Deck 15: Interest Rate and Currency Swaps

Question 1

The following would be an example of a policy, not a goal.

A) Management shall minimize the firm's overall weighted average cost of capital.
B) Management shall maximize shareholder's wealth.
C) Management will not write uncovered options.
D) Management will hire only happy employees.

Answer 1

Management will not write uncovered options.

Question 2

The most widely used reference rate for standardized quotations, loan agreements, or financial derivative valuations is the ________.

A) Federal Reserve Discount rate
B) federal funds rate
C) LIBOR
D) one-year U.S. Treasury Bill

Answer 2

LIBOR

Question 3

Historically, interest rate movements have shown less variability and greater stability than exchange rate movements.

Answer 3

True

Question 4

Instruction 15.1:
For following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
∙ Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
∙ Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%,
to be reset annually. The current LIBOR rate is 3.50%
∙ Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the
credit annually. The current one-year rate is 5%.
Refer to Instruction 15.1. Choosing strategy #2 will

A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.

Question 5

A ________ rate is the rate of interest used in a standardized quotation, loan agreement, or financial derivative valuation.

A) reference rate
B) central rate
C) benchmark rate
D) none of the above

Question 6

The single largest interest rate risk of a firm is ________.

A) interest sensitive securities
B) debt service
C) dividend payments
D) accounts payable

Question 7

________ is the possibility that the borrower's creditworthiness is reclassified by the lender at the time of renewing credit. ________ is the risk of changes in interest rates charged at the time a financial contract rate is set.

A) Credit risk; Interest rate risk
B) Repricing risk; Credit risk
C) Interest rate risk; Credit risk
D) Credit risk; Repricing risk

Question 8

Instruction 15.1:
For following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
∙ Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
∙ Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%,
to be reset annually. The current LIBOR rate is 3.50%
∙ Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the
credit annually. The current one-year rate is 5%.
Refer to Instruction 15.1. The risk of strategy #1 is that interest rates might go down or that your credit rating might improve. The risk of strategy #3 is (Assume your firm is borrowing money.)

A) that interest rates might go down or that your credit rating might improve.
B) that interest rates might go up or that your credit rating might improve.
C) that interest rates might go up or that your credit rating might get worse.
D) none of the above.

Question 9

Instruction 15.1:
For following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
∙ Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
∙ Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%,
to be reset annually. The current LIBOR rate is 3.50%
∙ Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the
credit annually. The current one-year rate is 5%.
Refer to Instruction 15.1. Choosing strategy #3 will

A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.

Question 10

Corporate treasury departments have traditionally been

A) profit centers.
B) centers of aggressive profit taking.
C) service or cost centers.
D) none of the above.

Question 11

Instruction 15.1:
For following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
∙ Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
∙ Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%,
to be reset annually. The current LIBOR rate is 3.50%
∙ Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the
credit annually. The current one-year rate is 5%.
Refer to Instruction 15.1. Which strategy (strategies) will eliminate credit risk?

A) Strategy #1
B) Strategy #2
C) Strategy #3
D) Strategy #1 and #2

Question 12

Instruction 15.1:
For following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
∙ Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
∙ Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%,
to be reset annually. The current LIBOR rate is 3.50%
∙ Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the
credit annually. The current one-year rate is 5%.
Refer to Instruction 15.1. If your firm felt very confident that interest rates would fall or, at worst, remain at current levels, and were very confident about the firm's credit rating for the next 10 years, which strategy would you likely choose? (Assume your firm is borrowing money.)

A) Strategy #3
B) Strategy #2
C) Strategy #1
D) Strategy #1, #2, or #3, you are indifferent among the choices.

Question 13

Instruction 15.1:
For following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
∙ Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
∙ Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%,
to be reset annually. The current LIBOR rate is 3.50%
∙ Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the
credit annually. The current one-year rate is 5%.
Refer to Instruction 15.1. The risk of strategy #1 is that interest rates might go down or that your credit rating might improve. The risk of strategy #2 is (Assume your firm is borrowing money.)

A) that interest rates might go down or that your credit rating might improve.
B) that interest rates might go up or that your credit rating might improve.
C) that interest rates might go up or that your credit rating might get worse.
D) none of the above.

Question 14

Instruction 15.1:
For following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
∙ Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
∙ Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%,
to be reset annually. The current LIBOR rate is 3.50%
∙ Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the
credit annually. The current one-year rate is 5%.
Refer to Instruction 15.1. After the fact, under which set of circumstances would you prefer strategy #1? (Assume your firm is borrowing money.)

A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.

Question 15

Which of the following is NOT true regarding a corporate policy?

A) A policy is intended to limit or restrict management actions.
B) Policies make management decision-making more difficult in potentially harmful situations.
C) A policy is intended to restrict some subjective management decision-making.
D) A policy is intended to establish operating guidelines independently of staff.

Question 16

Unlike the situation with exchange rate risk, there is no uncertainty on the part of management for shareholder preferences regarding interest rate risk. Shareholders prefer that managers hedge interest rate risk rather than having shareholders diversify away such risk through portfolio diversification.

Question 17

Instruction 15.1:
For following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
∙ Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
∙ Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%,
to be reset annually. The current LIBOR rate is 3.50%
∙ Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the
credit annually. The current one-year rate is 5%.
Refer to Instruction 15.1. After the fact, under which set of circumstances would you prefer strategy #2? (Assume your firm is borrowing money.)

A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.

Question 18

As a management tool, a ________ is a rule, but a ________ is an objective.

A) policy; goal
B) goal; policy
C) FIBOR; GIBOR
D) none of the above

Question 19

LIBOR is an acronym for

A) Latest Interest Being Offered Rate.
B) Large International Bank Offered Rate.
C) Least Interest Bearing: Official Rate.
D) London Interbank Offered Rate.

Question 20

Instruction 15.1:
For following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
∙ Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
∙ Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%,
to be reset annually. The current LIBOR rate is 3.50%
∙ Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the
credit annually. The current one-year rate is 5%.
Refer to Instruction 15.1. Choosing strategy #1 will

A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.

Question 21

Instruction 15.1:
For following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
∙ Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
∙ Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%,
to be reset annually. The current LIBOR rate is 3.50%
∙ Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the
credit annually. The current one-year rate is 5%.
Refer to Instruction 15.1. After the fact, under which set of circumstances would you prefer strategy #3? (Assume your firm is borrowing money.)

A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.

Question 22

A swap agreement may involve currencies or interest rates, but never both.

Question 23

Which of the following would be considered an example of a currency swap?

A) exchanging a dollar interest obligation for a British pound obligation
B) exchanging a eurodollar interest obligation for a dollar obligation
C) exchanging a eurodollar interest obligation for a British pound obligation
D) All of the above are example of a currency swap.

Question 24

An interbank-traded contract to buy or sell interest rate payments on a notional principal is called a/an ________.

A) forward rate agreement
B) interest rate future
C) interest rate swap
D) none of the above

Question 25

TABLE 15.1
Use the information for Polaris Corporation to answer following question(s).
Polaris is taking out a $5,000,000 two-year loan at a variable rate of LIBOR plus 1.00%. The LIBOR rate will be reset each year at an agreed upon date. The current LIBOR rate is 4.00% per year. The loan has an upfront fee of 2.00%

Refer Table 15.1. What portion of the cost of the loan is at risk of changing?

A) the LIBOR rate
B) the spread
C) the upfront fee
D) all of the above

Question 26

The interest rate swap strategy of a firm with fixed rate debt and that expects rates to go up is to

A) do nothing.
B) pay floating and receive fixed.
C) receive floating and pay fixed.
D) none of the above.

Question 27

TABLE 15.1
Use the information for Polaris Corporation to answer following question(s).
Polaris is taking out a $5,000,000 two-year loan at a variable rate of LIBOR plus 1.00%. The LIBOR rate will be reset each year at an agreed upon date. The current LIBOR rate is 4.00% per year. The loan has an upfront fee of 2.00%

Refer Table 15.1. If the LIBOR rate falls to 3.00% after the first year what will be the all-in-cost (i.e. the internal rate of return) for Polaris for the entire loan?

A) 4.00%
B) 4.50%
C) 5.25%
D) 5.60%

Question 28

A firm with fixed-rate debt that expects interest rates to fall may engage in a swap agreement to

A) pay fixed-rate interest and receive floating rate interest.
B) pay floating rate and receive fixed rate.
C) pay fixed rate and receive fixed rate.
D) pay floating rate and receive floating rate.

Question 29

A/an ________ is a contract to lock in today interest rates over a given period of time.

A) forward rate agreement
B) interest rate future
C) interest rate swap
D) none of the above

Question 30

The financial manager of a firm has a variable rate loan outstanding. If she wishes to protect the firm against an unfavorable increase in interest rates she could

A) sell an interest rate futures contract of a similar maturity to the loan.
B) buy an interest rate futures contract of a similar maturity to the loan.
C) swap the adjustable rate loan for another of a different maturity.
D) none of the above.

Question 31

An agreement to swap the currencies of a debt service obligation would be termed a/an ________.

A) currency swap
B) forward swap
C) interest rate swap
D) none of the above

Question 32

A basis point is one-tenth of one percent.

Question 33

An agreement to exchange interest payments based on a fixed payment for those based on a variable rate (or vice versa) is known as a/an ________.

A) forward rate agreement
B) interest rate future
C) interest rate swap
D) none of the above

Question 34

An agreement to swap a fixed interest payment for a floating interest payment would be considered a/an ________.

A) currency swap
B) forward swap
C) interest rate swap
D) none of the above

Question 35

A firm with variable-rate debt that expects interest rates to rise may engage in a swap agreement to

A) pay fixed-rate interest and receive floating rate interest.
B) pay floating rate and receive fixed rate.
C) pay fixed rate and receive fixed rate.
D) pay floating rate and receive floating rate.

Question 36

TABLE 15.1
Use the information for Polaris Corporation to answer following question(s).
Polaris is taking out a $5,000,000 two-year loan at a variable rate of LIBOR plus 1.00%. The LIBOR rate will be reset each year at an agreed upon date. The current LIBOR rate is 4.00% per year. The loan has an upfront fee of 2.00%

Refer Table 15.1. If the LIBOR rate jumps to 5.00% after the first year what will be the all-in-cost (i.e. the internal rate of return) for Polaris for the entire loan?

A) 5.25%
B) 5.50%
C) 6.09%
D) 6.58%

Question 37

TABLE 15.1
Use the information for Polaris Corporation to answer following question(s).
Polaris is taking out a $5,000,000 two-year loan at a variable rate of LIBOR plus 1.00%. The LIBOR rate will be reset each year at an agreed upon date. The current LIBOR rate is 4.00% per year. The loan has an upfront fee of 2.00%

Refer to Table 15.1. What is the all-in-cost (i.e., the internal rate of return) of the Polaris loan including the LIBOR rate, fixed spread and upfront fee?

A) 4.00%
B) 5.00%
C) 5.53%
D) 6.09%

Question 38

A basis point is ________.

A) 1.00%
B) 0.10%
C) 0.01%
D) none of the above

Question 39

Interest rate futures are relatively unpopular among financial managers because of their relative illiquidity and their difficulty of use.

Question 40

TABLE 15.1
Use the information for Polaris Corporation to answer following question(s).
Polaris is taking out a $5,000,000 two-year loan at a variable rate of LIBOR plus 1.00%. The LIBOR rate will be reset each year at an agreed upon date. The current LIBOR rate is 4.00% per year. The loan has an upfront fee of 2.00%

Refer Table 15.1. Polaris could have locked in the future interest rate payments by using

A) a forward rate agreement.
B) an interest rate future.
C) an interest rate swap.
D) any of the above.

Question 41

A U.S.-based firm with dollar denominated debt, but continuing sales denominated in Japanese yen, could

A) purchase an interest rate cap agreement.
B) enter into a swap agreement to swap dollar interest for Japanese interest payments.
C) purchase a series of rolling futures contracts to buy Japanese yen forward.
D) all of the above.

Question 42

TABLE 15.2
Use the information to answer following question(s).

Refer to Table 15.2. For a swap agreement structured by Barclay's to benefit both Shell and Merck, which of the following must be true?

A) Barclay's must be willing to lend to Merck at a fixed rate of less than 7.50% and to Shell at a variable rate of less than LIBOR + 1/2%.
B) Barclay's must be willing to lend to Shell at a fixed rate of less than 8.00% and to Merck at a variable rate of less than LIBOR + 1/2%.
C) Barclay's must be willing to lend to Merck at a variable rate of less than 8.00% and to Shell at a fixed rate of less than LIBOR + 1/2%.
D) Barclay's must be willing to lend to Merck at a fixed rate of greater than 8.00% and to Shell at a variable rate of greater than LIBOR + 1/2%.

Question 43

Which of the following is NOT true?

A) A plain vanilla swap allows a firm to change the currency of denomination of debt service.
B) A swap does not change the legal liabilities of existing debt obligations of MNEs.
C) The swap market does not differentiate participants on the basis of credit quality.
D) All of the above are true.

Question 44

TABLE 15.2
Use the information to answer following question(s).

Refer to Table 15.2. Which of the following swap agreements could work for Shell and Merck with Barclay's as the facilitating bank?

A) Merck borrows at a fixed rate of 6% and then enters into "receive fixed, pay floating" interest rate swap with Barclay's. Shell borrows money at a variable rate of LIBOR + 1% and then enters into "receive variable, pay fixed" interest rate swap with Barclay's.
B) Shell borrows at a fixed rate of 6% and then enters into a "receive variable, pay fixed" interest rate swap with Barclay's. Merck borrows money at a variable rate of LIBOR + 1% and then enters into "receive fixed, pay floating" interest rate swap with Barclay's.
C) Shell borrows at a fixed rate of 6% and then enters into "receive fixed, pay floating" interest rate swap with Barclay's. Merck borrows money at a variable rate of LIBOR + 1% and then enters into "receive variable, pay fixed" interest rate swap with Barclay's.
D) None of the above would satisfy both Shell and Merck.

Question 45

The potential exposure that any individual firm bears that the second party to any financial contract will be unable to fulfill its obligations under the contract is called ________.

A) interest rate risk
B) credit risk
C) counterparty risk
D) clearinghouse risk

Question 46

Polaris Inc. has a significant amount of bonds outstanding denominated in yen because of the attractive variable rate available to the firm in yen when the loan was made. However, Polaris does not have significant receivables in yen. Options available to Polaris to consider the risk of such a loan include which one of the following?

A) doing nothing to offset the need for yen
B) developing a currency swap of paying dollars and receiving yen
C) developing an interest rate swap of receiving a variable rate while paying a fixed rate
D) Polaris may engage in any of the strategies to a varying degree of effectiveness.

Question 47

Cross currency swaps typically have larger swings in total value than "plain vanilla" interest rate swaps because

A) cross currency swaps exchange principal as well as interest payments.
B) interest rate movements are more volatile than currency movements.
C) interest rate swap agreements do not allow, contractually, large movements from par.
D) all of the above.

Question 48

Which of the following would an MNE NOT want to do?

A) Pay a very low fixed rate of interest in the long term.
B) Swap into a foreign currency payment that is falling in value.
C) Swap into a floating interest rate receivable just prior to interest rates going up.
D) Swap into a fixed interest rate receivable just prior to interest rates going up.

Question 49

A preferred interest rate swap strategy for a firm with variable-rate debt and that expects rates to go up is to

A) do nothing.
B) pay floating and receive fixed.
C) pay floating and pay fixed.
D) none of the above.

Question 50

Counterparty risk is greater for exchange-traded derivatives than for over-the-counter derivatives.

Question 51

Graham Investments must pay floating rate interest 6 months from now. The firm can lock in the rate by buying an interest rate futures contract. Interest rate futures for 6 months from today are currently settled at 95.03 for a yield of 4.97% per annum. If the floating interest rate 6 months from now is 6%, how much did Graham gain or lose?

A) Loss; 1.03%
B) Loss; 2.06%
C) Gain; 1.03%
D) Gain; 2.06%

Question 52

Outright techniques of interest rate risk management do not include which of the following?

A) forward rate agreements
B) interest rate futures
C) currency swaps
D) cap, floors, and collars

Question 53

A firm entering into a currency or interest rate swap agreement is relieved of the ultimate responsibility for the timely servicing of its own debt obligations.

Question 54

Some of the world's largest and most financially sound firms may borrow at variable rates less than LIBOR.

Question 55

The largest amount of daily trading in the foreign exchange derivatives market occurs in which of the following types of securities?

A) swaps
B) FRAs
C) options
D) These three choices have equal daily trading volumes.

Question 56

OTC interest rate derivative daily turnover has declined over the last decade in part due to the threat of terrorism and high energy prices.

Question 57

TABLE 15.2
Use the information to answer following question(s).

Refer to Table 15.2. Which of the following are viable rates for the swap agreements with Barclay's Bank by Shell and Merck?

A) Shell borrows at a variable rate of LIBOR + 1% and enters into a swap with Barclay's that pays Shell variable LIBOR + 1% while Shell pays Barclay's fixed 7 1/4%. At the same time, Merck borrows at the fixed rate of 6.00% and enters into a swap agreement with Barclay's that pays Merck 6.00% while Merck pays Barclay's LIBOR plus 1/4%.
B) Merck borrows at a variable rate of LIBOR + 1% and enters into a swap with Barclay's that pays Merck variable LIBOR + 1% while Merck pays Barclay's fixed 7 1/4%. At the same time, Shell borrows at the fixed rate of 6.00% and enters into a swap agreement with Barclay's that pays Shell 6.00% while Shell pays Barclay's LIBOR plus 1/4%.
C) Merck borrows at a fixed rate of 7.5% and enters into a swap with Barclay's that pays Merck variable LIBOR + 1% while Merck pays Barclay's fixed 7 1/4%. At the same time, Shell borrows at the variable rate of LIBOR + 1/2% and enters into a swap agreement with Barclay's that pays Shell 6.00% while Shell pays Barclay's LIBOR plus 1/4%.
D) Merck borrows at a variable rate of LIBOR + 1% and enters into a swap with Barclay's that pays Merck a fixed rate of 7% while Merck pays Barclay's variable LIBOR +1%. At the same time, Shell borrows at the fixed rate of 6.00% and enters into a swap agreement with Barclay's that pays Shell 6.00% while Shell pays Barclay's LIBOR plus 1/4%.

Question 58

Counterparty risk is

A) present only with exchange-traded options.
B) based on the notional amount of the contract.
C) the risk of loss if the other party to a financial contract fails to honor its obligation.
D) eliminated by the use of insurance funds.

Question 59

Molson Brewery, a Canadian company wishes to borrow $1,000,000 for 12 weeks. A rate of 6.00% per annum is quoted by lenders in both New York and London using, respectively, international and British definitions of interest. From which source should Molson borrow other things equal? What is Molson's total interest charge from the selected source?

A) New York; $14,000
B) New York; $13,808
C) London; $14,000
D) London; $13,808

Question 60

A combined position of selling one currency forward at one maturity while buying the same currency forward at a different maturity to lock in a future interest rate in the foreign currency is a/an

A) forward swap.
B) forward rate agreement.
C) interest rate future.
D) currency and interest rate swap.

Question 61

How does counterparty risk influence a firm's decision to trade exchange-traded derivatives rather than over-the-counter derivatives?

Question 62

Your firm is faced with paying a variable rate debt obligation with the expectation that interest rates are likely to go up. Identify two strategies using interest rate futures and interest rate swaps that could reduce the risk to the firm.

Question 63

Over the last decade floating-rate notes have decreased in both total volume and percentage of total dollar-denominated bond issuances.