LOS h: Demonstrate the use of an interest rate swaption (1) to change the payment pattern of an anticipated future loan and (2) to terminate a swap.

Q1. A borrower who is also the owner of a swaption that gives the holder the right to become a fixed-rate payer and floating-rate receiver would most likely do which of the following? Exercise the swaption when interest rates:

A)   increase to convert a floating-rate loan to a fixed-rate loan.

B)   increase to convert a fixed-rate loan to a floating-rate loan.

C)   decrease to convert a floating-rate loan to a fixed-rate loan.

Q2. A firm has most of its liabilities in the form of floating-rate notes with a maturity of two years and a quarterly reset. The firm is not concerned with interest rate movements over the next four quarters but is concerned with potential movements after that. Which of the following strategies will allow the firm to hedge the expected change in interest rates?

A)   Enter into a 2-year, quarterly pay-fixed, receive-floating swap.

B)   Go short a payer’s swaption with a 2-year maturity.

C)   Go long a payer’s swaption with a 1-year maturity.

Q3. A firm contracts to borrow $5 million in one year. The firm enters into a one-year swaption where the swap maturity and notional principal match that of the planned loan. The swaption gives the firm the right to be a floating-rate payer. This hedging strategy would be most effective if the loan contract specifies a:

A)   variable rate and interest rates decline.

B)   fixed rate and interest rates decline.

C)   variable rate and interest rates increase.

LOS h: Demonstrate the use of an interest rate swaption (1) to change the payment pattern of an anticipated future loan and (2) to terminate a swap. fficeffice" />

Q1. A borrower who is also the owner of a swaption that gives the holder the right to become a fixed-rate payer and floating-rate receiver would most likely do which of the following? Exercise the swaption when interest rates:

A)   increase to convert a floating-rate loan to a fixed-rate loan.

B)   increase to convert a fixed-rate loan to a floating-rate loan.

C)   decrease to convert a floating-rate loan to a fixed-rate loan.

Correct answer is A)        

The owner will benefit when interest rates increase because the owner has the right to pay a fixed rate and receive the floating rate, which will be higher with the increase in interest rates. Receiving the floating rate and paying the fixed rate can turn a floating-rate loan to a fixed-rate loan.

Q2. A firm has most of its liabilities in the form of floating-rate notes with a maturity of two years and a quarterly reset. The firm is not concerned with interest rate movements over the next four quarters but is concerned with potential movements after that. Which of the following strategies will allow the firm to hedge the expected change in interest rates?

A)   Enter into a 2-year, quarterly pay-fixed, receive-floating swap.

B)   Go short a payer’s swaption with a 2-year maturity.

C)   Go long a payer’s swaption with a 1-year maturity.

Correct answer is C)        

The firm will want to receive floating payments to offset the volatility of its floating-rate obligations. A payer’s swaption allows the firm to become a fixed-rate payer/floating-rate receiver in a swap. The one-year maturity corresponds to the start of the period of concern.

Q3. A firm contracts to borrow $5 million in one year. The firm enters into a one-year swaption where the swap maturity and notional principal match that of the planned loan. The swaption gives the firm the right to be a floating-rate payer. This hedging strategy would be most effective if the loan contract specifies a:

A)   variable rate and interest rates decline.

B)   fixed rate and interest rates decline.

C)   variable rate and interest rates increase.

Correct answer is B)

A firm that has contracted to borrow at a fixed rate in the future would want a hedge against interest rates falling and being stuck paying a higher-than-market rate. A swaption to become a floating-rate payer benefits the owner when interest rates decline. The firm will receive a “high” fixed rate and pay “low” variable rates, and this will offset the higher-than-market rate in the contract.

Thx!