honeycfa

Parties agreeing to swap cash flows are:

A) swap facilitators.

B) counterparties.

C) agents.

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The parties agreeing to swap cash flows are called the counterparties.

honeycfa

Consider a U.S. investor who has a portfolio of Australian government bonds that are denominated in Australian dollars. Why would the investor wish to enter into a swap contract? As the:

A) Australian dollar increases in value, the interest payments from the Australian bonds translate into fewer U.S. dollars.

B) Australian interest rate decreases, the value of the Australian bonds decreases.

C) Australian dollar decreases in value, the interest payments from the Australian bonds translate into fewer U.S. dollars.

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As the Australian dollar decreases in value, the interest payments from the bond (and perhaps the bond’s face value if the bond is at maturity), translate into fewer U.S. dollars, which reduces the interest earned on the Australian bonds.

honeycfa

The term notional principal refers to:

A) the amount swapped.

B) the period of time involved.

C) the cash interest payment.

The notional principal is the amount swapped. Note that the notional principal does not actually change hands with plain vanilla interest rate swaps, but is used to calculate the interest payment streams to be exchanged. Notional principal does exchange hands in a foreign currency swap.

honeycfa

Consider a commercial bank with a portfolio of U.S. Treasury bonds. Why would the bank wish to engage in a swap contract? As the:

A) interest rate increases, the value of the bonds decreases.

B) U.S. dollar decreases, the value of the bonds decreases.

C) interest rate decrease, the value of the bonds decreases.

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Interest rates and bond prices are inversely related. Therefore, as interest rates increase, the value of the T-bonds decreases. The bank may wish to engage in a swap contract wherein the bank pays fixed and receives variable. In this case, as interest rates rise, the bank receives higher variable payments for making the same fixed payment in the swap. The cash flows received in the swap offset the reduction in the bond portfolio’s value.

honeycfa

Jan Jurgen, CFA charterholder, recently accepted a position in the Treasury area of a conservatively managed commercial bank. Jurgen intends to suggest the use of plain-vanilla interest rate swaps at today’s Asset & Liability Management Committee meeting. Jurgen is least likely to argue that the use of interest rate swaps will:

A) avoid costly regulations.

B) create arbitrage profits by exploiting market inefficiencies.

C) reduce the exposure from the mismatch between floating rate assets and fixed rate liabilities.

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Exploiting market inefficiencies is no longer considered a motivation for entering into swap agreements. Historically, there were two basic motivations for swaps, to exploit market inefficiencies and to attempt to obtain cheaper financing. Both were based on the belief that financial markets were inefficient. Today, the swap markets have matured and there are few arbitrage opportunities. The swap markets are considered operationally efficient and flexible. Thus, the main reasons to enter into swap agreements today include: to reduce transaction costs, to avoid costly regulations, and to maintain privacy.

honeycfa

Which of the following choices is generally NOT part of a plain-vanilla swap transaction?

A) Tenor.

B) Exchange of notional amount.

C) Swap facilitator.

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Since the notional principal swapped is the same (and in the same currency) for both counterparties, there is no need to actually exchange cash. The counterparties are the pay-fixed and receive-fixed sides. A swap facilitator helps to bring the counterparties together and may be either an agent or a broker. The tenor of the swap is the time frame covered by the deal, or the time to maturity of the swap.

honeycfa

Which of the following characteristics about swaps is least accurate? Swaps:

A) are highly regulated.

B) have no active secondary market.

C) are custom instruments.

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Swap contracts are largely unregulated.

honeycfa

Which of the following regarding a plain vanilla interest rate swap is most accurate?

A) The notional principal is swapped.

B) Only the net interest payments are made.

C) The notional principal is returned at the end of the swap.

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The plain vanilla interest rate swap involves trading fixed interest rate payments for floating rate payments. Swaps are a zero sum game, what one party gains the other party loses. In interest rate swaps, only the net interest rate payments actually take place because the notional principal swapped is the same for both counterparties and in the same currency units, there is no need to actually exchange the cash.

honeycfa

Consider a U.S. commercial bank that borrows funds in England for one year denominated in English pounds. Why would the investor wish to enter into a swap contract? As the:

A) English pound increases in value, it takes more U.S. dollars to pay off the English liability.

B) English pound decreases in value, it takes more U.S. dollars to pay off the English liability.

C) U.S. interest rate increases, the value of the English liability increases.

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As the English pound increases in value, it takes more U.S. dollars to pay off the English liability, which increases the interest cost of borrowing funds denominated in English pounds.

honeycfa

Which of the following is a reason to use the swaps market rather than the futures market? To:

A) reduce the credit risk involved with the contract.

B) increase the liquidity of the contract.

C) maintain the firm's privacy.

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The futures market, because of the use of a standardized contract, is more liquid; and, because the exchange guarantees the contract, futures contracts have less credit risk. However, swaps contracts, because they are over-the-counter (private) contracts, allow the firm to maintain privacy.