honeycfa

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

Given the above diagrams, which of the following statements is TRUE? At the end of year 3:

A) A pays B $1 million.

B) A pays B $1.25 million.

C) A pays B $2.5 million.

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The variable rate to be used at the end of year 3 is set at the end of 2? years (the arrears method). Therefore, the appropriate variable rate is 9%, the fixed rate is 6.5%, 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 (0.065 - 0.09)(180/360)($100 million) = $-1.25 million.

honeycfa

Consider a swap with a notional principal of $300 million, annual payments, and a 30E/360 daycount convention (every month has 30 days, a year has 360 days).

	LIBOR
Counterparty	???????????	Counterparty
A	???????????	B
	7% Fixed

 

0		1		2
LIBOR = 5.5%		LIBOR = 6.5%		LIBOR = 7%

Given the above diagram, which of the following statements is most accurate? At time period 2:

A) B pays A $1.5 million.

B) A pays B $1.5 million.

C) B pays A $21.0 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 6.5%, the fixed rate is 7%, 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 [0.07 – 0.065][360/360][$300 million] = 1.5 million.

honeycfa

Currency swap markets consist of transactions in:

A) the forward market only.

B) both spot and forward contracts.

C) spot markets only.

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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).

honeycfa

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.

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

honeycfa

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) $0.

C) $250.

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The net payment formula for the floating rate payer is:

Floating Rate Payment_t = (LIBOR_t-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.

honeycfa

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.

honeycfa

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).

honeycfa

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

honeycfa

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

A) The payments are denominated in two different currencies.

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

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.

honeycfa

Consider a U.S. commercial bank that wishes to make a two-year, fixed-rate loan in Australia denominated in Australian dollars. The U.S. bank will fund the loan by issuing two-year CDs in the U.S. Why would the U.S. bank wish to enter into a currency swap? The bank faces the risk that:

A) the Australian dollar decreases in value against the U.S. dollar.

B) the Australian dollar increases in value against the U.S. dollar.

C) interest rates in Australia decline.

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There is no interest rate risk for the bank because the bank has fixed rates for two years on both the asset and the liability. However, the bank faces a problem in that if the Australian dollar decreases in value, the loan (and the interest payments from the loan) will not translate back into as many U.S. dollars. Indeed, if the Australian dollar decreases significantly, the loan (and the interest payments from the loan) may not translate back into enough U.S. dollars to repay the CDs.