Deck 7: Financial Engineering and Swaps

Question 1

Your company is planning to buy euros in six months time.The spot price is $1.25 per euro.Boldman Bankers Inc.(fictitious name)designs a "fancy derivative" that provides protection against an appreciation in the euro,but it also limits your benefits if the euro declines.After six months,by the terms of this "range forward," (1)if the spot exchange rate for the euro is above $1.30,then you pay $1.30; (2)if the spot exchange rate for the euro is below $1.20,then you pay $1.20;and (3)if the spot exchange rate lies between this range,then you buy euros at the prevailing market price.
Another cousin,who is also studying derivatives at university,said your portfolio must include a long spot position in euros,because you are planning to buy euros.Her breakdown is:

A) long spot,short put with strike price $1.30,and short call with strike price $1.20
B) short spot,long put with strike price $1.30,and short call with strike price $1.20
C) long spot,long put with strike price $1.20,and short call with strike price $1.30
D) short spot,long put with strike price $1.20,and short call with strike price $1.30
E) long spot,long put with strike price $1.30,and long call with strike price $1.20

Answer 1

C

Question 2

The following is NOT a feature of plain vanilla interest rate swap contracts:

A) interest rate risk
B) counterparty risk
C) early termination of the swap with the consent of all counterparties
D) existence of swap facilitators
E) the Swap Trading Corporation (STC)overseeing all swap transactions

Answer 2

E

Question 3

Hybrids:

A) are bonds with repayment pegged to the stock's price
B) are derivative securities that combine swaps with options
C) are derivative securities that combine calls with puts
D) are derivatives whose payoffs are tied to exchange rates
E) are combinations of options and futures

Answer 3

A

Question 4

Americana Bank has $200 million of excess funds and Britannia Bank has £100 million of excess funds in pound sterling.The spot exchange rate S_A is $2 per pound sterling.They enter into a currency swap today that has a tenor of two months.The annual risk-free simple interest rates are i = 4 percent in the United States and i_E = 5 percent in the United Kingdom.Cash flows are exchanged at the end of each month.
The currency swap begins today with:

A) Americana paying $200 million to Britannia and receiving £200 million in return
B) Americana paying $200 million to Britannia and receiving £100 million in return
C) Americana paying $100 million to Britannia and receiving £100 million in return
D) currency swaps have notional principal-no exchange of cash flows takes place today
E) None of these answers are correct.

Question 5

Your company is planning to buy euros in six months time.The spot price is $1.25 per euro.Boldman Bankers Inc.(fictitious name)designs a "fancy derivative" that provides protection against an appreciation in the euro,but it also limits your benefits if the euro declines.After six months,by the terms of this "range forward," (1)if the spot exchange rate for the euro is above $1.30,then you pay $1.30; (2)if the spot exchange rate for the euro is below $1.20,then you pay $1.20;and (3)if the spot exchange rate lies between this range,then you buy euros at the prevailing market price.
Your cousin,who is studying derivatives at college,says "This is no big deal," and breaks down this range forward into basic building blocks.His breakdown is:

A) long zero-coupon bond with a face value $1.20,long call with strike price $1.20,and short call with strike price $1.30
B) long zero-coupon bond with a face value $1.20,short call with strike price $1.20,and short call with strike price $1.30
C) short zero-coupon bond with a face value $1.20,short call with strike price $1.20,and long call with strike price $1.30
D) short zero-coupon bond with a face value $1.30,short call with strike price $1.20,and long call with strike price $1.30
E) long zero-coupon bond with a face value $1.30,short call with strike price $1.20,and short call with strike price $1.30

Question 6

A plain vanilla currency swap does NOT involve which of the following?

A) an exchange of equivalent amounts in two different currencies on the start date
B) a net payment by one of the counterparties
C) cash flows in different currencies at intermediate dates
D) exchange of interest payments on these two currency loans on intermediate dates
E) repayment of the principal amounts on the ending date along with the final period's interest payments

Question 7

The holder of the following security gives an option to the issuer:

A) a callable bond
B) a convertible bond
C) an employee stock option
D) a stock
E) a warrant

Question 8

The holder of the following security gets an additional option embedded within the bond:

A) a callable bond
B) a convertible bond
C) an employee stock option
D) a stock
E) a warrant

Question 9

Americana Bank has $200 million of excess funds and Britannia Bank has £100 million of excess funds in pound sterling.The spot exchange rate S_A is $2 per pound sterling.They enter into a currency swap today that has a tenor of two months.The annual risk-free simple interest rates are i = 4 percent in the United States and i_E = 5 percent in the United Kingdom.Cash flows are exchanged at the end of each month.
At the end of one month:

A) Americana pays £0.4167 million to Britannia and receives $0.6667 million in return
B) Americana pays £0.8333 million to Britannia and receives $0.3333 million in return
C) Americana pays £0.4167 million to Britannia and receives $0.3333 million in return
D) Americana pays £0.8333 million to Britannia and receives $0.6667 million in return
E) None of these answers are correct.

Question 10

A credit default swap (CDS)on a bond with physical delivery is:

A) a term insurance policy,with a regular premium payment,that pays the face value of the bond if there is a credit event
B) a term insurance policy,with a regular premium payment,that pays the value of the firm's equity if there is a credit event
C) a term insurance policy,with a one time up-front premium,that pays the face value of the bond if there is a credit event
D) a term insurance policy,with a one time up-front premium,that pays the value of the firm's equity if there is a credit event
E) None of these answers are correct.

Question 11

A plain vanilla forex swap does NOT involve which of the following?

A) exchange of principal at the beginning
B) exchange back of principal along with interest payments
C) cash flows in different currencies
D) cash flows at intermediate dates
E) more than two counterparties

Question 12

A typical commodity swap involves:

A) a payment of the difference between two different commodities' prices on the expiration date
B) an exchange of a fixed payment for the daily average of a commodity's price over a time period
C) an exchange of a fixed payment for a floating payment that depends on one of the counterparty's fluctuating commodity need during the month
D) payments in two different currencies
E) None of these answers are correct.

Question 13

The following is NOT a characteristic feature of a plain vanilla interest rate swap:

A) cash flows in the same currency
B) counterparty risk
C) exchange of principal at the beginning and at the end
D) a net payment by one of the parties
E) notional principal

Question 14

Suppose that you want to short BUG's outstanding ten-year,5 percent coupon bond,but you cannot find anyone willing to lend you the bond (to short).Given that US Treasuries and CDS trade,you can create a short position in BUG's bond by:

A) going long a ten-year CDS on BUG
B) going short a ten-year CDS on BUG
C) going long a ten-year CDS on BUG and buying a ten-year US Treasury bond
D) going long a ten-year CDS on BUG and shorting a ten-year US Treasury bond
E) going short a ten-year CDS on BUG and shorting a ten-year US Treasury bond

Question 15

Americana Bank has $200 million of excess funds and Britannia Bank has £100 million of excess funds in pound sterling.The spot exchange rate S_A is $2 per pound sterling.They enter into a currency swap today that has a tenor of two months.The annual risk-free simple interest rates are i = 4 percent in the United States and i_E = 5 percent in the United Kingdom.Cash flows are exchanged at the end of each month.
After two months,the swap ends with the following transaction:

A) Americana pays £100 million to Britannia and receives $200 million in return
B) Americana pays £100.8333 million to Britannia and receives $201.3333 million in return
C) Americana pays £100.4167 million to Britannia and receives $200.6667 million in return
D) Americana pays £100.4167 million to Britannia and receives $201.3333 million in return
E) None of these answers are correct.