Deck 24: Swaps

Question 1

Both parties in an interest rate swap normally are fully hedged against interest rate risk on the notional amount of the swap.

Answer 1

False

Question 2

Once a fixed-floating interest rate swap agreement has been negotiated under no-arbitrage conditions, both parties to the swap agreement know with certainty the exact amount of their respective cash flows.

Answer 2

False

Question 3

Swap transactions are homogeneous in nature so that the contracts can be easily traded in the secondary market for swaps.

Answer 3

False

Question 4

In a conventional interest rate swap agreement, the fixed-rate payer is attempting to transform the variable-rate nature of its liabilities into fixed-rate liabilities.

Question 5

Whether fixed-rate or floating-rate, a swap arrangement can be designed to be equivalent to a similar maturity bond.

Question 6

A total return swap involves exchanging an obligation to pay interest at a specified rate for payments representing the total return on a loan or a bond of a specified amount.

Question 7

In a conventional interest rate swap agreement, the swap buyer agrees to make a number of fixed interest rate payments to the swap seller.

Question 8

A plain vanilla fixed-floating interest rate swap may involve a third party that acts as a broker, but is not likely to have any sophisticated special features.

Question 9

The fastest growing group of swaps in recent years has been those designed to help FIs manage interest rate risk.

Question 10

Pricing a fixed-floating rate swap agreement to meet no-arbitrage conditions requires that the expected present value of the cash flow payments made by the fixed-rate seller should equal the expected value of the cash flow payments made by the variable-rate buyer.

Question 11

The buyer of an interest rate swap is likely to have a negative duration gap that they would like to reduce.

Question 12

The extreme growth of the swap market has raised concern about the credit risk exposures of banks engaging in this market.

Question 13

Swaps generally have a shorter maturity than other derivative instruments.

Question 14

Currency swaps can be designed to reduce foreign exchange risk.

Question 15

An interest rate swap is essentially a series of forward contracts on interest rates.

Question 16

The largest segment of the global swap market is the currency swap market.

Question 17

The party in a swap that receives fixed-rate payments will always have zero basis risk since the fixed-rate swap payments can be structured to cover the fixed-rate liability payments.

Question 18

Determining the pricing of a swap agreement requires the calculation of expected one- year rates from the Treasury yield curve that is accomplished by calculating the spot or zero-coupon discount yield curve.

Question 19

One reason for basis risk in an interest rate swap is that changes in the index on the variable rate portion of the swap may not be perfectly correlated with changes in the index on the balance sheet portion of the liabilities.

Question 20

The on-the-run yield curve of U.S. Treasury securities is the yield curve for outstanding, previously issued securities.

Question 21

By 2008, the insurance company AIG had more than $440 billion in credit default swaps outstanding.

Question 22

A pure credit swap is similar to buying credit insurance.

Question 23

One reason for the rapid growth of the OTC interest rate and foreign exchange swap markets is that banks are not required to allocate any capital toward their usage.

Question 24

Policies established by The International Swaps and Derivatives Association (ISDA) forbid swap contracts to be made between parties of different credit standing.

Question 25

In recent years, the fastest growing type of swap agreement has been a fixed-fixed currency swap.

Question 26

In terms of valuation, a 12-year interest rate swap can be can be considered in terms of

A)a series of option contracts.
B)a zero-coupon bond.
C)a U.S. Treasury STRIP.
D)bond-equivalent valuation.
E)securitization of a derivative contract.

Question 27

What is the basic reason that two counterparties enter into a swap agreement?

A)Exchange of one specified cash flow in the future based on some underlying index.
B)Better management of credit risk by using a fixed or floating rate bond as hedging instrument.
C)To restructure or off-set the expected future cash flows to be collected from assets or liabilities held on the balance sheet.
D)Exchange of assets for a specific period of time at a specified interval.
E)Taking the opposite side of each transaction in order to keep the swap market liquid.

Question 28

In a pure credit swap the FI lender makes a payment each period in exchange for the payment of interest in any period that the borrower defaults on the loan.

Question 29

A bank with a strong positive leverage adjusted duration gap can hedge their exposure to interest rate increases by entering into

A)a currency swap agreement to receive the fixed rate payment.
B)an interest rate swap agreement to make the fixed-rate payment side of the swap.
C)a credit swap agreement to receive the floating rate payment.
D)a commodity swap agreement to make the fixed-rate payment side of the swap.
E)an equity swap agreement to make the floating-rate payment side of the swap.

Question 30

A commercial bank that acts as a swap dealer must include swap risk exposure when calculating risk-based capital requirements.

Question 31

When compared to swap and option contracts, credit risk exposure is greatest with a futures contract.

Question 32

A pure credit swap will reduce interest rate risk.

Question 33

The U.S. Commodity Futures Trading Commission (CFTC) has jurisdiction over swaps in the United States.

Question 34

The credit risk on an interest rate swap is generally much less than on an individual loan.

Question 35

An interest rate swap

A)involves a swap buyer who agrees to make a number of variable-rate payments on periodic settlement dates.
B)involves a swap seller who agrees to make a number of fixed-rate payments on periodic settlement dates.
C)is effectively a succession of forward contracts on interest rates.
D)involves comparative advantage by the fixed-rate side of the swap, but not the variable-rate side.
E)eliminates credit risk.

Question 36

The U.S. Wall Street Reform and Consumer Protection Act of 2010 established comprehensive regulation of over-the-counter (OTC) derivatives including swaps.

Question 37

The secondary market for the trading of swaps is second in liquidity to the U.S. T-bill market.

Question 38

At the end of 2012, the world-wide notional value of swap agreements was less than US$400 trillion.

Question 39

Credit risk is more likely to lead to failure of an FI than either interest rate or foreign-exchange risk.

Question 40

A total return credit swap is eliminates interest rate risk as well as credit risk.

Question 41

The cash flows that actually are paid on an interest rate swap depend on

A)the market's expectations of future short-term interest rates.
B)upfront fee payments.
C)varying notional values underlying the swap.
D)special interest rate terms and indexes.
E)actual market rates that materialize over the life of the swap contract.

Question 42

In the derivatives markets, the instrument with the longest potential maturity is

A)options.
B)futures.
C)forwards.
D)swaps.
E)currencies.

Question 43

Swapping an obligation to pay interest at a specified fixed or floating rate for payments representing the total return on a loan or a bond of a specified amount is an example of

A)a commodity swap.
B)a credit swap.
C)a currency swap.
D)an equity swap.
E)an interest rate swap.

Question 44

Why were inverse floaters developed?

A)To exchange specified periodic cash flows in the future based on some underlying instrument.
B)To better manage their interest rate, foreign exchange, and credit risks of corporate enterprises.
C)To lower the cost of financing for government agencies.
D)To determine payments and timing of payments when there is no standardized contract.
E)To keep the swap market liquid by locating or matching counterparties.

Question 45

What is the special feature of an off-market swap arrangement?

A)It involves special nonstandard considerations that must be negotiated between the parties.
B)The swap is used to hedge against exchange rate risk from mismatched currencies on assets and liabilities.
C)It involves additional financing costs resulting from the fixed-fixed currency swap.
D)It involves an obligation to pay interest at a fixed or floating rate for payments representing the total return on a specified amount.
E)FI receives the par value of the loan on default in return for paying a periodic swap fee.

Question 46

An FI has purchased an agency security that is an inverse floater at 9 percent minus LIBOR. Which of the following characteristics reflect this type of asset?

A)If LIBOR is 4 percent, the asset will pay 5 percent to the investor.
B)As LIBOR increases, the investor will receive a lower return on the security.
C)The agency issuing this security may convert it into a LIBOR liability by entering into a swap agreement.
D)If the FI funded the asset at LIBOR, and LIBOR reaches 10 percent, the FI will have a negative 10 percent spread on the asset.
E)All of these.

Question 47

Swap contracts are actively traded on the

A)NYSE.
B)AMEX.
C)CBOE.
D)TSX.
E)Swaps are not actively traded.

Question 48

The vast majority of credit derivative contracts held by commercial banks consist of credit

A)forward contracts.
B)futures contracts.
C)options.
D)swaps.
E)currency contracts

Question 49

During the most recent financial crisis, the FI segment that was most negatively affected by credit default swaps was

A)commercial banks.
B)insurance companies.
C)pension funds.
D)finance companies.
E)mutual funds.

Question 50

A swap that technically is a succession of forward contracts on interest rates is

A)a commodity swap.
B)a credit swap.
C)a currency swap.
D)an equity swap.
E)an interest rate swap.

Question 51

Which of the following is the primary sellers of credit risk protection?

A)Insurance companies.
B)Mutual funds.
C)Depository institutions.
D)Vulture funds.
E)Commercial banks.

Question 52

Which of the following is an advantage of having swap dealers?

A)They serve the function of taking the opposite side of each transaction in order to keep the swap market liquid.
B)They reduce the search costs of finding counterparties having mirror image financing requirement.
C)They generally guarantee swap payments over the life of the contract.
D)They incur any costs associated with the default by replacing the defaulting party on the same terms as the original swap.
E)All of these.

Question 53

In the derivatives markets, transactions costs are highest for

A)options.
B)futures.
C)forwards.
D)swaps.
E)currencies.

Question 54

A contract that is a fixed-floating interest rate swap with a third party acting as an intermediary is known as

A)a pure credit swap.
B)a total return swap.
C)an off-market swap.
D)a plain vanilla swap.
E)an currency rate swap.

Question 55

The type of swap that is in the largest segment of the global swap market is

A)a commodity swap.
B)a credit swap.
C)a currency swap.
D)an equity swap.
E)an interest rate swap.

Question 56

A swap used to hedge against exchange rate risk from mismatched currencies on assets and liabilities is

A)a commodity swap.
B)a credit swap.
C)a currency swap.
D)an equity swap.
E)an interest rate swap.

Question 57

The fastest growing type of swap is

A)a commodity swap.
B)a credit swap.
C)a currency swap.
D)an equity swap.
E)an interest rate swap.

Question 58

In the derivatives markets, the credit risk exposure is greatest for

A)options.
B)futures.
C)forwards.
D)swaps.
E)currencies.

Question 59

Which of the following is the primary factor that determines the fixed and floating rates set at the time an interest rate swap is initiated?

A)Actual market rates that materialized over the life of the swap contract.
B)London interbank offer rate (LIBOR).
C)Upfront fee payments.
D)Market's expectations of future short-term rates.
E)Varying notional values underlying the swap.

Question 60

A swap that often involves an up-front fee or payment as compensation for nonstandard terms is

A)a pure credit swap.
B)a total return swap.
C)an off-market swap.
D)a plain vanilla swap.
E)an interest rate swap.

Question 61

Consider a situation where the duration of the fixed portion of a swap is greater than the floating portion of a swap. Which of the following statements is most correct?

A)The fixed-rate payers gain when rates fall.
B)The market value of fixed-rate payments will decrease by more than the market value of floating-rate payments when interest rates fall.
C)The market value of fixed-rate payments will decrease by more than the market value of floating-rate payments when interest rates rise.
D)The floating-rate payers gain when rates rise.
E)The market value of the swap will increase with an increase in interest rates.

Question 62

It is common to include

A)both the interest and principal payments in an interest rate swap.
B)only the interest payments in a currency swap.
C)both the interest and principal payments in a currency swap.
D)only the principal payments in an interest rate swap.
E)only the principal payments in a currency swap.

Question 63

Which of the following is true of the "netting" process in the swap market?

A)It decreases or mitigates the credit risk on swaps.
B)Both parties make payments to each other as a consequence.
C)It implies that the default exposure of the in-the-money party is the total fixed or floating payment.
D)It does not happen across contracts.
E)Netting by novation increases the potential risk of loss.

Question 64

If a Canadian bank has variable-rate assets in Canadian dollars and fixed-rate liabilities in Euros, the bank is exposed to

A)interest rate increases and an appreciation of the dollar.
B)interest rate declines and an appreciation of the dollar.
C)interest rate increases and a depreciation of the dollar.
D)interest rate declines and a depreciation of the dollar.
E)zero exposure to interest rate and exchange rate exposures.

Question 65

A pure credit swap

A)is like buying credit insurance.
B)is like buying a multi-period credit option.
C)eliminates the interest rate risk contained in a total return swap.
D)All of these.
E)None of these.

Question 66

What kind of interest rate swap (of liabilities) would an FI with a positive funding gap utilize to hedge interest rate risk exposure?

A)Swap floating-rate payments for fixed-rate payments.
B)Swap floating-rate receipts for fixed-rate payments.
C)Swap fixed-rate receipts for floating-rate receipts.
D)Swap floating-rate receipts for fixed-rate receipts.
E)Swap floating-rate payments for fixed-rate receipts.

Question 67

Which of the following is NOT a reason that a swap may have less credit risk than an individual loan?

A)Netting of payments.
B)Payment flows are interest and not principal.
C)Standby letters of credit are available.
D)Swaps can be cancelled, individual loans cannot.
E)None of these.

Question 68

A Canadian bank has fixed-rate assets in Canadian dollars and variable-rate liabilities in Euros. This bank is exposed to

A)interest rate increases and an appreciation of the dollar.
B)interest rate declines and an appreciation of the dollar.
C)interest rate increases and a depreciation of the dollar.
D)interest rate declines and a depreciation of the dollar.
E)zero exposure to interest rate and exchange rate exposures.

Question 69

When a bank enters into a fixed-floating currency swap, it is exposed to

A)both interest rate and currency exposures.
B)only interest rate exposures.
C)only exchange rate exposure.
D)zero interest rate exposure over the life of the swap.
E)zero interest rate and currency exposure over the life of the swap.

Question 70

The credit risk on swaps is considered to be

A)more than the credit risk on loans.
B)less than the credit risk on loans.
C)same as the credit risk on loans.
D)is negligible compared to the credit risk on loans.
E)less likely to cause an FI to fail than is interest rate risk.

Question 71

Which of the following is NOT true?

A)FI bearing the credit risk of a loan is often different from the FI that issued the loan.
B)The buyer of a credit swap makes periodic payments to the seller until the end of the life of the swap.
C)Banks have been more willing than the insurance companies to bear credit risk.
D)The settlement of the swap in the event of a default involves either physical delivery of the bonds or a cash payment.
E)Credit swap specifies the number of different bonds that can be delivered in the event of a default.

Question 72

An FI has entered a $100 million swap agreement with a counterparty. The fixed-payment portion of the swap is similar to a government bond with maturity of 6 years and duration of 5 years. The swap payment interval is 1 year. If the relative shock to interest rates [ΔR/(1 + R)] is a decline of 50 basis points, what will be the change in market value of the swap contract?

A)+$2.0 million.
B)-$2.0 million.
C)+$2.5 million.
D)-$2.5 million.
E)More information is needed.

Question 73

Which of the following describes the process of "netting" in the swap market?

A)Stripping out the "interest rate" sensitive element of total return swaps to reduce the net portfolio risk.
B)Acting as an intermediary by bringing together two FIs with opposing interest rate risk exposures to enter into a swap agreement.
C)Turning fixed-rate liabilities into net variable-rate liabilities.
D)Calculating the net difference between the two payments, and making a single payment for the net difference.
E)Squaring off contracts on or before expiry.

Question 74

A bank has assets of $500,000,000 and equity of $40,000,000. The assets have an average duration of 5.5 years, and the liabilities have an average duration of 2.5 years. An 8-year fixed-rate T-bond with the same coupon as the fixed-rate on the swap has a duration of 6 years, and the duration of a floating-rate bond that reprices annually is one year. The bank wishes to hedge its balance sheet with swap contracts that have notional contracts of $100,000. What is the optimal number of swap contracts into which the bank should enter?

A)2,500 contracts.
B)2,760 contracts.
C)13,800 contracts.
D)3,200 contracts.
E)None of these.

Question 75

What is replacement risk in the swap market?

A)The risk of substituting a defaulted swap with a new swap at less favorable terms.
B)The cost incurred by the swap dealer in replacing the defaulting party on the same terms as the original swap.
C)The risk involved in exchanging fixed interest payments for floating interest payments by two counterparties.
D)The risk associated with long-term hedge sometimes for as long as 15 years.
E)The comparative disadvantage faced by swap seller in making variable or floating rate payments.

Question 76

Which of the following is NOT a reason for the credit risk on a swap to be less than the credit risk on a loan?

A)Swap contracts often extend beyond the maturity of normal loan contracts.
B)Swap payments can be netted more easily than on a loan contract.
C)Interest rate swaps involve interest, but not principal.
D)Differences in credit quality between parties can be equalized through the use of standby letters of credit.
E)All of these are reasons for swaps to have less credit risk.

Question 77

A total return credit swap

A)can allow an FI to maintain long-term customer lending relationships without bearing the full credit risk exposure from these relationships.
B)involves exchanging an obligation to pay interest at a specified rate for payments representing the total return on a loan of a specified amount.
C)can be important because credit risk is more likely to cause an FI to fail than either interest rate risk or FX risk.
D)All of these.
E)can allow an FI to maintain long-term customer lending relationships without bearing the full credit risk exposure from those relationships, and can be important because credit risk is more likely to cause an FI to fail than either interest rate risk or FX risk.

Question 78

An existing swap can be effectively hedged against interest rate risk by

A)selling out to another party.
B)entering into another swap agreement that is the mirror image of the original swap.
C)setting interest sensitive assets equal to interest sensitive liabilities.
D)setting asset duration equal to liability duration.
E)defaulting to the swap intermediary.

Question 79

When are the standby letters of credit used in swap agreements?

A)When the counterparty is perceived to be of significantly lower credit quality than the other party.
B)Where the swap agreement is made between parties of equal credit standing.
C)Where the swap agreement is made between high-quality counterparties.
D)When one party posts collateral in lieu of default.
E)When the no-arbitrage condition does not hold good.

Question 80

Swaps create value if

A)relative prices differ across markets.
B)there are barriers to entry in some markets.
C)information is costly.
D)All of these.
E)None of these.