiation and at the termination of the swap.

B) Only a net payment is made on each settlement date.

C) If interest rates decrease, the swap has a negative value to the fixed rate payer.

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There is no exchange of the principal amount at the initiation or termination of a plain vanilla swap.

kim226

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.

kim226

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.

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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

kim226

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.

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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 plain vanilla swap.

kim226

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.

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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.

kim226

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.

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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.

kim226

The term exchange of borrowings refers to:

A) currency swaps.

B) swaptions.

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).