Chapter 21 - Swaps - notes for all

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 Chapter 21 - Test Bank

Multiple Choice Questions

1. An interest rate swap is:

A. another name for a call option.

B. another name for a put option.
C. an agreement between two or more persons to exchange cash flows over some future period.
D. the name for the exchange of a bond futures contract for an option contract.

2. When two parties exchange their respective interest payments associated with existing debt borrowed in
the capital markets, this is called a/an:

A. interest exchange.
B. financial switch.
C. swap.
D. financial transfer.

3. Which of the following about interest rate swaps is NOT correct?

A. An interest rate swap allows a company to change the net characteristics of its interest rate cash flows.
B. An interest rate swap is based on interest rates worked out on a notional principal.
C. If a company has a fixed-rate loan it can enter into an interest rate swap whereby the bank lender
will pay it a variable rate to net out the fixed rate from the company.
D. A cross-currency swap involves the exchange and interest payments based on a fixed exchange rate.

4. A financial agreement between two parties to exchange a series of cash flows similar to those
resulting from an exchange of different types of bonds is called a/an:

A. credit swap.
B. interest rate swap.
C. yield curve swap.
D. notional spread.

5. The growth of the interest rate swaps market has been due to firms wanting to:

A. lower the cost of funds.

B. hedge interest rate risk.
C. lock in profit margins.
D. All of the given choices.

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6. The advantages(s) for a company to use an interest rate swap is:

A. it may lower the cost of funds if comparative advantages exist.

B. it may hedge interest rate risk.
C. it may gain access to otherwise inaccessible debt markets.
D. all of the given answers.

7. The first interest rate swap involving the World Bank and IBM was arranged in:

A. August 1961.
B. August 1971.
C. August 1981.
D. August 1991.

8. An interest rate swap is similar to which of the following transactions?

A. Borrowing money at one floating rate and lending it at a higher floating rate
B. The purchase of a share and the sale of a bond
C. A series of forward rate agreements (FRAs)
D. All of the given choices

9. A credit default swap means:

A. initial payment of a periodic premium by the buyer of a credit default swap.

B. the buyer of a credit default swap obtains protection against credit risk exposures associated with
specified debt issues.
C. if the specified debt issuer defaults then the credit default swap protection seller assumes the risk.
D. all of the given answers are correct.

10. The size of one basis point is:

A. 0.01
B. 0.001
C. 0.0001
D. 0.00001

11. One hundred basis points equal:

A. 100%
B. 10%
C. 1%
D. 0.1%

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12. The two parties contracting to exchange their respective interest payments in an interest rate swap
are formally called:

A. options holders.
B. counterparties.
C. exchange parties.
D. long and short positions.

13. When two parties agree to exchange a set of interest rate cash flows based on a notional principal,
this transaction is called:

A. cross-hedging.
B. interest rate swap.
C. cash flow swap.
D. fixed-for floating swap.

14. The fictional principal on which an interest rate swap is based is called the:

A. swap dealer's call rate.

B. notional principal.
C. LIBOR.
D. basis rate.

15. In an interest rate swap, the notional principal:

A. is the principal relating only to the fixed rate payer.

B. is the principal relating only to the floating rate payer.
C. does not receive any interest payments.
D. is equal to the amount of the underlying debt borrowed.

16. In an interest rate swap, the party who is the fixed-rate payer:

A. currently has fixed-rate obligations, but prefers floating.

B. currently has floating-rate obligations, but prefers fixed.
C. receives a fixed-rate payment if interest rates increase.
D. pays a floating-rate payment if interest rates increase.

17. In relation to an interest rate swap transaction when the two parties are each entering into a swap to
manage a particular interest rate risk exposure, this is called a:

A. bank swap.
B. direct swap.
C. intermediated swap.
D. credit swap.

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18. In relation to an interest rate swap transaction when the one of the two parties is a financial institution
this is called a:

A. bank swap.
B. direct swap.
C. intermediated swap.
D. credit swap.

19. The main type of interest rate:

A. is a direct swap between two parties.

B. is known as a vanilla swap.
C. is a basis swap.
D. involves a swap of floating for floating interest payments.

20. The main type of interest rate:

A. is a direct swap between two parties.

B. involves accompany entering into a swap with a financial intermediary whereby the company
swaps fixed for floating payments.
C. is a basis swap.
D. involves a swap of floating for floating interest payments.

21. In a vanilla interest rate swap:

A. the amounts payable between parties depend on a specified principal that is exchanged at the outset.
B. one party pays another party an amount calculated according to a floating interest rate on a
notional principal, in exchange for an amount calculated on the basis of a fixed interest rate.
C. only interest flows are exchanged until maturity, when the principal is exchanged according to
the difference in the interest rates over the lifetime of the swap.
D. the amounts payable between parties depends on a specified principal that is exchanged at the beginning
and at the end.

22. If a company that had a fixed-rate liability wanted to achieve a floating-rate cost of funds through a swap,
it would pay a:

A. fixed rate to the counterparty and receive a floating rate in return from the counterparty.
B. floating rate to the counterparty and pay a floating rate to the fixed-rate lender.
C. floating rate to the counterparty and pay a fixed rate to the fixed-rate lender.
D. floating rate to the counterparty and receive a fixed rate in return from the counterparty.

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23. If a company that had a floating-rate liability wanted to enter into a swap to achieve a fixed-rate cost
of funds, it would pay a:

A. fixed rate to the counterparty and receive a floating rate in return from the counterparty.
B. floating rate to the counterparty and pay a floating rate to the fixed-rate lender.
C. floating rate to the counterparty and pay a fixed-rate to the fixed-rate lender.
D. floating rate to the counterparty and receive a fixed-rate in return from the counterparty.

24. In an interest rate swap, gains/gain when the three-month BBSW rises.

A. the floating-rate payer

B. the fixed-rate payer
C. both floating- and fixed-rate payers
D. neither floating- nor fixed-rate payers

25. In an interest rate swap gains/gain when the three-month BBSW falls.

A. the floating-rate payer

B. the fixed-rate payer
C. both floating- and fixed-rate payers
D. neither floating- nor fixed-rate payers

26. If a company with a fixed-rate debt of 11% enters into a swap and pays floating-rate debt of 8%
and receives fixed-rate payments of 9%, its net cost of debt becomes:

A. 9%
B. 10%
C. 11%
D. 12%

27. If a company with a fixed-rate debt of 11% enters into a swap and pays floating-rate debt of
BBSW+1.20% and receives fixed-rate payments of 9%, its net cost of debt becomes:

A. 11%
B. BBSW+0.20%
C. BBSW+2.20%
D. 12%

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28. Which of the following statements regarding interest rate swaps is incorrect?

A. In contrast with a forward contract, the exact terms of exchange of an interest rate swap will change with
interest rates.
B. The two parties exchange net interest difference in an interest rate swap.
C. An interest rate swap is similar to a forward contract in that it guarantees the exchange of two items of
value at some future point in time.
D. The two parties in an interest rate swap generally have the same level of default risk.

29. When a financial intermediary is involved as an interest rate swap counterparty, it often seeks to arrange
an offsetting swap called a:

A. counterparty swap.
B. simultaneous swap.
C. synchronised swap.
D. matched swap.

30. These days, the majority of swaps require a/an to act as an intermediary.

A. commercial bank
B. investment bank
C. merchant bank
D. Any of the given choices

31. A key motive for companies and financial institutions to participate in an interest rate swap is:

A. the low information costs of swaps, compared with other financial derivatives.
B. to transfer interest-rate risk to parties more willing to bear it.
C. the greater liquidity of swaps, compared with other financial derivatives.
D. the favourable tax implications of swaps, compared with other financial derivatives.

32. Which of the following is NOT an advantage of having an interest rate swap market?

A. As it is generally liquid, it benefits both borrowers and lenders.

B. As most swaps involve banks, their credit departments can carry out credit assessments more easily
than potential lenders.
C. As the banks are involved in most swaps, banks require a spread between the two interest rates.
D. Swaps enable companies to carry out regulatory and tax arbitrage.

33. Which of the following statements is NOT an advantage of a swap transaction?

A. It usually allows the company to achieve a lower cost of funds.

B. It is used to hedge both interest rate risk and foreign exchange risk.
C. It facilitates the restructuring of cash flows associated with existing borrowings.
D. It transfers the credit risk to the counterparty.

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34. Which of the following statements regarding interest rate swaps is incorrect?

A. The principal involved is called notional.

B. Parties involved borrow funds where they have a comparative advantage.
C. The two parties in the swap always share equally the cost of the spread that the intermediary receives.
D. The financial intermediary involved often engages in an offsetting swap, known as a matched swap.

35. Which of the following is a way to change the basic structure of a swap?

A. Vary the notional principal over the lifetime of the swap.

B. Change the timing of when the swap begins or ends.
C. Reverse the swap if market conditions change.
D. All of the given answers are correct.

36. An interest rate swap in which all the fixed payments are paid in one lump sum is called a/an:

A. amortised swap.
B. term swap.
C. zero-coupon swap.
D. none of the given choices.

37. An interest rate swap in which the notional principal declines over time is called a/an:

A. amortised swap.
B. term swap.
C. zero-coupon swap.
D. none of the given choices.

38. An interest rate swap that obligates traders to enter a swap at some date in the future, with terms
agreed today, is a:

A. term swap.
B. forward swap.
C. flexible swap.
D. long swap.

39. In a swap arrangement, both parties may be able to receive more favourable funding rates than they
would have done without the swap, and the swap dealer receives a spread as well. Where does the cost
saving originate from?

A. The bank swap dealer effectively guarantees payments of all obligations.

B. The parties involved in the swap are able to borrow where each has a relative cost advantage.
C. The party paying floating cash flows always pays less than the party paying fixed cash flows.
D. With the bank always acting as a swap counterparty, each party is able to reduce the risk profile.

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40. If one company has better access to fixed-term financing than another company, it may be said that
this company has a than the other company.

A. lower credit rating

B. comparative advantage
C. greater market share
D. higher credit risk

41. If two firms have the following cost of borrowing, what is the net differential for an interest rate
swap? Firm A: fixed rate 10.8% per annum; floating rate BBSW+0.3% per annum
Firm B: fixed rate 11.6% per annum; floating rate BBSW+1.7% per annum

A. 2.2%
B. 1.4%
C. 0.7%
D. 0.6%

42. An investment bank is to advise two client companies on the establishment of a mutually beneficial
swap facility. Both companies are able to access funding within the fixed interest rate debt markets and
the floating interest rate debt markets. However, company X has a comparative advantage over company
Y within one of the debt markets. Based on the following data, what is the comparative advantage of
company X?
Company X: fixed rate 10.8% per annum; floating rate BBSW+ .3% per annum Company
Y: fixed rate 11.5% per annum; floating rate BBSW+1.7% per annum

A. Fixed interest rate debt market, 0.7% per annum

B. Floating interest rate debt market, 1.4% per annum
C. Fixed interest rate debt market, 10.8% per annum
D. Floating interest rate debt market, BBSW + 0.3% per annum

43. Using the data below, calculate the fixed interest rate payable by company B in the swap transaction.

A. 11.075% per annum

B. 11.275% per annum
C. 11.325% per annum
D. 11.550% per annum

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44. Which of the following may be said to create a debt market environment, whereby one company
may obtain a comparative interest rate advantage over another company in the fixed interest rate
market, compared with the floating interest rate market?

A. The existence of market segmentation between the fixed and floating rate markets.
B. Typically, fixed-rate market risk premiums are based on external credit rating agency reports.
C. Professional institutional lenders, such as banks and merchant banks, apply their own internal credit
risk premiums.
D. All of the given answers.

45. Ossie Ltd is about to establish a new funding arrangement. It is able to borrow in either the fixed-rate
or floating-rate debt markets. The company wishes to lower its cost of borrowing by entering into a
swap transaction with Battler Ltd. Based on the following data for the two companies, in which interest
rate market will Ossie Ltd borrow, and swap into?

Ossie Ltd fixed rate 10.8% per annum; floating rate BBSW+0.3% per annum

Battler Ltd fixed rate 11.5% per annum; floating rate BBSW+1.7% per annum

A. Borrow at fixed interest rate; swap into floating rate

B. Borrow at floating interest rate; swap into fixed rate
C. Borrow at fixed interest rate; no advantage in swap transaction
D. Borrow at floating interest rate; no advantage in swap transaction

46. Bosie Ltd is about to establish a new funding arrangement. It is able to borrow in either the fixed-rate
or floating-rate debt markets. The company wishes to lower its cost of borrowing by entering into a
swap transaction with Matlock Ltd. Based on the following data for the two companies, in which
interest rate market will Matlock Ltd borrow, and swap into?

Bosie Ltd fixed rate 10.8% per annum; floating rate BBSW+0.3% per annum

Matlock Ltd fixed rate 11.5% per annum; floating rate BBSW+0.7% per annum

A. Borrow at fixed interest rate; swap into floating rate

B. Borrow at floating interest rate; swap into fixed rate
C. Borrow at fixed interest rate; no advantage in swap transaction
D. Borrow at floating interest rate; no advantage in swap transaction

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47. A bank has intermediated a matched swap facility with two client companies. Which of the
following statements best describes a matched swap?

A. The role of the bank is that of an agent in bringing the two companies together.
B. The notional principal amounts are exchanged and matched by currency and maturity.
C. The bank as intermediary effectively engineers separate offsetting contracts.
D. All of the given answers.

48. An interest rate swap can effectively be hedged against interest rate risk by:

A. selling out to another party.

B. entering into another swap agreement that has the opposite transactions to the first swap.
C. setting floating-rate obligations equal to fixed-rate obligations.
D. matching durations of assets and liabilities.

49. Which of the following is considered a factor on the supply side in the growth of the swaps market?

A. Interest rate swaps provide a linkage between segmented markets.

B. Interest rate swaps can minimise the costs of regulation and tax laws.
C. The efficiency and technology of financial intermediaries in providing risk management.
D. All of the given answers.

50. Growth in the interest rate swaps market has occurred as a consequence of:

A. companies looking for ways to manage risk or lower total funding costs.
B. swaps creating a link between segmented markets.
C. swaps minimising the costs of regulation and tax laws.
D. all of the given answers.

51. For an ordinary interest rate swap already in place, if counterparty A's obligation for one year is $100
000 and counterparty B's obligation is $120 000:

A. counterparty A will pay counterparty B $20 000

B. counterparty A will pay counterparty B $100 000
C. counterparty B will pay counterparty A $20 000
D. counterparty B will pay counterparty A $120 000

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52. Consider the following five statements:
i. Swaps may be used to achieve a lower cost of funds for a company.
ii. In an interest rate swap, the two parties swap the principal amount plus the ongoing associated
interest obligations.
iii. An intermediated swap is said to be ‘matched' when a bank enters into swaps with both firms
involved in an interest rate swap.
iv. A ‘plain vanilla' swap is the fixed AUD to floating AUD swap.
v. If an intermediary is involved in a swap between two parties, the intermediary will also provide
the initial loan to both parties.
How many of these statements are true and how many are false?

A. 3 statements are true and 2 are false

B. 2 statements are true and 3 are false
C. 4 statements are true and 1 is false
D. 1 statement is true and 4 are false

53. Consider the following five statements:

i. Swaps may be used to achieve a lower cost of funds for a company.
ii. In an interest rate swap, the two parties swap the principal amount plus the ongoing associated
interest obligations.
iii. An intermediated swap is said to be ‘matched' when a bank enters into swaps with both firms
involved in an interest rate swap
iv. A ‘plain vanilla' swap is the fixed AUD to floating AUD swap.
v. If an intermediary is involved in a swap between two parties, the intermediary will also provide
the initial loan to both parties.
Which of the following are correct?

A. i, ii, iii and iv are true

B. ii, iii, iv and v are true
C. ii, and iv are true
D. i and iii are true

54. Interest rate swap transactions may be used by a multinational corporation as part of a funding strategy to:

A. lower the cost of borrowing, using a comparative advantage in a particular debt market.
B. spread debt issues across a range of currencies.
C. diversify funding sources across a range of debt markets.
D. all of the given answers.

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55. A company is concerned that the cost of its long-term debt facilities is based on a fixed interest rate that is
considerably above current market rates, and that rates will continue to fall. The company decides to use
a swap to manage its risk exposure. using the data provided below, which of the following statements is
incorrect?
Data:
Existing debt fixed interest rate: 13.50% per annum Current
long-term fixed swap rate: 11.75% per annum
Current long-term floating swap rate: BBSW+0.50% per annum

A. The company has created a synthetic fixed rate liability.

B. Short-term interest rates are expected to remain below the existing fixed cost of debt.
C. The effective cost of borrowing is lower, as long as BBSW averages less than 11.25% per annum.
D. This strategy assumes a ‘normal' yield curve, on average, over the life of the swap.

56. If the exchange rate alters during the lifetime of a cross-currency swap, this:

A. has no impact as all FX risk has been eliminated.

B. will impact only on the interest payments during the swap's lifetime.
C. will impact only when the principal amounts are re-exchanged at maturity.
D. will impact on both interest payments and principal repayments.

57. As a foreign exchange hedge, cross-currency swaps have all of the following features, except:

A. each party pays the other's interest payment.

B. principal amounts are reversed at a pre-specified rate at maturity.
C. an initial exchange of the two principal amounts by the two parties in the two different currencies.
D. principal amounts are reversed at the spot rate at maturity.

58. Which of the following statements regarding a cross-currency swap is incorrect?

A. There is an exchange of principal amounts between counterparties at the beginning and end of the swap.
B. The re-exchange at the conclusion of a cross-currency swap usually takes place at the initial
exchange rate.
C. As the cross-currency swap is arranged through a bank, there is no credit risk.
D. Once the cross-currency swap rate is determined, cash flows are known with certainty.

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59. An Australian company has issued USD paper into the US debt markets. The company is investigating
the possibility of entering into a cross-currency swap. Which of the following generally form the basic
mechanics of a cross-currency swap?
i. Re-exchange of principal normally takes place at the same exchange rate as that used at the
commencement of the swap.
ii. At the conclusion of the swap, principal amounts are re-exchanged.
iii. Principal amounts, in the currency of debt, are exchanged at the start of the swap.
iv. Interest payment commitments are swapped.
v. Involves the exchange between two parties of debt denominated in one currency, for debt
denominated in another currency.

A. i, ii, iii, v
B. ii, iii, iv, v
C. i, ii, iii, iv, v
D. i, ii, iii, iv

60. One of the key motives for a cross-currency swap is:

A. the need to evade the domestic country's regulations.

B. the need to obtain the actual use of the foreign currency.
C. to gain risk exposure.
D. to make money from interest rate differences between countries.

61. Interest rate swaps and cross-currency swaps permit a counterparty to exchange a:

A. floating interest rate payment or currency value for a lower floating payment value over the term.
B. fixed interest rate position for a currency position over the contract term.
C. floating interest rate payment or currency value for a fixed payment value over the contract term.
D. fixed interest rate payment or currency value for a fixed value over the contract term.

62. The advantage of over-the-counter products such as swaps or forwards contracts, relative to
exchange- traded products such as options or futures, is:

A. standardisation.
B. regulation.
C. flexibility.
D. all of the given answers.

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63. Consider these five statements:
i. Swaps can be used to create a synthetic floating rate debt for a company's fixed rate debt.
ii. If an intermediary has arranged a matched swap, it has no net exposure to interest rate risk.
iii. A cross-currency swap differs from an interest rate swap in that, for a cross-currency swap, the
principals, as well as the agreed interest obligations, are swapped for the duration of the swap
agreement.
iv. With a cross-currency swap, the exchange rate used at the principal re-exchange date is based on
the current spot rate at that time.
v. If a bank acts as an intermediary in a swap and does not fund the swap parties' underlying loan
facilities, it has no obligation under the bank capital adequacy requirements.
How many of the statements are true and how many are false?

A. 3 statements are true and 2 are false

B. 2 statements are true and 3 are false
C. 4 statements are true and 1 is false
D. 1 statement is true and 4 are false

64. Consider these five statements:

i. Swaps can be used to create a synthetic floating rate debt for a company's fixed rate debt.
ii. If an intermediary has arranged a matched swap, it has no net exposure to interest rate risk.
iii. A cross-currency swap differs from an interest rate swap in that, for a cross-currency swap, the
principals, as well as the agreed interest obligations, are swapped for the duration of the swap
agreement.
iv. With a cross-currency swap, the exchange rate used at the principal re-exchange date is based on
the current spot rate at that time.
v. If a bank acts as an intermediary in a swap and does not fund the swap parties' underlying loan
facilities, it has no obligation under the bank capital adequacy requirements.
Which of the following are correct?

A. i, ii, iii and iv are true

B. ii, iii and iv are true
C. i, ii and iii are true
D. i, ii, iii and v are true

65. When a bond investor buys a credit default swap (CDS), they will:

A. pay a premium to the seller.

B. receive compensation from the protection seller if a default occurs.
C. retain their original bonds.
D. do all of the given answers.

66. Cash settlement for a credit default swap (CDS) means the:

A. protection buyer delivers the agreed notional value of the debt to the protection seller.
B. protection buyer transfers the specified debt to the protection seller.
C. protection seller pays a net cash amount to the protection buyer.
D. protection buyer delivers the face value of the debt to the protection seller.

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67. Which of the following regarding the role of a financial intermediary in an interest rate swap is incorrect?

A. Most swaps involve a financial intermediary as counterparty.

B. The financial intermediary will most often seek to engage in an offsetting swap.
C. The intermediary makes its profit by maintaining a spread between the rates offered to the
two counterparties.
D. The financial intermediary, by establishing a matched swap, ends up with a positive net exposure in
the swap market.

68. Which of the following statements regarding interest rate swaps is incorrect?

A. The practice of marking-to market is carried out in the swaps market (similar to the futures market).
B. In contrast with a forward contract, the exact terms of exchange of a swap will change with
interest rates.
C. The swap market is similar to the futures market in that if the market moves against the contract,
a maintenance margin call is required.
D. The two parties in a swap generally have the same level of default risk.

69. During a swap, the risk of one party not forwarding its payment while the other party does fulfil
its payment obligation is called:

A. Herstatt risk.
B. swap risk.
C. settlement risk.
D. repayment risk.

70. In order to reduce interest rate swap risk exposures, a financial intermediary may:

A. practise marking-to market.

B. use margin calls.
C. ask for security collateral.
D. do all of the given answers.

71. If a party in a matched swap defaults, the financial intermediary faces:

A. credit risk.
B. default risk.
C. settlement risk.
D. default and settlement risk.

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72. The risk owing to a timing difference in an interest rate swap transaction, when one party defaults on
a payment to another before the other realises it, is called:

A. basis risk.
B. mismatch risk.
C. settlement risk.
D. front-end
risk.

73. When the normal relationship between fixed and floating interest rates alters in an interest rate swap,
this risk is called:

A. basis risk.
B. exchange risk.
C. mismatch risk.
D. front-end
risk.

74. Whereas in the mid-1980s swap spreads might have been 50 basis points, a/an basis-point spread
is more common today.

A. 80
B. 60
C. 30
D. 10

75. All of the following are factors that directly affect swap pricing, except:

A. the availability of extra counterparties.

B. the credit risk of the swap counterparty.
C. the term structure of interest rates.
D. current government regulation.

76. In order to measure and manage interest rate swap risk exposures, a financial intermediary may:

A. practise marking-to market.

B. seek security collateral.
C. require a written performance guarantee from the
counterparty's sponsor.
D. do all of the given answers.

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77. If a company expects interest rates to increase, which of the following strategies should the
company consider?

A. A short interest rate call

B. A swap involving paying fixed rate and receiving floating rate
C. A short forward rate
agreement
D. All of the given choices

78. While both the international and AUD swap markets have matured, growth may still be expected. Which of
the following factors is a determinant in the future growth of the swaps markets?

A. Periodic nervousness from a lack of clear direction of interest rates

B. Speculative trading transactions to take advantage of future price movements
C. Development of new, sophisticated products to hedge interest rate and currency risk
D. All of the given choices

79. Interest rate swaps and cross-currency swaps:

A. appear on the balance sheets of commercial banks as current assets.

B. appear on the balance sheets of commercial banks as current liabilities.
C. appear on the balance sheets of commercial banks as long-term liabilities.
D. do not appear on the balance sheet.

80. Interest rate swaps and cross-currency swaps:

A. appear on the balance sheets of commercial banks as current assets.

B. appear on the balance sheets of commercial banks as current liabilities.
C. appear on the balance sheets of commercial banks as long-term liabilities.
D. represent a contingent liability for an intermediary.

81. Because interest rate swaps are off-balance-sheet transactions for an intermediary, they:

A. only involve receiving deposits.

B. only involve lending funds.
C. are not involved in capital adequacy requirements.
D. are involved in capital adequacy requirements.

True / False Questions

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82. A financial contract that obligates one party to exchange a set of payments it owns for another set
of payments owned by another party is called a cross call option.

True False

83. An interest rate swap may be used by a company only able to borrow variable rate funds to
obtain favourable longer term funding from otherwise difficult to access long-term debt markets.

True False

84. An interest rate swap that involves two parties entering into agreements where floating for floating
interest rate payments is called a money market swap.

True False

85. A rise in LIBOR will benefit the fixed-rate borrowing party in an interest-rate swap contract.

True False

86. When a company can borrow at a fixed rate of 8% per annum and a variable rate of LIBOR + 0.60% per
annum and another company can borrow at a fixed rate of 9% per annum and a variable rate of LIBOR
+
0.80 a profitable vanilla swap can be arranged between them so that both their borrowing obligations can
be lowered.

True False

87. For the majority of interest rate swaps, an intermediary is involved.

True False

88. When a firm has borrowed floating rate from a bank but at the same time has entered into a fixed-price
contract to manufacture goods, a fixed rate to variable rate swap allows the firm to lock in its profit
margin on goods manufactured if interest rates rise.

True False

89. When two parties do a cross-currency swap involving floating rate interest payments in one currency and
fixed interest rate payments denominated in another currency, the cash flows involved vary as the
exchange rate changes.

True False

90. With a cross-currency swap the exchange rate used at the principal re-exchange date at maturity is based
on the exchange rate at the beginning of the swap.

True False

91. A CDS protection buyer is a lender who seeks protection from credit risk associated with a particular
debt issue and is willing to pay a premium to the CDS protection seller.

True False

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Short Answer Questions

92. Discuss possible reasons why interest rate swap markets have formed and grown.

93. Discuss the structure and cash-flows arrangement for the main type of interest rate swap.

94. Explain in the context of interest rate swaps what a matched swap is.

95. Discuss the use of interest rate swaps in hedging interest rate exposure.

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96. As of December 2010 the Bank for International Settlements (BIS) estimated the notional value of
currency swaps was USD16 347 billion. Discuss possible reasons for the growth in currency swaps.

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 Chapter 21 - Test Bank Key

Multiple Choice Questions

1. An interest rate swap is:

A. another name for a call option.

B. another name for a put option.
C. an agreement between two or more persons to exchange cash flows over some future period.
D. the name for the exchange of a bond futures contract for an option contract.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts
within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: Introduction

2. When two parties exchange their respective interest payments associated with existing debt borrowed
in the capital markets, this is called a/an:

A. interest exchange.
B. financial switch.
C. swap.
D. financial transfer.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts
within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: Introduction

3. Which of the following about interest rate swaps is NOT correct?

A. An interest rate swap allows a company to change the net characteristics of its interest rate cash
flows.
B. An interest rate swap is based on interest rates worked out on a notional principal.
C. If a company has a fixed-rate loan it can enter into an interest rate swap whereby the bank lender
will pay it a variable rate to net out the fixed rate from the company.
D. A cross-currency swap involves the exchange and interest payments based on a fixed exchange rate.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts
within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: Introduction

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4. A financial agreement between two parties to exchange a series of cash flows similar to those
resulting from an exchange of different types of bonds is called a/an:

A. credit swap.
B. interest rate swap.
C. yield curve swap.
D. notional spread.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: Introduction

5. The growth of the interest rate swaps market has been due to firms wanting to:

A. lower the cost of funds.

B. hedge interest rate risk.
C. lock in profit margins.
D. All of the given choices.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: Introduction

6. The advantages(s) for a company to use an interest rate swap is:

A. it may lower the cost of funds if comparative advantages exist.

B. it may hedge interest rate risk.
C. it may gain access to otherwise inaccessible debt markets.
D. all of the given answers.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: Introduction

7. The first interest rate swap involving the World Bank and IBM was arranged in:

A. August 1961.
B. August 1971.
C. August 1981.
D. August 1991.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: Introduction

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8. An interest rate swap is similar to which of the following transactions?

A. Borrowing money at one floating rate and lending it at a higher floating rate
B. The purchase of a share and the sale of a bond
C. A series of forward rate agreements (FRAs)
D. All of the given choices
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-02 Understand the reasons why interest rate swap markets have become significant within the global financial markets.
Section: Introduction

9. A credit default swap means:

A. initial payment of a periodic premium by the buyer of a credit default swap.

B. the buyer of a credit default swap obtains protection against credit risk exposures associated
with specified debt issues.
C. if the specified debt issuer defaults then the credit default swap protection seller assumes the risk.
D. all of the given answers are correct.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: Introduction

10. The size of one basis point is:

A. 0.01
B. 0.001
C. 0.0001
D. 0.00001
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

11. One hundred basis points equal:

A. 100%
B. 10%
C. 1%
D. 0.1%
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

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12. The two parties contracting to exchange their respective interest payments in an interest rate swap
are formally called:

A. options holders.
B. counterparties.
C. exchange parties.
D. long and short positions.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

13. When two parties agree to exchange a set of interest rate cash flows based on a notional principal,
this transaction is called:

A. cross-hedging.
B. interest rate swap.
C. cash flow swap.
D. fixed-for floating swap.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

14. The fictional principal on which an interest rate swap is based is called the:

A. swap dealer's call rate.

B. notional principal.
C. LIBOR.
D. basis rate.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

15. In an interest rate swap, the notional principal:

A. is the principal relating only to the fixed rate payer.

B. is the principal relating only to the floating rate payer.
C. does not receive any interest payments.
D. is equal to the amount of the underlying debt borrowed.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

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16. In an interest rate swap, the party who is the fixed-rate payer:

A. currently has fixed-rate obligations, but prefers floating.

B. currently has floating-rate obligations, but prefers fixed.
C. receives a fixed-rate payment if interest rates increase.
D. pays a floating-rate payment if interest rates increase.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

17. In relation to an interest rate swap transaction when the two parties are each entering into a swap
to manage a particular interest rate risk exposure, this is called a:

A. bank swap.
B. direct swap.
C. intermediated swap.
D. credit swap.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

18. In relation to an interest rate swap transaction when the one of the two parties is a financial
institution this is called a:

A. bank swap.
B. direct swap.
C. intermediated swap.
D. credit swap.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

19. The main type of interest rate:

A. is a direct swap between two parties.

B. is known as a vanilla swap.
C. is a basis swap.
D. involves a swap of floating for floating interest payments.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

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20. The main type of interest rate:

A. is a direct swap between two parties.

B. involves accompany entering into a swap with a financial intermediary whereby the company
swaps fixed for floating payments.
C. is a basis swap.
D. involves a swap of floating for floating interest payments.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

21. In a vanilla interest rate swap:

A. the amounts payable between parties depend on a specified principal that is exchanged at the outset.
B. one party pays another party an amount calculated according to a floating interest rate on a
notional principal, in exchange for an amount calculated on the basis of a fixed interest rate.
C. only interest flows are exchanged until maturity, when the principal is exchanged according to
the difference in the interest rates over the lifetime of the swap.
D. the amounts payable between parties depends on a specified principal that is exchanged at the
beginning and at the end.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

22. If a company that had a fixed-rate liability wanted to achieve a floating-rate cost of funds through
a swap, it would pay a:

A. fixed rate to the counterparty and receive a floating rate in return from the counterparty.
B. floating rate to the counterparty and pay a floating rate to the fixed-rate lender.
C. floating rate to the counterparty and pay a fixed rate to the fixed-rate lender.
D. floating rate to the counterparty and receive a fixed rate in return from the counterparty.
Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

23. If a company that had a floating-rate liability wanted to enter into a swap to achieve a fixed-rate cost
of funds, it would pay a:

A. fixed rate to the counterparty and receive a floating rate in return from the counterparty.
B. floating rate to the counterparty and pay a floating rate to the fixed-rate lender.
C. floating rate to the counterparty and pay a fixed-rate to the fixed-rate lender.
D. floating rate to the counterparty and receive a fixed-rate in return from the counterparty.
Difficulty: Hard
Est time: <1 minute

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 Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

24. In an interest rate swap, gains/gain when the three-month BBSW rises.

A. the floating-rate payer

B. the fixed-rate payer
C. both floating- and fixed-rate payers
D. neither floating- nor fixed-rate payers
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

25. In an interest rate swap gains/gain when the three-month BBSW falls.

A. the floating-rate payer

B. the fixed-rate payer
C. both floating- and fixed-rate payers
D. neither floating- nor fixed-rate payers
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

26. If a company with a fixed-rate debt of 11% enters into a swap and pays floating-rate debt of 8%
and receives fixed-rate payments of 9%, its net cost of debt becomes:

A. 9%
B. 10%
C. 11%
D. 12%
Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate
swap. Section: 21.2 Rationale for the existence of interest
rate swaps

27. If a company with a fixed-rate debt of 11% enters into a swap and pays floating-rate debt
of BBSW+1.20% and receives fixed-rate payments of 9%, its net cost of debt becomes:

A. 11%
B. BBSW+0.20%
C. BBSW+2.20%
D. 12%
Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.

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 Section: 21.2 Rationale for the existence of interest rate swaps

28. Which of the following statements regarding interest rate swaps is incorrect?

A. In contrast with a forward contract, the exact terms of exchange of an interest rate swap will
change with interest rates.
B. The two parties exchange net interest difference in an interest rate swap.
C. An interest rate swap is similar to a forward contract in that it guarantees the exchange of two
items of value at some future point in time.
D. The two parties in an interest rate swap generally have the same level of default risk.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

29. When a financial intermediary is involved as an interest rate swap counterparty, it often seeks to
arrange an offsetting swap called a:

A. counterparty swap.
B. simultaneous swap.
C. synchronised swap.
D. matched swap.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

30. These days, the majority of swaps require a/an to act as an intermediary.

A. commercial bank
B. investment bank
C. merchant bank
D. Any of the given choices
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

31. A key motive for companies and financial institutions to participate in an interest rate swap is:

A. the low information costs of swaps, compared with other financial derivatives.
B. to transfer interest-rate risk to parties more willing to bear it.
C. the greater liquidity of swaps, compared with other financial derivatives.
D. the favourable tax implications of swaps, compared with other financial derivatives.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

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32. Which of the following is NOT an advantage of having an interest rate swap market?

A. As it is generally liquid, it benefits both borrowers and lenders.

B. As most swaps involve banks, their credit departments can carry out credit assessments more
easily than potential lenders.
C. As the banks are involved in most swaps, banks require a spread between the two interest rates.
D. Swaps enable companies to carry out regulatory and tax arbitrage.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

33. Which of the following statements is NOT an advantage of a swap transaction?

A. It usually allows the company to achieve a lower cost of funds.

B. It is used to hedge both interest rate risk and foreign exchange risk.
C. It facilitates the restructuring of cash flows associated with existing borrowings.
D. It transfers the credit risk to the counterparty.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

34. Which of the following statements regarding interest rate swaps is incorrect?

A. The principal involved is called notional.

B. Parties involved borrow funds where they have a comparative advantage.
C. The two parties in the swap always share equally the cost of the spread that the
intermediary receives.
D. The financial intermediary involved often engages in an offsetting swap, known as a matched swap.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

35. Which of the following is a way to change the basic structure of a swap?

A. Vary the notional principal over the lifetime of the swap.

B. Change the timing of when the swap begins or ends.
C. Reverse the swap if market conditions change.
D. All of the given answers are correct.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

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36. An interest rate swap in which all the fixed payments are paid in one lump sum is called a/an:

A. amortised swap.
B. term swap.
C. zero-coupon swap.
D. none of the given choices.
Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

37. An interest rate swap in which the notional principal declines over time is called a/an:

A. amortised swap.
B. term swap.
C. zero-coupon swap.
D. none of the given choices.
Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

38. An interest rate swap that obligates traders to enter a swap at some date in the future, with terms
agreed today, is a:

A. term swap.
B. forward swap.
C. flexible swap.
D. long swap.
Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

39. In a swap arrangement, both parties may be able to receive more favourable funding rates than they
would have done without the swap, and the swap dealer receives a spread as well. Where does the
cost saving originate from?

A. The bank swap dealer effectively guarantees payments of all obligations.

B. The parties involved in the swap are able to borrow where each has a relative cost advantage.
C. The party paying floating cash flows always pays less than the party paying fixed cash flows.
D. With the bank always acting as a swap counterparty, each party is able to reduce the risk profile.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

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40. If one company has better access to fixed-term financing than another company, it may be said that
this company has a than the other company.

A. lower credit rating

B. comparative advantage
C. greater market share
D. higher credit risk
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

41. If two firms have the following cost of borrowing, what is the net differential for an interest rate
swap? Firm A: fixed rate 10.8% per annum; floating rate BBSW+0.3% per annum
Firm B: fixed rate 11.6% per annum; floating rate BBSW+1.7% per annum

A. 2.2%
B. 1.4%
C. 0.7%
D. 0.6%
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

42. An investment bank is to advise two client companies on the establishment of a mutually beneficial
swap facility. Both companies are able to access funding within the fixed interest rate debt markets
and the floating interest rate debt markets. However, company X has a comparative advantage over
company Y within one of the debt markets. Based on the following data, what is the comparative
advantage of company X?
Company X: fixed rate 10.8% per annum; floating rate BBSW+ .3% per annum
Company Y: fixed rate 11.5% per annum; floating rate BBSW+1.7% per annum

A. Fixed interest rate debt market, 0.7% per annum

B. Floating interest rate debt market, 1.4% per annum
C. Fixed interest rate debt market, 10.8% per annum
D. Floating interest rate debt market, BBSW + 0.3% per annum
Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-02 Understand the reasons why interest rate swap markets have become significant within the global financial markets.
Section: 21.2 Rationale for the existence of interest rate swaps

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43. Using the data below, calculate the fixed interest rate payable by company B in the swap transaction.

A. 11.075% per annum

B. 11.275% per annum
C. 11.325% per annum
D. 11.550% per annum
Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

44. Which of the following may be said to create a debt market environment, whereby one company
may obtain a comparative interest rate advantage over another company in the fixed interest rate
market, compared with the floating interest rate market?

A. The existence of market segmentation between the fixed and floating rate markets.
B. Typically, fixed-rate market risk premiums are based on external credit rating agency reports.
C. Professional institutional lenders, such as banks and merchant banks, apply their own internal
credit risk premiums.
D. All of the given answers.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-02 Understand the reasons why interest rate swap markets have become significant within the global financial markets.
Section: 21.2 Rationale for the existence of interest rate swaps

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45. Ossie Ltd is about to establish a new funding arrangement. It is able to borrow in either the fixed-rate
or floating-rate debt markets. The company wishes to lower its cost of borrowing by entering into a
swap transaction with Battler Ltd. Based on the following data for the two companies, in which interest
rate market will Ossie Ltd borrow, and swap into?

Ossie Ltd fixed rate 10.8% per annum; floating rate BBSW+0.3% per annum

Battler Ltd fixed rate 11.5% per annum; floating rate BBSW+1.7% per annum

A. Borrow at fixed interest rate; swap into floating rate

B. Borrow at floating interest rate; swap into fixed rate
C. Borrow at fixed interest rate; no advantage in swap transaction
D. Borrow at floating interest rate; no advantage in swap transaction
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

46. Bosie Ltd is about to establish a new funding arrangement. It is able to borrow in either the fixed-rate
or floating-rate debt markets. The company wishes to lower its cost of borrowing by entering into a
swap transaction with Matlock Ltd. Based on the following data for the two companies, in which
interest rate market will Matlock Ltd borrow, and swap into?

Bosie Ltd fixed rate 10.8% per annum; floating rate BBSW+0.3% per annum

Matlock Ltd fixed rate 11.5% per annum; floating rate BBSW+0.7% per annum

A. Borrow at fixed interest rate; swap into floating rate

B. Borrow at floating interest rate; swap into fixed rate
C. Borrow at fixed interest rate; no advantage in swap transaction
D. Borrow at floating interest rate; no advantage in swap transaction
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

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47. A bank has intermediated a matched swap facility with two client companies. Which of the
following statements best describes a matched swap?

A. The role of the bank is that of an agent in bringing the two companies together.
B. The notional principal amounts are exchanged and matched by currency and maturity.
C. The bank as intermediary effectively engineers separate offsetting contracts.
D. All of the given answers.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

48. An interest rate swap can effectively be hedged against interest rate risk by:

A. selling out to another party.

B. entering into another swap agreement that has the opposite transactions to the first swap.
C. setting floating-rate obligations equal to fixed-rate obligations.
D. matching durations of assets and liabilities.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-02 Understand the reasons why interest rate swap markets have become significant within the global financial markets.
Section: 21.2 Rationale for the existence of interest rate swaps

49. Which of the following is considered a factor on the supply side in the growth of the swaps market?

A. Interest rate swaps provide a linkage between segmented markets.

B. Interest rate swaps can minimise the costs of regulation and tax laws.
C. The efficiency and technology of financial intermediaries in providing risk management.
D. All of the given answers.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-02 Understand the reasons why interest rate swap markets have become significant within the global financial markets.
Section: 21.2 Rationale for the existence of interest rate swaps

50. Growth in the interest rate swaps market has occurred as a consequence of:

A. companies looking for ways to manage risk or lower total funding costs.
B. swaps creating a link between segmented markets.
C. swaps minimising the costs of regulation and tax laws.
D. all of the given answers.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-02 Understand the reasons why interest rate swap markets have become significant within the global financial markets.
Section: 21.2 Rationale for the existence of interest rate swaps

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51. For an ordinary interest rate swap already in place, if counterparty A's obligation for one year is
$100 000 and counterparty B's obligation is $120 000:

A. counterparty A will pay counterparty B $20 000

B. counterparty A will pay counterparty B $100 000
C. counterparty B will pay counterparty A $20 000
D. counterparty B will pay counterparty A $120 000
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-02 Understand the reasons why interest rate swap markets have become significant within the global financial markets.
Section: 21.2 Rationale for the existence of interest rate swaps

52. Consider the following five statements:

i. Swaps may be used to achieve a lower cost of funds for a company.
ii. In an interest rate swap, the two parties swap the principal amount plus the ongoing
associated interest obligations.
iii. An intermediated swap is said to be ‘matched' when a bank enters into swaps with both
firms involved in an interest rate swap.
iv. A ‘plain vanilla' swap is the fixed AUD to floating AUD swap.
v. If an intermediary is involved in a swap between two parties, the intermediary will also provide
the initial loan to both parties.
How many of these statements are true and how many are false?

A. 3 statements are true and 2 are false

B. 2 statements are true and 3 are false
C. 4 statements are true and 1 is false
D. 1 statement is true and 4 are false
Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-02 Understand the reasons why interest rate swap markets have become significant within the global financial markets.
Section: 21.2 Rationale for the existence of interest rate swaps

53. Consider the following five statements:

i. Swaps may be used to achieve a lower cost of funds for a company.
ii. In an interest rate swap, the two parties swap the principal amount plus the ongoing
associated interest obligations.
iii. An intermediated swap is said to be ‘matched' when a bank enters into swaps with both
firms involved in an interest rate swap
iv. A ‘plain vanilla' swap is the fixed AUD to floating AUD swap.
v. If an intermediary is involved in a swap between two parties, the intermediary will also provide
the initial loan to both parties.
Which of the following are correct?

A. i, ii, iii and iv are true

B. ii, iii, iv and v are true
C. ii, and iv are true
D. i and iii are true
Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-02 Understand the reasons why interest rate swap markets have become significant within the global financial markets.

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 Section: 21.2 Rationale for the existence of interest rate swaps

54. Interest rate swap transactions may be used by a multinational corporation as part of a funding
strategy to:

A. lower the cost of borrowing, using a comparative advantage in a particular debt market.
B. spread debt issues across a range of currencies.
C. diversify funding sources across a range of debt markets.
D. all of the given answers.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-02 Understand the reasons why interest rate swap markets have become significant within the global financial markets.
Section: 21.2 Rationale for the existence of interest rate swaps

55. A company is concerned that the cost of its long-term debt facilities is based on a fixed interest rate
that is considerably above current market rates, and that rates will continue to fall. The company
decides to use a swap to manage its risk exposure. using the data provided below, which of the
following statements is incorrect?
Data:
Existing debt fixed interest rate: 13.50% per annum
Current long-term fixed swap rate: 11.75% per annum
Current long-term floating swap rate: BBSW+0.50% per annum

A. The company has created a synthetic fixed rate liability.

B. Short-term interest rates are expected to remain below the existing fixed cost of debt.
C. The effective cost of borrowing is lower, as long as BBSW averages less than 11.25% per annum.
D. This strategy assumes a ‘normal' yield curve, on average, over the life of the swap.
Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-02 Understand the reasons why interest rate swap markets have become significant within the global financial markets.
Section: 21.2 Rationale for the existence of interest rate swaps

56. If the exchange rate alters during the lifetime of a cross-currency swap, this:

A. has no impact as all FX risk has been eliminated.

B. will impact only on the interest payments during the swap's lifetime.
C. will impact only when the principal amounts are re-exchanged at maturity.
D. will impact on both interest payments and principal repayments.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-03 Examine the structure of a cross-currency swap and show the circumstances under which cross-currency swaps may be arranged. Structure
and calculate a cross-currency swap.
Section: 21.3 Cross-currency swaps

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57. As a foreign exchange hedge, cross-currency swaps have all of the following features, except:

A. each party pays the other's interest payment.

B. principal amounts are reversed at a pre-specified rate at maturity.
C. an initial exchange of the two principal amounts by the two parties in the two different currencies.
D. principal amounts are reversed at the spot rate at maturity.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-03 Examine the structure of a cross-currency swap and show the circumstances under which cross-currency swaps may be arranged. Structure
and calculate a cross-currency swap.
Section: 21.3 Cross-currency swaps

58. Which of the following statements regarding a cross-currency swap is incorrect?

A. There is an exchange of principal amounts between counterparties at the beginning and end of the
swap.
B. The re-exchange at the conclusion of a cross-currency swap usually takes place at the
initial exchange rate.
C. As the cross-currency swap is arranged through a bank, there is no credit risk.
D. Once the cross-currency swap rate is determined, cash flows are known with certainty.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-03 Examine the structure of a cross-currency swap and show the circumstances under which cross-currency swaps may be arranged. Structure
and calculate a cross-currency swap.
Section: 21.3 Cross-currency swaps

59. An Australian company has issued USD paper into the US debt markets. The company is
investigating the possibility of entering into a cross-currency swap. Which of the following generally
form the basic mechanics of a cross-currency swap?
i. Re-exchange of principal normally takes place at the same exchange rate as that used at the
commencement of the swap.
ii. At the conclusion of the swap, principal amounts are re-exchanged.
iii. Principal amounts, in the currency of debt, are exchanged at the start of the swap.
iv. Interest payment commitments are swapped.
v. Involves the exchange between two parties of debt denominated in one currency, for
debt denominated in another currency.

A. i, ii, iii, v
B. ii, iii, iv, v
C. i, ii, iii, iv, v
D. i, ii, iii, iv
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-03 Examine the structure of a cross-currency swap and show the circumstances under which cross-currency swaps may be arranged. Structure
and calculate a cross-currency swap.
Section: 21.3 Cross-currency swaps

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60. One of the key motives for a cross-currency swap is:

A. the need to evade the domestic country's regulations.

B. the need to obtain the actual use of the foreign currency.
C. to gain risk exposure.
D. to make money from interest rate differences between countries.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-03 Examine the structure of a cross-currency swap and show the circumstances under which cross-currency swaps may be arranged. Structure
and calculate a cross-currency swap.
Section: 21.3 Cross-currency swaps

61. Interest rate swaps and cross-currency swaps permit a counterparty to exchange a:

A. floating interest rate payment or currency value for a lower floating payment value over the term.
B. fixed interest rate position for a currency position over the contract term.
C. floating interest rate payment or currency value for a fixed payment value over the contract term.
D. fixed interest rate payment or currency value for a fixed value over the contract term.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-04 Explain the rationale for the existence of the cross-currency swap markets.
Section: 21.4 Rationale for the existence of currency swaps

62. The advantage of over-the-counter products such as swaps or forwards contracts, relative to
exchange- traded products such as options or futures, is:

A. standardisation.
B. regulation.
C. flexibility.
D. all of the given answers.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-04 Explain the rationale for the existence of the cross-currency swap markets.
Section: 21.4 Rationale for the existence of currency swaps

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63. Consider these five statements:
i. Swaps can be used to create a synthetic floating rate debt for a company's fixed rate debt.
ii. If an intermediary has arranged a matched swap, it has no net exposure to interest rate risk.
iii. A cross-currency swap differs from an interest rate swap in that, for a cross-currency swap,
the principals, as well as the agreed interest obligations, are swapped for the duration of the swap
agreement.
iv. With a cross-currency swap, the exchange rate used at the principal re-exchange date is based on
the current spot rate at that time.
v. If a bank acts as an intermediary in a swap and does not fund the swap parties' underlying
loan facilities, it has no obligation under the bank capital adequacy requirements.
How many of the statements are true and how many are false?

A. 3 statements are true and 2 are false

B. 2 statements are true and 3 are false
C. 4 statements are true and 1 is false
D. 1 statement is true and 4 are false
Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-04 Explain the rationale for the existence of the cross-currency swap markets.
Section: 21.4 Rationale for the existence of currency swaps

64. Consider these five statements:

i. Swaps can be used to create a synthetic floating rate debt for a company's fixed rate debt.
ii. If an intermediary has arranged a matched swap, it has no net exposure to interest rate risk.
iii. A cross-currency swap differs from an interest rate swap in that, for a cross-currency swap,
the principals, as well as the agreed interest obligations, are swapped for the duration of the swap
agreement.
iv. With a cross-currency swap, the exchange rate used at the principal re-exchange date is based on
the current spot rate at that time.
v. If a bank acts as an intermediary in a swap and does not fund the swap parties' underlying
loan facilities, it has no obligation under the bank capital adequacy requirements.
Which of the following are correct?

A. i, ii, iii and iv are true

B. ii, iii and iv are true
C. i, ii and iii are true
D. i, ii, iii and v are true
Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-04 Explain the rationale for the existence of the cross-currency swap markets.
Section: 21.4 Rationale for the existence of currency swaps

65. When a bond investor buys a credit default swap (CDS), they will:

A. pay a premium to the seller.

B. receive compensation from the protection seller if a default occurs.
C. retain their original bonds.
D. do all of the given answers.
Difficulty: Easy

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 Est time: <1
minute Learning Objective: 21-05 Introduce the concept and identify the parties to a credit
default swap.
Section: 21.5 Credit default swaps

66. Cash settlement for a credit default swap (CDS) means the:

A. protection buyer delivers the agreed notional value of the debt to the protection seller.
B. protection buyer transfers the specified debt to the protection seller.
C. protection seller pays a net cash amount to the protection buyer.
D. protection buyer delivers the face value of the debt to the protection seller.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-05 Introduce the concept and identify the parties to a credit default swap.
Section: 21.5 Credit default swaps

67. Which of the following regarding the role of a financial intermediary in an interest rate swap
is incorrect?

A. Most swaps involve a financial intermediary as counterparty.

B. The financial intermediary will most often seek to engage in an offsetting swap.
C. The intermediary makes its profit by maintaining a spread between the rates offered to the
two counterparties.
D. The financial intermediary, by establishing a matched swap, ends up with a positive net exposure
in the swap market.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contract.
Section: 21.6 Credit and settlements risk associated with swaps

68. Which of the following statements regarding interest rate swaps is incorrect?

A. The practice of marking-to market is carried out in the swaps market (similar to the futures market).
B. In contrast with a forward contract, the exact terms of exchange of a swap will change with
interest rates.
C. The swap market is similar to the futures market in that if the market moves against the contract,
a maintenance margin call is required.
D. The two parties in a swap generally have the same level of default risk.
Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contract.
Section: 21.6 Credit and settlements risk associated with swaps

69. During a swap, the risk of one party not forwarding its payment while the other party does fulfil
its payment obligation is called:

A. Herstatt risk.
B. swap risk.
C. settlement risk.
D. repayment risk.
Difficulty: Medium

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 Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap
contract.
Section: 21.6 Credit and settlements risk associated with swaps

70. In order to reduce interest rate swap risk exposures, a financial intermediary may:

A. practise marking-to market.

B. use margin calls.
C. ask for security collateral.
D. do all of the given answers.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contract.
Section: 21.6 Credit and settlements risk associated with swaps

71. If a party in a matched swap defaults, the financial intermediary faces:

A. credit risk.
B. default risk.
C. settlement risk.
D. default and settlement risk.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contract.
Section: 21.6 Credit and settlements risk associated with swaps

72. The risk owing to a timing difference in an interest rate swap transaction, when one party defaults on
a payment to another before the other realises it, is called:

A. basis risk.
B. mismatch risk.
C. settlement risk.
D. front-end risk.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contract.
Section: 21.6 Credit and settlements risk associated with swaps

73. When the normal relationship between fixed and floating interest rates alters in an interest rate
swap, this risk is called:

A. basis risk.
B. exchange risk.
C. mismatch risk.
D. front-end risk.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contract.
Section: 21.6 Credit and settlements risk associated with swaps

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74. Whereas in the mid-1980s swap spreads might have been 50 basis points, a/an basis-point
spread is more common today.

A. 80
B. 60
C. 30
D. 10
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contract.
Section: 21.6 Credit and settlements risk associated with swaps

75. All of the following are factors that directly affect swap pricing, except:

A. the availability of extra counterparties.

B. the credit risk of the swap counterparty.
C. the term structure of interest rates.
D. current government regulation.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contract.
Section: 21.6 Credit and settlements risk associated with swaps

76. In order to measure and manage interest rate swap risk exposures, a financial intermediary may:

A. practise marking-to market.

B. seek security collateral.
C. require a written performance guarantee from the counterparty's sponsor.
D. do all of the given answers.
Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contract.
Section: 21.6 Credit and settlements risk associated with swaps

77. If a company expects interest rates to increase, which of the following strategies should the
company consider?

A. A short interest rate call

B. A swap involving paying fixed rate and receiving floating rate
C. A short forward rate agreement
D. All of the given choices
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contract.
Section: 21.6 Credit and settlements risk associated with swaps

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78. While both the international and AUD swap markets have matured, growth may still be
expected. Which of the following factors is a determinant in the future growth of the swaps
markets?

A. Periodic nervousness from a lack of clear direction of interest rates

B. Speculative trading transactions to take advantage of future price movements
C. Development of new, sophisticated products to hedge interest rate and currency risk
D. All of the given choices
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contract.
Section: 21.6 Credit and settlements risk associated with swaps

79. Interest rate swaps and cross-currency swaps:

A. appear on the balance sheets of commercial banks as current assets.

B. appear on the balance sheets of commercial banks as current liabilities.
C. appear on the balance sheets of commercial banks as long-term liabilities.
D. do not appear on the balance sheet.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contract.
Section: 21.6 Credit and settlements risk associated with swaps

80. Interest rate swaps and cross-currency swaps:

A. appear on the balance sheets of commercial banks as current assets.

B. appear on the balance sheets of commercial banks as current liabilities.
C. appear on the balance sheets of commercial banks as long-term liabilities.
D. represent a contingent liability for an intermediary.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contract.
Section: 21.6 Credit and settlements risk associated with swaps

81. Because interest rate swaps are off-balance-sheet transactions for an intermediary, they:

A. only involve receiving deposits.

B. only involve lending funds.
C. are not involved in capital adequacy requirements.
D. are involved in capital adequacy requirements.
Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contract.
Section: 21.6 Credit and settlements risk associated with swaps

True / False Questions

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82. A financial contract that obligates one party to exchange a set of payments it owns for another set
of payments owned by another party is called a cross call option.

FALSE

The contract is called an interest rate swap.

Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: Introduction

83. An interest rate swap may be used by a company only able to borrow variable rate funds to
obtain favourable longer term funding from otherwise difficult to access long-term debt markets.

TRUE

A firm that is only able to obtain funds at a variable rate can do a swap and change the net interest rate
characteristic to a rate closer to that of fixed-rate funding.

Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

84. An interest rate swap that involves two parties entering into agreements where floating for
floating interest rate payments is called a money market swap.

FALSE

This type of swap is known as a basis swap.

Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

85. A rise in LIBOR will benefit the fixed-rate borrowing party in an interest-rate swap contract.

TRUE

The fixed-rate party has locked in their borrowing interest rate.

Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

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86. When a company can borrow at a fixed rate of 8% per annum and a variable rate of LIBOR + 0.60%
per annum and another company can borrow at a fixed rate of 9% per annum and a variable rate of
LIBOR
+ 0.80 a profitable vanilla swap can be arranged between them so that both their borrowing obligations
can be lowered.

TRUE

The first company can borrow at the fixed interest rate where it has the greater advantage.

Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

87. For the majority of interest rate swaps, an intermediary is involved.

TRUE

The main type of interest rate swap is a vanilla swap through a financial intermediary.

Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

88. When a firm has borrowed floating rate from a bank but at the same time has entered into a fixed-
price contract to manufacture goods, a fixed rate to variable rate swap allows the firm to lock in its
profit margin on goods manufactured if interest rates rise.

FALSE

The firm needs a variable to fixed rate swap to fix its cost of funds.

Difficulty: Hard
Est time: <1 minute
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

89. When two parties do a cross-currency swap involving floating rate interest payments in one currency
and fixed interest rate payments denominated in another currency, the cash flows involved vary as
the exchange rate changes.

FALSE

All cash flows are calculated at an exchange rate fixed at the start of the cross-currency swap.

Difficulty: Medium
Est time: <1 minute
Learning Objective: 21-03 Examine the structure of a cross-currency swap and show the circumstances under which cross-currency swaps may be arranged. Structure
and calculate a cross-currency swap.
Section: 21.3 Cross-currency swaps

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90. With a cross-currency swap the exchange rate used at the principal re-exchange date at maturity is
based on the exchange rate at the beginning of the swap.

TRUE

Using the rate that prevailed at the start allows a company to know with certainty what its re-exchange
of principal amounts will be.

Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-03 Examine the structure of a cross-currency swap and show the circumstances under which cross-currency swaps may be arranged. Structure
and calculate a cross-currency swap.
Section: 21.3 Cross-currency swaps

91. A CDS protection buyer is a lender who seeks protection from credit risk associated with a
particular debt issue and is willing to pay a premium to the CDS protection seller.

TRUE

The CDS buyer is typically a financial institution that has provided a loan facility to a borrower.

Difficulty: Easy
Est time: <1 minute
Learning Objective: 21-03 Examine the structure of a cross-currency swap and show the circumstances under which cross-currency swaps may be arranged. Structure
and calculate a cross-currency swap.
Section: 21.3 Cross-currency swaps

Short Answer Questions

92. Discuss possible reasons why interest rate swap markets have formed and grown.

Originally swaps were between parties who wanted to change the nature of their cash flows such as
from paying a fixed rate to a floating rate on debt and also took advantage of parties' different
borrowing abilities in different markets. The growth of swaps is accounted for by their versatility from
the viewpoint of both borrowers and investors. Swaps may be used to hedge interest rate risk, FX risk
and credit risk associated with existing or expected transactions. By far the largest market is in the area
of interest rate swaps. For example, a company may fix its cost of funds for a project and hedge its
interest rate exposure.

Est time: 1-3 minutes

Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: Introduction

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93. Discuss the structure and cash-flows arrangement for the main type of interest rate swap.

The main type of interest rate swap is called a vanilla swap, for example when a company enters into a
swap with a financial intermediary by swapping fixed for floating payments. Initially the company has
set up a variable-rate loan and then enters into a swap contract with the bank. The hypothetical cash
flows are: the company will pay a fixed interest rate to the bank and receive a variable rate from the
bank as well as paying a variable interest rate to the borrowing facility. In practice, the net cash-flow
requirement is calculated and only that amount is paid.

Est time: 1-3 minutes

Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

94. Explain in the context of interest rate swaps what a matched swap is.

The majority of swaps involve a commercial bank, an investment bank or a merchant bank acting as an
intermediary. In an intermediated interest rate swap, the intermediary will seek to enter into an
offsetting swap, also known as a matched swap, where the bank will enter into swaps with both firm A
and firm B. The bank will act as counterparty to firm A in one intermediated swap and, separately, as
counterparty to firm B in another intermediated swap contract. By establishing a matched swap the
intermediary, in effect, has no net exposure in the market.

Est time: 1-3 minutes

Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate swap contracts within the
context of comparative advantage. Structure and calculate an interest rate swap.
Section: 21.1 Interest rate swaps

95. Discuss the use of interest rate swaps in hedging interest rate exposure.

The use of interest rate swaps may protect a company's borrowing costs. For example, a company has
an existing variable-rate loan and expects the variable rate to rise during the term of the loan. Through
a swap the company may pay a fixed rate to the swap counterparty and receive a variable-rate payment
from the counterparty. If the variable interest rate does rise, this means the payment to the variable rate
lender will increase but this would be offset by the increase in the variable-rate receipts from the swap
counterparty. The company's fixed-rate payment would remain the same.

Est time: 1-3 minutes

Learning Objective: 21-02 Understand the reasons why interest rate swap markets have become significant within the global financial
markets.
Section: 21.2 Rationale for the existence of interest rate swaps

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96. As of December 2010 the Bank for International Settlements (BIS) estimated the notional value of
currency swaps was USD16 347 billion. Discuss possible reasons for the growth in currency
swaps.

First, the reasons for swaps apply. These are to lower the cost of funds, to gain access to otherwise
inaccessible debt markets, to hedge interest rate risk exposures and to lock in profit margins on business
transactions. The use of cross-currency swaps allows hedging of FX risk exposures such as where
companies have issued debt instruments in a range of currencies. Parties to a cross-currency swap may
be able to establish a natural hedge by borrowing in one currency and swapping into a currency being
generated by its business operations.

Est time: 1-3 minutes

Learning Objective: 21-04 Explain the rationale for the existence of the cross-currency swap markets.
Section: 21.4 Rationale for the existence of currency swaps

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 Chapter 21 - Test Bank Summary

Category # of Qu
estions
Difficulty: Easy 39
Difficulty: Hard 16
Difficulty: Medium 36
Est time: <1 minute 91
Est time: 1-3 minutes 5
Learning Objective: 21-01 Describe the nature of a swap contract and explain the structure and operation of vanilla and basis interest rate s 54
wap contracts within the context of comparative advantage. Structure and calculate an interest rate swap.
Learning Objective: 21-02 Understand the reasons why interest rate swap markets have become significant within the global financial mark 12
ets.
Learning Objective: 21-03 Examine the structure of a cross-currency swap and show the circumstances under which cross-currency swaps 8
may be arranged. Structure and calculate a cross-currency swap.
Learning Objective: 21-04 Explain the rationale for the existence of the cross-currency swap markets. 5
Learning Objective: 21-05 Introduce the concept and identify the parties to a credit default swap. 2
Learning Objective: 21-06 Consider the credit and settlement risks associated with being an intermediary or counterparty to a swap contrac 15
t.
Section: 21.1 Interest rate swaps 42
Section: 21.2 Rationale for the existence of interest rate swaps 13
Section: 21.3 Cross-currency swaps 8
Section: 21.4 Rationale for the existence of currency swaps 5
Section: 21.5 Credit default swaps 2
Section: 21.6 Credit and settlements risk associated with swaps 15
Section: Introduction 11

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