Session 17 - Reading 72 Swap Markets and Contracts - LOS a

CFA Level 1 - Derivative Investments Session 17 - Reading 72 Swap Markets and Contracts - LOS a (Notes, Practice Questions, Sample Questions) 1. Which of the following statements regarding plain-vanilla interest rate swaps is least accurate? A) In a swap contract, the counterparties usually swap the notional principal. B) The settlement dates are when the interest payments are to be made. C) The time frame covered by the swap is called the tenor of the swap. Explanation: The notional principal is generally not swapped, as it is usually the same for both parties in the swap deal 2. Determine the transactions involved with a plain vanilla interest rate swap and whether or not notional principal is generally swapped: Plain vanilla interest rate swap Notional principal A) pay fixed rate, pay fixed rate swapped B) pay fixed rate, pay floating rate swapped C) pay floating rate, pay fixed rate not swapped Explanation: The most common type of interest rate swap is called a plain vanilla interest rate swap. It involves trading fixed interest rate payments for floating-rate payments. Notional principal is generally not swapped in single currency swaps 3. Swap contracts typically: A) do not require a payment from either party at initiation. B) cover a single payment. C) are standardized contracts Explanation: Swaps typically do not require a payment from either party at initiation. The exception is currency swaps 4. Which of the following statements about swaps is least accurate? A) Swaps are illiquid. B) Swaps typically have zero value at initiation. C) Parties to swap contracts are often individual speculators Explanation: Parties to swaps contracts are usually large institutions, rarely individual speculators or hedgers 5. Consider a U.S. commercial bank that borrows funds in England for one year denominated in English pounds. Why would the investor wish to enter into a swap contract? As the: A) English pound decreases in value, it takes more U.S. dollars to pay off the English liability. B) English pound increases in value, it takes more U.S. dollars to pay off the English liability. C) U.S. interest rate increases, the value of the English liability increases Explanation: As the English pound increases in value, it takes more U.S. dollars to pay off the English liability, which increases the interest cost of borrowing funds denominated in English pounds 6. Which of the following is a reason to use the swaps market rather than the futures market? To: A) reduce the credit risk involved with the contract. B) maintain the firm's privacy. C) increase the liquidity of the contract Explanation: The futures market, because of the use of a standardized contract, is more liquid; and, because the exchange guarantees the contract, futures contracts have less credit risk. However, swaps contracts, because they are over-the-counter (private) contracts, allow the firm to maintain privacy 7. Which of the following is an advantage of the swaps market over the futures markets? The: A) credit risk of the contract. B) liquidity of the contract. C) ability to hedge over long time horizons. Explanation: The futures market uses a standardized contract, which increases the liquidity of the contract. Also, futures exchanges assume the credit risk. However, as the time horizon increases, the liquidity of futures contracts decreases substantially. Therefore, swaps are considered a better method of hedging over long time horizons 8. Which of the following is NOT a likely motivation today for entering into a swap agreement? A) Maintain privacy. B) Avoid costly regulation. C) Exploit perceived market inefficiencies Explanation: During the 1980s, some parties entered the swap market in an effort to exploit perceived market inefficiencies. Today, the uses of the swaps market are not motivated by perceived informational inefficiencies 9. The motivation for swap agreements would be: A) the reduction of transactions costs. B) guaranteed performance on the contracts for all parties. C) the reduction of business risk Explanation: Historically, there were two basic motivations for swaps: to exploit perceived market inefficiencies and to attempt to obtain cheaper financing. Both of these motivations are based on the concept that the financial markets are inefficient. This fact, unfortunately, is no longer true. Today, the swap markets are mature and offer few arbitrage opportunities. Swap markets are now viewed as being more operationally efficient and a more flexible means of packaging and transforming cash flows than any other method. The reasons given now for using the swap markets are to: reduce transactions costs, avoid costly regulations, and maintain privacy 10. Which of the following choices is generally NOT part of a plain-vanilla swap transaction? A) Tenor. B) Exchange of notional amount. C) Swap facilitator Explanation: Since the notional principal swapped is the same (and in the same currency) for both counterparties, there is no need to actually exchange cash. The counterparties are the pay-fixed and receive-fixed sides. A swap facilitator helps to bring the counterparties together and may be either an agent or a broker. The tenor of the swap is the time frame covered by the deal, or the time to maturity of the swap