kim226

XYZ, Inc. has entered into a "plain-vanilla" interest rate swap on $5,000,000 notional principal. XYZ company pays a fixed rate of 8.5% on payments that occur at 180-day intervals. Platteville Investments, a swap broker, negotiates with another firm, SSP, to take the receive-fixed side of the swap. The floating rate payment is based on LIBOR (currently at 7.2%). At the time of the next payment (due in exactly 180 days), XYZ company will:

A) pay the dealer net payments of $65,000.

B) receive net payments of $32,500.

C) pay the dealer net payments of $32,500.

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The net payment formula for the fixed-rate payer is:

Fixed Rate Paymentt = (Swap Fixed Rate − LIBORt-1) × (# days in term / 360) × Notional Principal

If the result is positive, the fixed-rate payer owes a net payment and if the result is negative, then the fixed-rate payer receives a net inflow. Note:We are assuming a 360 day year.

Fixed Rate Payment = (0.085 − 0.072) × (180 / 360) × 5,000,000 = $32,500.

Since the result is positive, XYZ owes this amount to the dealer, who will remit to SSP.

kim226

A contract in which one party pays a fixed rate of interest on a notional amount in return for the return on a single stock, paid quarterly for four quarters, is a(n):

A) returns swap.

B) equity swap.

C) plain vanilla swap.

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A swap contract in which at least one party makes payments based on the return on an equity, portfolio, or market index, is called an equity swap.

kim226

When one party pays a fixed rate of interest in an equity swap, which of the following is least accurate?

A) The fixed-rate receiver will never get more than the fixed rate.

B) The equity-return payer will gain if the equity return is zero.

C) Unlike other swaps, in an equity swap the one-quarter-ahead payment is not known at the end of the previous quarter.

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If the periodic return on the equity is negative, the fixed-rate payer must pay the fixed rate plus the percentage of (negative) equity return, times the notional principal.

kim226

An equity swap can specify that one party pay any of the following EXCEPT:

A) the return on a specific portfolio of three stocks including dividends.

B) the return on a single stock.

C) the total return on a corporate bond.

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A swap involving the return on a bond would not be an equity swap.

kim226

Travis Dillard, CFA, is the equity return receiver in a monthly-pay equity swap. If the equity index declines by 2% in a month, Dillard must pay the swap counterparty an amount of cash that is:

A) greater than 2% of the notional amount of the swap.

B) equal to 2% of the notional amount of the swap.

C) less than 2% of the notional amount of the swap.

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If the equity return is negative, the equity return receiver (fixed rate payer) in an equity swap owes the equity return payer (fixed rate receiver) the percentage decline in the equity index times the notional amount, plus the fixed rate payment for the period.

kim226

Which of the following statements about a currency swap is CORRECT?

A) Changes in exchange rates do not affect the swap payments.

B) Payments are netted at each settlement date.

C) If one party pays a fixed rate of interest, the other party must pay a floating rate.

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Swap payments are based on the notional amounts of each currency and either a fixed or floating rate for either or both parties. While changes in exchange rates might be reflected in interest rates, they have no direct effect on any of the payment amounts over the term of the swap.

kim226

Which of the following statements regarding a fixed-for-fixed currency swap of euros for British pounds is least accurate?

A) The notional principal amounts, adjusted for exchange rate changes, are exchanged at the termination of the swap.

B) One party makes certain payments in Euros.

C) The periodic payments are not netted, both payments are always made.

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The original notional principal amounts are exchanged at contract termination; there is no adjustment to the amounts for the change in exchange rates over the life of the swap.

kim226

An investor enters into a swap that requires the notional principal amounts be exchanged at the beginning and at the end of the swap contract. This is most likely a:

A) plain-vanilla swap.

B) fixed-for-fixed swap.

C) currency swap.

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A currency swap requires that the notional amount of one currency be exchanged for the notional amount of the other currency at both the beginning and the end of the swap.

kim226

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.

kim226

Consider a U.S. commercial bank that takes in one-year certificates of deposit (CDs) in its Hong Kong branch, denominated in Hong Kong dollars, to fund three-year, fixed-rate loans the bank is making in the U.S. denominated in U.S. dollars. Why would this bank wish to enter into a currency swap? The bank faces the risk that the Hong Kong dollar:

A) decreases in value against the U.S. dollar and the risk that interest rates increase in Hong Kong.

B) decreases in value against the U.S. dollar and the risk that interest rates decrease in Hong Kong.

C) increases in value against the U.S. dollar and the risk that interest rates increase in Hong Kong.

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The bank faces two problems. First, if the Hong Kong dollar increases in value, it will take more U.S. dollars to repay the Hong Kong depositors. Indeed, if the Hong Kong dollar increases significantly, it may take more U.S. dollars to repay the Hong Kong depositors than the bank makes on the U.S. loan. Secondly, if the interest rate in Hong Kong rises, the bank pays more in interest on its CDs while the rate on the bank’s U.S. loans does not change. In this case, interest expense would rise and interest income would remain the same, which narrows the bank’s profits.