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

CFA Level 1 - Derivative Investments Session 17 - Reading 72 Swap Markets and Contracts-LOS b (Notes, Practice Questions, Sample Questions) 1. Which of the following statements about a currency swap is CORRECT? A) Changes in exchange rates do not affect the swap payments. (Explanation: Swap payments are based on the notional amounts of each currency and either a fixed or floating rate for either or both parties. While changes in exchange rates might be reflected in interest rates, they have no direct effect on any of the payment amounts over the term of the swap) B) Payments are netted at each settlement date. C) If one party pays a fixed rate of interest, the other party must pay a floating rate. 2. Which of the following statements regarding a fixed-for-fixed currency swap of euros for British pounds is least accurate? A) One party makes certain payments in Euros. B) The notional principal amounts, adjusted for exchange rate changes, are exchanged at the termination of the swap. (Explanation: The original notional principal amounts are exchanged at contract termination; there is no adjustment to the amounts for the change in exchange rates over the life of the swap) C) The periodic payments are not netted, both payments are always made 3. An investor enters into a swap that requires the notional principal amounts be exchanged at the beginning and at the end of the swap contract. This is most likely a: A) plain-vanilla swap. B) fixed-for-fixed swap. C) currency swap. (Explanation: A currency swap requires that the notional amount of one currency be exchanged for the notional amount of the other currency at both the beginning and the end of the swap) 4. Consider a U.S. commercial bank that wishes to make a two-year, fixed-rate loan in Australia denominated in Australian dollars. The U.S. bank will fund the loan by issuing two-year CDs in the U.S. Why would the U.S. bank wish to enter into a currency swap? The bank faces the risk that: A) the Australian dollar increases in value against the U.S. dollar. B) interest rates in Australia decline. C) the Australian dollar decreases in value against the U.S. dollar. (Explanation: There is no interest rate risk for the bank because the bank has fixed rates for two years on both the asset and the liability. However, the bank faces a problem in that if the Australian dollar decreases in value, the loan (and the interest payments from the loan) will not translate back into as many U.S. dollars. Indeed, if the Australian dollar decreases significantly, the loan (and the interest payments from the loan) may not translate back into enough U.S. dollars to repay the CDs) 5. Consider a U.S. commercial bank that takes in one-year certificates of deposit (CDs) in its Hong Kong branch, denominated in Hong Kong dollars, to fund three-year, fixed-rate loans the bank is making in the U.S. denominated in U.S. dollars. Why would this bank wish to enter into a currency swap? The bank faces the risk that the Hong Kong dollar: A) decreases in value against the U.S. dollar and the risk that interest rates increase in Hong Kong. B) decreases in value against the U.S. dollar and the risk that interest rates decrease in Hong Kong. C) increases in value against the U.S. dollar and the risk that interest rates increase in Hong Kong. (Explanation: The bank faces two problems. First, if the Hong Kong dollar increases in value, it will take more U.S. dollars to repay the Hong Kong depositors. Indeed, if the Hong Kong dollar increases significantly, it may take more U.S. dollars to repay the Hong Kong depositors than the bank makes on the U.S. loan. Secondly, if the interest rate in Hong Kong rises, the bank pays more in interest on its CDs while the rate on the bank’s U.S. loans does not change. In this case, interest expense would rise and interest income would remain the same, which narrows the bank’s profits) 6. The term exchange of borrowings refers to: A) swaptions. B) currency swaps. (Explanation: In effect, in a currency swap, the two parties make independent borrowings and then exchange the proceeds. This is known as an exchange of borrowings. A swaption is an option on a swap that can be either American or European in form. (Swaptions are a Level II Topic)) C) interest rate swaps. 7. Why are payments NOT usually netted out in a currency swap? A) There are no payments in a currency swap except at initiation and maturity. B) The payments are denominated in two different currencies. (Explanation: Payments are not usually netted out because the payments are denominated in two different currencies, which does not easily allow for netting) C) There is no credit risk in a currency swap. 8. Consider a quarterly-pay currency swap where Party A pays London Interbank Offered Rate (LIBOR) on $1,000,000 and Party B pays 4% on 900,000 euros. Current LIBOR is 3% and at the end of 90 days it is 4%. Which of the following statements regarding the first settlement date is most accurate? A) Party A must make a payment of $10,000. B) Party A must make a payment of $7,500. (Explanation: Floating rate payments in a swap are based on the reference rate for the prior period. The payment is: 0.03 × 90/360 × 1,000,000 = $7,500) C) The payments made depend on the exchange rate. 9. Consider a currency swap in which Party A pays 180-day London Interbank Offered Rate on $1,000,000 and Party B pays the Japanese yen riskless rate on 130,000,000 yen. Which of the following statements regarding the terms required at the initiation of the swap is CORRECT? A) Party A must pay 130,000,000 yen and receive $1,000,000. (Explanation: Since Party A is paying in dollars, Party A must receive dollars in exchange for yen at the beginning of the swap) B) An exchange of principal amounts is not required at the initiation of the swap. C) Party A must pay $1,000,000 and receive 130,000,000 yen.